Monday, May 21, 2018

Valuation Discounting - Part Two

Overview

In Part One last Thursday, I examined the basics of valuation discounting in the context of a family limited partnership (FLP). In Part Two today, I dig deeper on the I.R.C. §2036 issue, recent cases that have involved IRS challenges to valuation discounts under that Code section, and possible techniques for avoiding IRS challenges.

I.R.C. §2036 – The Basics

Historically, the most litigated issues involving valuation discounts surround I.R.C. §2036. Section 2036(a) specifies as follows:

(a) General rule. The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—

    (1) the possession or enjoyment of, or the right to the income from, the property, or

    (2) the right, either alone or in conjunction with any person, to designate the persons who shall
          possess or enjoy the property or the income therefrom.

(b) Voting rights

    (1) In general. For purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled shall be considered to be a retention of the enjoyment of transferred property.

Retained interest. As you can imagine, a big issue under I.R.C. §2036 is whether assets that are contributed to an FLP (or an LLC) are pulled back into the transferor’s estate at death without any discount without the application of any discount on account of the restrictions that apply to the decedent’s FLP interest. The basic argument of the IRS is that the assets should be included in the decedent’s estate due to an implied agreement of retained enjoyment, even where the decedent had transferred the assets before death. See, e.g., Estate of Harper v. Comr., T.C. Memo. 2002-121; Estate of Korby v. Comr., 471 F.3d 848 (8th Cir. 2006).

In the statutory language laid out above, the parenthetical language of subsection (a) is important. That’s the language that estate planners use to circumvent the application of I.R.C. §2036. The drafting of the FLP agreement and the associated planning and implementation of the entity should ensure that there are legitimate and significant non-tax reasons for the use of the FLP/LLC. That doesn’t mean that a tax reason creating the entity cannot be present, but there must be a major non-tax reason present also.

If the IRS denies a valuation discount in the context of an FLP/LLC and the taxpayer cannot rely on the parenthetical language, the focus then becomes whether there existed an implied agreement of retained enjoyment in the transferred assets. There aren’t many cases that taxpayer’s win where the taxpayer’s argument is outside of the parenthetical exception and is based on the lack of retained enjoyment in the transferred assets, but there are some. See, e.g., Estate of Mirowski v. Comr., T.C. Memo. 2008-74; Estate of Kelley v. Comr., T.C. Memo. 2005-235.

Designating possession or enjoyment. What about the retained right to designate the persons who will possess or enjoy the transferred property or its income? In other words, what about the potential problem of subsection (a)(2)? A basic issue with the application of this subsection is whether the taxpayer can be a general partner of the FLP (or manager of an LLC). There is some caselaw on this question, but those cases involve unique facts. In both cases, the court determined that I.R.C. §2036(a)(2) applied to cause inclusion of the transferred property in the decedent’s gross estate. See, e.g., Estate of Strangi v. Comr., T.C. Memo. 2003-145, aff’d., 417 F.3d 468 (5th Cir. 2005); Estate of Turner v. Comr., T.C. Memo. 2011-209. In an earlier case in 1982, the Tax Court determined that co-trustee status does not trigger inclusion under (a)(2) if there are clearly identifiable limits on distributions. Estate of Cohen v. Comr., 79 T.C. 1015 (1982). That Tax Court opinion has generally led to the conclusion that (a)(2) also does not apply to investment powers.

While the Strangi litigation indicates that (a)(2) can apply if the decedent is a co-general partner or co-manager, the IRS appears to focus almost solely on situations where the decedent was a sole general partner or manager. The presence of a co-partner or co-manager is similar to a co-trustee situation and also can help build the argument that the entity was created with a significant non-tax reason.

Succession planning. From a succession planning perspective, it may be best for one parent to be the transferor of the limited partnership interests and the other to be the general partner. For example, both parents could make contributions to the partnership in the necessary amounts so that one parent receives a 1 percent general partnership interest and the other parent receives the 99 percent limited partnership interest. The parent holding the limited partnership interest then could make gifts of the limited partnership interests to the children (or their trusts). The other parent is able to retain control of the “family assets” while the parent holding the limited partnership interest is the transferor of the interests. Unlike IRC §672(e), which treats the grantor as holding the powers of the grantor’s spouse, IRC §2036 does not have a similar provision. Thus, if one spouse is able to retain control of the partnership and the other spouse is the transferor of the limited partnership interests, then IRC §2036 should not be applicable.

I.R.C. §2703 and Indirect Gifts

The IRS may also take an audit position against an FLP/LLC that certain built-in restrictions in partnership agreements should be ignored for tax purposes. This argument invokes I.R.C. §2703. That Code section reads as follows:

(a) General rule. For purposes of this subtitle, the value of any property shall be determined without regard to—

    (1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or

    (2) any restriction on the right to sell or use such property.

(b) Exceptions. Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:

    (1) It is a bona fide business arrangement.

    (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.

    (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.

In both Holman v. Comr., 601 F.3d 763 (8th Cir. 2010) and Fisher v. United States, 1:08-cv-0908-LJM-TAB, 2010 U.S. Dist. LEXIS 91423 (S.D. Ind. Sept. 1, 2010), the IRS claimed that restrictions in a partnership agreement should be ignored in accordance with I.R.C. §2703. In Holman, the restrictions were not a bona fide business arrangement and were disregarded in valuing the gifts at issue. In Fisher, transfer restrictions were likewise ignored.

Recent Cases

Several valuation discounting cases have been decided recently that provide further instruction on the pitfalls to avoid in creating an FLP/LLC to derive valuation discounts. Conversely, the cases also provide further detail on the proper roadmap to follow when trying to create valuation discounts via entities.

    • Estate of Purdue v. Comr., T.C. Memo. 2015-249. In this case, the decedent and her husband transferred marketable securities, an interest in a building and other assets to an LLC. The decedent also made gifts annually to a Crummey-type trust from 2002 until death in 2007. Post-death, the beneficiaries made a loan to the decedent’s estate to pay the estate taxes. The estate deducted the interest payments as an administration expense. The court concluded that I.R.C. §2036 did not apply because the transfers to the LLC were bona fide and for full consideration. There was also a significant, non-tax reason present for forming the LLC and there was no commingling of the decedent’s personal assets with those of the LLC. In addition, both the decedent and her husband were in good health at that time the LLC was formed and the assets were transferred to it.

    • Estate of Holliday v. Comr., T.C. Memo. 2016-51. The decedent’s predeceased husband established trusts and a family limited partnership (FLP). The FLP agreement stated that, “To the extent that the General Partner determines that the Partnership has sufficient funds in excess of its current operating needs to make distributions to the Partners, periodic distributions of Distributable Cash shall be made to the partners on a regular basis according to their respective Partnership Interests.” The decedent, who was living in a nursing home at the time the FLP was formed, contributed approximately $6 million of marketable securities to the FLP and held a 99.9 percent limited partner interest. Before death, the decedent received one check from the FLP (a pro-rata distribution of $35,000). At trial, the General Partner testified that he believed that the FLP language was merely boilerplate and that distributions weren’t made because “no one needed a distribution.” The court viewed the FLP language and the General Partner’s testimony as indicating that the decedent retained an implied right to the possession or enjoyment of the right to income from the property she had transferred to the FLP. The decedent also retained a large amount of valuable assets personally, thus defeating the General Partners’ arguments that distributions were not made to prevent theft and caregiver abuse. The court also noted that the FLP was not necessary for the stated purposes to protect the surviving spouse from others and for centralized management because trusts would have accomplished the same result. The decedent was also not involved in the decision whether to form an FLP or some other structure, indicating that she didn’t really express any desire to insure family assets remained in the family. The court also noted that there was no meaningful bargaining involved in establishing the FLP, with the family simply acquiescing to what the attorney suggested. The FLP also ignored the FLP agreement – no books and records were maintained, and no formal meetings were maintained.

Accordingly, the court determined that there was no non-tax purpose for the formation of the FLP, there was no bona fide sale of assets to the FLP and the decedent had retained an implied right to income from the FLP assets for life under I.R.C. §2036(c) causing inclusion of the FLP assets in the decedent’s estate.

    • Estate of Beyer v. Comr., T.C. Memo. 2016-183. In this case, the decedent was in his upper 90s at the time of his death. He had never married and had no children, but he did have four sisters. The decedent had been the CFA of Abbott Lab and had acquired stock options from the company, starting exercising them in 1962 and had accumulated a great deal of Abbott stock. He formed a trust in 1999 and put 800,000 shares of Abbott stock into the trust. He amended the trust in 2001 and again in 2002. Ultimately, the decedent created another trust, and irrevocable trust, and it eventually ended up owning a limited partnership. Within three years of his death, the decedent made substantial gifts to family members from his living trust. Significant gifts were also made to the partnership.

The IRS claimed that the value of the assets that the decedent transferred via the trust were includable in the value of his gross estate under I.R.C. §2036(a). The estate claimed that the transfers to the partnership were designed to keep the Abbott stock in a block and keep his investment portfolio intact, and wanted to transition a family member into managing his assets. The IRS claimed that the sole purpose of the transfers to the partnership were to generate transfer tax savings. The partnership agreement contained a list of the purposes the decedent wanted to accomplish by forming the partnership. None of the decedent’s stated reasons for the transfers were in the list.

The court determined that the facts did not support the decedent’s claims and the transfers were properly included in his estate. The decedent also continued to use assets that he transferred to the partnership and did not retain sufficient assets outside of the partnership to pay his anticipated financial obligations. On the valuation issue, the court disallowed valuation discounts because the partnership held assets in a restricted management account where distributions of principal were prohibited.

Conclusion

As the cases point out, valuation discounts can be achieved even if asset management is consolidated. Also, it is important that the decedent/transferor is not financially dependent on distributions from the FLP/LLC, retains substantial assets outside of the entity to pay living expenses, does not commingle personal and entity funds, is in good health at the time of the transfers, and the entity follows all formalities of the entity structure. For gifted interests, it is important that the donees receive income from the interests. Their rights cannot be overly restricted. See, e.g., Estate of Wimmer v. Comr., T.C. Memo. 2012-157.

Appropriate drafting and planning are critical to preserve valuation discounts. Now that the onerous valuation regulations have been removed, they are planning opportunities. But, care must be taken.

May 21, 2018 in Business Planning, Estate Planning | Permalink | Comments (0)

Thursday, May 17, 2018

Valuation Discounting

Overview

In 2016, the IRS issued new I.R.C. §2704 proposed regulations that could have seriously impacted the ability to generate valuation discounts associated with the transfer of family-owned entities. The effective date of the proposed regulation reached back to include valuations associated with any lapse of any right created on or after October 8, 1990 occurring on or after the date the proposed regulation was published in the Federal Register as a final regulation. This would have made it nearly impossible to avoid the application of the final regulation by various estate planning techniques.

With the election of President Trump and his subsequent instruction to federal agencies to eliminate unnecessary regulation, the Treasury announced the withdrawal of the I.R.C. §2704 proposed regulations in 2017. That means that valuation discounting as a planning tool is now back in the planner’s toolbox.

Today’s post is part one in a two-part series on valuation discounting in the context of a family limited partnership (FLP) and how the concept can be used properly, as well as the potential pitfalls. Today I look at the basics of valuation discounts and their use in the FLP context. In part two next week, I will examine some recent cases where the IRS has challenged the use of discounting and discuss what can be learned from the cases to properly structure FLPs and obtain valuation discounts.

Valuation Discounting – Interests in Family Limited Partnerships

While discounting can apply to interests in corporations, one of the most common vehicles for discounting is the family limited partnership (FLP). The principal objective of an FLP is to carry on a closely-held business where management and control are important. FLPs have non-tax advantages, but a significant tax advantage is the transfer of present value as well as future appreciation with reduced transfer tax. See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235. Discounts from fair market value in the range of 30-45 percent (combined) are common for minority interests and lack of marketability in closely-held entities. See Estate of Watts, T.C. Memo. 1985-595

Commonly in many family businesses, the parents contribute most of the partnership assets in exchange for general and limited partnership interests. The nature of the partnership interest and whether the transfer creates an assignee interest (an interest where giving the holder the right to income from the interest, but not ownership of the interest) with the assignee becoming a partner only upon the consent of the other partners, as well as state law and provisions in the partnership agreement that restrict liquidation and transfer of the partnership interest can result in discounts from the underlying partnership asset value.

In a typical scenario, the parents that own a family business establish an FLP with the interest of the general partnership totaling 10% of the company's value and the limited partnership's interest totaling 90%. Each year, both parents give each child limited-partnership shares with a market value not to exceed the gift tax annual exclusion amount. In this way, the parents progressively transfer business ownership to their children consistent with the present interest annual exclusion for gift tax purposes, and significantly lessen or eliminate estate taxes at death. Even if the limited partners (children) together own 99% of the company, the general partner (parents) will retain all control and the general partner is the only partnership interest with unlimited liability.

IRS has successfully limited or eliminated valuation discounts upon a finding of certain factors, such as formation shortly before death where the sole purpose for formation was to avoid estate tax or depress asset values with nothing of substance changed as a result of the formation. But, while an FLP formed without a business purpose may be ignored for income tax purposes, lack of business purpose should not prevent an FLP from being given effect for transfer tax purposes, thereby producing valuation discounts if it is formed in accordance with state law and the entity structure is respected.
Also, when an interest in a corporation or partnership is transferred to a family member, and the transferor and family members hold, immediately before the transfer, control of the entity any applicable restrictions (such as a restriction on liquidating the entity that the transferor and family members can collectively remove) are disregarded in valuing the transferred interest.

While the technical aspects of the various tax code provisions governing discounts are important and must be satisfied, the more basic planning aspects that establish the tax benefits of an FLP must not be overlooked:

• The parties must follow all requirements set forth in state law and the partnership agreement in all actions taken with respect to the partnership;

• The general partner must retain only those rights and powers normally associated with a general partnership interest under state law (no extraordinary powers);

• The partnership must hold only business or investment assets, and not assets for the personal use of the general partner, and;

• The general partner must report all partnership actions to the limited partners; and

• The limited partners must act to assure that the general partners do not exercise broader authorities over partnership affairs than those granted under state law and the partnership agreement.

FLPs and the IRC §2036 Problem

Clearly, the most litigated issue involving valuation discounting in the context of an FLP is whether assets contributed to an FLP/LLC should be included in the estate under §2036 (without a discount regarding restrictions applicable to the limited partnership interest). I.R.C. § 2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. However, an exception to the inclusion rules exists for transfers made pursuant to a bona fide sale for an adequate and full consideration in money or money’s worth.

Conclusion

About 40 cases have been decided at the appellate level involving I.R.C. §2036. Many of these have involved taxpayer losses. Part two next week will look at some of the most instructive cases involving I.R.C. §2036 and what planning pointers can be gleaned from those court decisions.

May 17, 2018 in Business Planning | Permalink | Comments (0)

Tuesday, May 15, 2018

Converting a C Corporation To An S Corporation – The Problem of Passive Income

Overview

Many farm and ranch clients (and others) are asking about the appropriate entity structure for 2018 and going forward in light of the Tax Cuts and Jobs Act (TCJA). Some may be enticed to create a C corporation to get the 21 percent flat tax rate. Other, conversely, may think that a pass-through structure that can get a 20 percent qualified business income deduction is the way to go.

But, what is the correct approach? While the answer to that question depends on the particular facts of a given situation, if an existing C corporation elects S-corporate status, passive income can be a problem. The conversion from C to S may be desirable, for example, if corporate income is in the $50,000-$70,000 range. Under the TCJA, a C corporate income in that range would be taxed at 21 percent. Under prior law it would have been taxed at a lower rate – 15 percent on the first $50,000 of corporate taxable income.

Today’s post takes a look at a problem for S corporations that used to be C corporations – passive income.

S Corporation Passive Income

While S corporations are not subject to the accumulated earnings tax or the personal holding company tax (“penalty” taxes that are in addition to the regular corporate tax) as are C corporations, S corporations that have earnings and profits from prior C corporate years are subject to certain limits on passive investment income. I.R.C. §1362. Under I.R.C. §1375, a 21 percent tax is imposed on "excess net" passive income in the meantime if the corporation has C corporate earnings and profits at the end of the taxable year and greater than 25 percent of its gross receipts are from passive sources of income. For farm and ranch businesses, a major possible source of passive income is cash rent.

If passive income exceeds the 25% limit for three years, the S election is automatically terminated, and the corporation reverts to C status immediately at the end of that third taxable year. I.R.C. §1362(d)(3).

How Can Passive Income Be Avoided?

There may be several strategies that can be utilized to avoid passive income exceeding the 25 percent threshold. Here are some of the more common strategies:

Pre-paying expenses. The S corporation can avoid reporting any excess net passive income if the corporation is able to prepay sufficient expenses to offset all passive investment income and/or create negative net passive income.

Distribution of earnings and profits.  In addition, another method for avoiding passive income issues is for the corporation to distribute all accumulated C corporate earnings and profits to shareholders before the end of the first S corporate year-end. I.R.C. §1375(a)(1). However, corporate shareholders will always have to deal with the problem of income tax liability that will be incurred upon the distribution of C corporate earnings and profits unless the corporation is liquidated. Generally, distributions of C corporate earnings and profits should occur when income taxation to the shareholders can be minimized. Consideration should be given to the effect that the distribution of earnings and profits will have upon the taxability of social security benefits for older shareholders. In order to make a distribution of accumulated C corporation earnings and profits, an S corporation within accumulated adjustments account (AAA) can, with the consent of all shareholders, treat distributions for any year is coming first from the subchapter C earnings and profits instead of the AAA. I.R.C. §1368(e)(3).

Deemed dividend election.  If the corporation did not have sufficient cash to pay out the entire accumulated C corporation earnings and profits, the corporation may make a deemed dividend election (with the consent of all of the shareholders) under Treas. Reg. §1.1368-1(f)(3). Under this election, the corporation can be treated as having distributed all or part of its accumulated C corporate earnings and profits to the shareholders as of the last day of its taxable year. The shareholders, in turn, are deemed to have contributed the amount back to the corporation in a manner that increases stock basis. With the increased stock basis, the shareholders will be able to extract these proceeds in future years without additional taxation, as S corporate cash flow permits.

The election for a deemed dividend is made by attaching an election statement to the S corporation's timely filed original or amended Form 1120S. The election must state that the corporation is electing to make a deemed dividend under Treas. Reg. §1.1368-1(f)(3). Each shareholder who is deemed to receive a distribution during the tax year must consent to the election. Furthermore, the election must include the amount of the deemed dividend that is distributed to each shareholder. Treas. Reg. §1.1368-1(f)(5).

It should be noted that S corporation distributions are normally taxed to the shareholders as ordinary income dividends to the extent of accumulated earnings and profits (AE&P) after the accumulated adjustments account (AAA) and previously taxed income (pre-1983 S corporation undistributed earnings) have been distributed. Deemed dividends issued proportionately to all shareholders are not subject to one-class-of-stock issues and do not require payments of principal or interest.

A 20 percent tax rate applies for qualified dividends if AGI is greater than $450,000 (MFJ), $400,000 (single), $425,000 (HOH) and $225,000 (MFS). In addition, the 3.8 percent Medicare surtax on net investment income (NIIT) applies to qualified dividends if AGI exceeds $250,000 (MFJ) and $200,000 (single/HoH). However, if accumulated C corporate earnings and profits can be distributed while minimizing shareholder tax rates (keeping total AGI below the net investment income tax (NIIT) thresholds and avoiding AMT) qualified dividend distributions may be a good strategy.

The deemed dividend election can be for all or part of earnings and profits. Furthermore, the deemed dividend election automatically constitutes an election to distribute earnings and profits first as discussed above. The corporation may therefore be able to distribute sufficient cash dividends to the shareholders for them to pay the tax and to treat the balance as the deemed dividend portion. This can make it more affordable to eliminate or significantly reduce the corporation’s earnings and profits.

Modification of rental arrangements. Rents do not constitute passive investment income if the S corporation provides significant services or incurs substantial costs in conjunction with rental activities. Whether significant services are performed or substantial costs are incurred is a facts and circumstances determination. Treas. Reg. §1.1362-2(c)(5)(ii)(B)(2). The significant services test can be met by entering into a lease format that requires significant management involvement by the corporate officers.

For farm C corporations that switch to S corporate status, consideration should be given to entering into a net crop share lease (while retaining significant management decision-making authority) upon making the S election, as an alternative to a cash rent lease or a 50/50 crop share lease. Some form of bonus bushel clause is usually added to a net crop share lease in case a bumper crop is experienced or high crop sale prices result within a particular crop year. Net crop leases in the Midwest, for example, normally provide the landlord with approximately 30-33 percent of the corn and 38-40 percent of the beans grown on the real estate.

Since crop share income is generally not considered "passive" (if the significant management involvement test can be met), a net crop share lease should allow the corporation to limit involvement in the farming operation and avoid passive investment income traps unless the corporation has significant passive investment income from other sources (interest, dividends, etc.) such that passive investment income still exceeds 25 percent of gross receipts.

Other strategies.  Gifts of stock to children or grandchildren could be considered so that dividends paid are taxed to those in lower tax brackets. However, tax benefits may be negated for children and grandchildren up to the age of 18–23 if they receive sufficient dividends to cause the "kiddie" tax rules to be invoked. In addition, a corporation may redeem a portion of the stock held by a deceased shareholder and treat such redemption as a capital gain redemption to the extent that the amount of the redemption does not exceed the sum of estate taxes, inheritance taxes and the amount of administration expenses of the estate. IRC §303. The capital gain reported is usually small or nonexistent due to step up in basis of a shareholder’s stock at date of death.

Conclusion

The TCJA may change the equation for the appropriate entity structure for a farm or ranch (or other business). If an existing C corporation elects S status, passive income may be an issue to watch out for.

May 15, 2018 in Business Planning, Income Tax | Permalink | Comments (0)

Friday, May 11, 2018

Ag Law and Tax Seminar Season

Overview

I just finished up a week on the road with seminars on various ag law and tax topics.  Next week is another one with a national tax webinar on Monday, and then an estate planning event for practitioners on Wednesday in Illinois and then the Iowa Bar Spring Tax Institute on Friday in Des Moines.  The following week finds me in Indianapolis for an all-day ag tax seminar.  This will be a busy year with discussions concerning the new tax law and it's impact on clients.  Many of the more significant events are posted on washburnlaw.edu/waltr.  There you will find a list of upcoming CPE events.

Summer Seminar in Pennsylvania

For numerous years, I have conducted a summer event or events in choice spots across the country.  They provide a great place for practitioners to attend and bring the family and get some high-quality ag tax and estate planning CPE.  This summer's event will be in Shippensburg, PA on June 7-8.  The Gettysburg National Military Park is nearby and the ag areas of Lancaster County are also not that far away.  Also within reasonable distance are Philadelphia and D.C.  It's a beautiful part of the country.

You can find information on the PA seminar at: http://washburnlaw.edu/farmandranchtax.   It's also webcast, so if you can't attend in person, you can still participate on line.  It will be interactive so that you can ask questions and here and see the audience and the speakers.   On-site seating is limited, so early registration is recommended.  

Conclusion

I hope to see you at an event this summer or fall.  Digging through the new tax law and then contemplating its application to client situations is a significant focus of these events.  Clients are asking questions and it would be nice if the IRS/Treasury would issue guidance sooner rather than later.  We shall see. 

May 11, 2018 | Permalink | Comments (0)

Wednesday, May 9, 2018

Purchase and Sale Allocations to CRP Contracts

In General

Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period.  Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications. 

But, what happens if the CRP land is sold even though several years remain on the contract?  This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production. 

The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post.

Consequences of Early Termination

When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived).  That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits.  When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction.  The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right.  If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment.  See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995).  That would be the case, for instance, when a lessee terminates a lease by buying the leased property.  I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest.  Thus, allocations to lease contracts by real estate purchasers of real estate are not effective.  The taxpayer must allocate the entire adjusted basis to the underlying capital asset. 

Sale Price Allocation To CRP Contract

The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt.  C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply.  The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835.  On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year.  On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer.  The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return.  The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit.  The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser.  The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date.  In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt.  See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).

The acquiring farmer may pay the early termination costs.  In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).

Early Termination Payments

Generally.  A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor.  Treas. Reg. §1.263(a)-4(d)(7).  The amortization period depends on the intended use of the property subject to the canceled lease.

If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term.  Rev. Rul. 71-283.   However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale.

As applied to CRP contracts.  A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated.  That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property.  However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract.  However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term.  Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981).  Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.

Conclusion

The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax.  It’s important to understand what might happen if early termination is a possibility.

May 9, 2018 in Income Tax, Real Property | Permalink | Comments (0)

Monday, May 7, 2018

Is There a Downside Risk to E-Filing Your Taxes?

Overview

The popularity of e-filing taxes has now increased to the extent that more than 90 percent of all individual income tax returns are filed electronically.  The vast majority of taxpayers that e-file find the process a simple and convenient way to file and, if a refund is due, a faster way to obtain it.  But, is there any downside to e-filing?  A recent federal case from California indicates that if a taxpayer isn’t diligent a big problem could arise.

The potential peril of e-filing – that’s the topic of today’s post.

California Case

In Spottiswood v. United States, No. 17-cv-00209-MEJ, 2018 U.S. Dist. LEXIS 69064 (N.D. Cal. Apr 24, 2018), the plaintiff electronically filed a joint return for the 2012 tax year via TurboTax software on April 12, 2013.  The return contained an erroneous Social Security number for a dependent. The same day, the IRS rejected the return because the Social Security number and last name did not match IRS records. Later that same day, TurboTax sent the plaintiff an email notifying him that the return had been rejected due to the mismatch of the name and Social Security number for the dependent.

The email notification of the rejected return is exactly how the system is supposed to work.  However, the plaintiff failed to check his email account and, hence, did not learn of the e-file status of the return until about 18 months later. Consequently, the IRS assessed late payment and late filing penalties.

The plaintiff filed the 2012 return on January 7, 2015 and paid the $395,619 tax liability in full. On February 16, 2015, the IRS assessed a late filing penalty of $89,014.27 and a late payment penalty of $41,539.99 plus interest of $26,216.81 on the late payment. The plaintiff paid the interest, but not the penalties. On April 27, 2015, the plaintiff submitted a statement to the IRS noting that had he realized that the return had not been accepted he could have paper filed the return on a timely basis. The plaintiff also conceded that he didn’t read the “fine print” of the tax software agreement that “may have” notified him that he needed to log back in to ensure that the return was accepted. The plaintiff, in August of 2016, filed a request via Form 843 for abatement of the penalties for late filing and late payment, and lied that the 2012 return had been electronically filed via TurboTax without issue. The plaintiff filed suit challenging the assessment of the penalties.

At trial, the plaintiff conceded the late payment penalty (and associated interest) but challenged the other penalties and interest assessed. The plaintiff claimed that the document filed should have been accepted as a “return” and should not have been rejected. The plaintiff claimed that the return met all of the requirements of Beard v. Comr., 82 T.C. 766 (1984) because it was sufficient to calculate the tax liability; purported to be a return; was an honest and reasonable attempt to satisfy the requirements of the tax law; and was executed under the penalty of perjury. The plaintiff also pointed out that the IRS would have accepted the return had it been paper-filed, citing the Internal Revenue Manual (IRM).

Unfortunately for the plaintiff, the trial court determined that the plaintiff had not properly established a foundation for the IRM, and did not create a triable issue of fact as to whether the same mistake on a paper-filed return would have been accepted by the IRS. Accordingly, the court held that the return, as filed, did not allow the IRS to compute the plaintiff’s tax liability (without providing any explanation of how a Social Security number mismatch had anything to do with computing tax liability) and granted the government’s motion for summary judgment. 

Conclusion

While e-filing a return can be a desirable method for filing a return it is imperative to ensure that the IRS has accepted the return.  Any type of communication that doesn’t involve direct, face-to-face communication has its drawbacks.  When a return is e-filed, it’s a must to make sure that the return has been accepted.  Diligently checking for an email verification is absolutely essential.  Not doing so could be quite costly.

May 7, 2018 in Income Tax | Permalink | Comments (1)

Thursday, May 3, 2018

Reasonable Foreseeability

Overview

Tort cases involve personal injuries or property damage.  Most tort cases are based in negligence which is a fault-based system.  That means that for a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained.  What are those links?  They are duty, breach, causation and damages.  The defendant must have owed the plaintiff a duty to act in a certain way; that duty was breached; and the breach of the duty caused the plaintiff’s damages.

Perhaps the trickiest of the links is the causation link.  The requirement that the breach of the duty owed to the plaintiff must be causally linked to the plaintiff’s damages is the last issue to resolve in many tort cases.  Tied to the concept of causality is reasonable foreseeability.  Was it or should it have been reasonably foreseeable to the defendant at the time the defendant did whatever it was that the defendant did, that the defendant’s conduct would result in harm to the plaintiff? 

Reasonable foreseeability - that’s the focus of today’s post.

The Basics

As noted above, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause).  For instance, in a Colorado case that was decided by the U.S. Court of Federal Claims, a farmer claimed personal injury caused by drinking water contaminated by U.S. Army operations.  The court not only questioned the existence of the farmer's personal injuries but held that the farmer failed to prove by a preponderance of the evidence (the legal standard applicable in a civil tort case) that his personal injuries and the cattle deaths were caused by the contaminated groundwater.  Land v. United States, 35 Fed. Cl. 345 (1996). 

Proximate cause can also be an issue (apart from negligence) with respect to coverage for an insured-against loss.  In a Nebraska case, the court dealt with the proximate cause issue in determining whether an insurance policy on livestock covered damages resulting from an infectious disease transmitted by a tornado.  The policy covered damage caused by windstorm, but not specifically cover damage caused by infectious disease.  The court held that the proximate cause of the damage to the hogs at issue was the windstorm – without the windstorm, the hogs would not have been infected by the disease.  Griess & Sons v. Farm Bureau Insurance Co., 247 Neb. 526, 528 N.W.2d 329 (1995).

The Palsgraf Case

Some things are reasonably foreseeable and other things are not; and an individual will be held liable for harm that is reasonably foreseeable or reasonably expected to result from the defendant's actions. For example, in one case a landowner was not liable for the death of a motorist that was stuck by a falling tree because eve thought the tree leaned over the road, there was no visible decay present and the landowner had no notice of a dangerous condition.  Wade v. Howard., 499 S.E.2d 652 (Ga. Ct. App. 1998).    This just reinforces the notion that there must be a causal connection - a causal linkage - between the defendant's action and the plaintiff's harm. On the other hand, a superseding cause is an intervening force that relieves an actor from liability for harm that the actor’s negligence was a substantial factor in producing.  Thus, negligence that is too remote from the subsequent injury bars liability.”

Foreseeability may also be an issue with respect to the plaintiff.  The famous case of Palsgraf v. Long Island Railroad Co., 248 N.Y. 339, 162 N.E. 99 (1928), is an example of an injury which was caused by an unbroken chain of events.  The plaintiff was standing on a platform of the defendant's railroad after buying a ticket to ride one of the defendant’s trains.  As the court described the facts: “[A] train stopped at the station, bound for another place.  Two men ran forward to catch it.  One of the men reached the platform of the car without mishap, though the train was already moving.  The other man, carrying a package, jumped aboard the car, but seemed unsteady as if about to fall.  A guard on the car, who had held the door open, reached forward to help him in, and another guard on the platform pushed him from behind.  In this act, the package was dislodged, and fell upon the rails.  It was a package of small size, about fifteen inches long, and was covered by a newspaper.  In fact it contained fireworks, but there was nothing in its appearance to give notice of its contents.  The fireworks when they fell exploded.  The shock of the explosion threw down some scales at the other end of the platform many feet away.  The scales struck the plaintiff, causing injuries for which she sues.”

Based on those facts, the court ruled that it was not foreseeable to a reasonable and prudent person that the actions which triggered the chain of events could ultimately cause injury to the plaintiff.  The railroad was not legally responsible for the plaintiff’s injuries.  For a modern version of Palsgraf, see Zokhrabov v. Park 963 N.E.2d 1035 (Ill. Ct. App. 2011).

Application to Agricultural Activities

It is possible that a negligent tort claim could be brought against a farmer that plants genetically modified (GM) crops if the crops cross-pollinate and contaminate a neighbor’s conventional crop.  For the neighbor to prevail in court, the neighbor would have to prove that the farmer had a duty to prevent contamination, that the duty was breached (e.g., failure to select seed properly, adhere to specified buffer zones, or follow growing and harvesting procedures), and that the breach of the duty caused the neighbor’s damages, which were a reasonably foreseeable result of the farmer’s conduct.  But is there a duty on the part of the farmer planting GM crops to prevent contamination when it is the convention crops that are the rarity?  I don’t know the answer to that one.  To date, no appellate-level court has rendered a published opinion in a negligence tort case involving genetically modified crops on that specific set of facts that I am aware of.

Conclusion

As noted above, the foreseeability of harm is generally a major factor that is considered in determining the existence of a duty.  However, the Restatement (Third) of Torts states that the foreseeability of physical injury to a third party is not to be considered in determining whether there exists a duty to exercise reasonable care.  That’s an interesting take, and at least one court has adopted the Restatement approach in holding that a landowner has a duty to exercise reasonable care to keep their premises in a manner that would not create hazards on adjoining roadways.  See, e.g.,  Thompson v. Kaczinski, et al., 774 N.W.2d 829 (Iowa 2009), vac’g, 760 N.W.2d 211 (Iowa Ct. App. 2008).  If that is the case, then there is a duty to maintain a premises.  That would be of particular importance to a rural landowner.

May 3, 2018 in Civil Liabilities | Permalink | Comments (0)

Tuesday, May 1, 2018

When Can I Shoot My Neighbor’s Dog?

Overview

Occasionally, farmers and ranchers are required to defend their livestock from harm caused by trespassing dogs.  Many states have adopted statutes that permit dogs to be killed if they are caught in the act of harming domesticated animals. However, it is critical to follow the specifics of the applicable state statute allowing the killing of trespassing dogs.  Failure to do so can result in a criminal charge of cruelty to animals.

Today’s post examines the issue of killing trespassing dogs. 

Sample State Statutes

Here’s a sample of state “dog-kill” statutes: 

Illinois (Illinois Comp. Stat. Ann. Chapter 510, Section 5, Subsection 18):  “Any owner seeing his or her livestock, poultry, or equidae being injured, wounded, or killed by a dog, not accompanied by or not under the supervision of its owner, may kill such dog.”

Indiana (Indiana Code §15-20-2-2):  “A person who observes a dog in the act of killing or injuring livestock may kill the dog if the person has the consent of the person in possession of the real estate on which the dog is found.”

Iowa (Iowa Code §351.26-.28):  “It shall be lawful for any person, and the duty of all peace officers within their respective jurisdictions unless such jurisdiction shall have otherwise provided for the seizure and impoundment of dogs, to kill any dog for which a rabies vaccination tag is required, when the dog is not wearing a collar with rabies vaccination tag attached. It shall be lawful for any person to kill a dog, wearing a collar with a rabies vaccination tag attached, when the dog is caught in the act of chasing, maiming, or killing any domestic animal or fowl, or when such dog is attacking or attempting to bite a person.  The owner of a dog shall be liable to an injured party for all damages done by the dog, when the dog is caught in the action of worrying, maiming, or killing a domestic animal.”

Kansas (Kansas Stat. Ann. §47-646):  “It shall be lawful for any person at any time to kill any dog which may be found injuring or attempting to injure any livestock as defined in K.S.A. 47-1001, and amendments thereto.”  The term “livestock” is defined in K.S.A. §47-1001 as meaning and including, “cattle, bison, swine, sheep, goats, horses, mules, domesticated deer, camelids, domestic poultry, domestic waterfowl, all creatures of the ratite family that are not indigenous to this state, including, but not limited to, ostriches, emus and rheas, and any other animal as deemed necessary by the [animal health commissioner of the department of agriculture] established through rules and regulations.”

Nebraska (Neb. Rev. Stat. §54-604):  “Any person [,firm or corporation] shall have the right to kill any dog found [killing, wounding, injuring, worrying, or chasing any person or persons or any sheep or other domestic animals belonging to such person, firm, or corporation] doing any damage …to any sheep or domestic animal, or if he shall have just and reasonable ground to believe that such dog has been killing, wounding, chasing or worrying such sheep or animal; and no action shall be maintained for such killing.”

Observations

As can be noted from the above-cited state statutes, they all require certain conditions to be satisfied before a trespassing dog can be killed without legal ramifications.  Essentially, the statutes require that the dog be “caught in the act” of doing some specified act to covered livestock.  The statutory definitions of the acts described are important, as is the definition of the livestock that are covered.  That makes it critical to preserve evidence showing that the statutory requirements have been met.  For example, in Grabenstein v. Sunsted, 237 Mont. 254, 772 P.2d 865 (1989), a farmer shot a neighbor’s dog that had broken into the farmer’s chicken coop and had killed all but one of the chickens when the farmer found him in the pen trying to kill that chicken and shot him.  The Court held that the farmer had a common law right to kill the dog in such a situation and that the later enactment of the dog-kill statute had not removed that right.  It was of no importance that the dog was of much more value at the time it was shot than was the sole remaining chicken.

Failure to maintain strict compliance with a particular state’s dog-kill statute could result in the person killing the dog being convicted of cruelty to animals.  Indeed, the Oregon cruelty to animal statute has been upheld against a constitutional challenge that it was vague and overbroad.  State v. Thomas, 63 P.3d 1242 (Or. Ct. App. 2003).  The court held that the Tenth Amendment does not prohibit the authority of states to regulate the conduct of its citizens.  As a result, the statute under which the defendant was charged with first degree animal abuse for shooting neighbor’s dog was constitutional as not prohibited by Tenth Amendment.  Also, in State v. Walter, 266 Mont. 429, 880 P.2d 1346 (1994), the Montana Supreme Court held that the defendant was properly found guilty by the trial court of the misdemeanor of cruelty to animals.  The court determined that there was sufficient evidence that the defendant did not shoot the dog while it was in the act of doing any of the statutorily enumerated things that would give the defendant the right to shoot the dog.  Also, in Propes v. Griffith, 25 S.W.3d 544 (Mo. Ct. App. 2000) the court held the defendant liable for actual and punitive damages for killing dogs that the defendant claimed were harming his sheep.  The court determined there was insufficient evidence presented that the dogs were “killing, wounding or chasing” the sheep as required by state law.

Most dog-kill statutes are only designed to protect livestock-type animals.  For example, dogs are not “livestock” for purposes of the typical state statute.  See, e.g., People v. Bugaiski, 224 Mich. App. 241, 568 N.W.2d 391 (1997).  In addition, deer are usually not defined as “livestock.”  Thus, there is no statutory protection for shooting a dog while in the act of attacking deer.  See, e.g., Bueckner v. Hamel, 886 S.W.2d 368 (Tex. App. 1994).  Similarly, the usually is no statutory protection under a “dog-kill” statute for the killing a dog while in the act of attacking a household pet, such as a kitten.  See, e.g., McKinney v. Robbins, 319 Ark. 596, 892 S.W.2d 502 (1995).

Conclusion

Trespassing dogs can be a big problem for farmers and ranchers.  When they are shot in the act of damaging livestock as defined by the applicable state statute, they can be shot without repercussion.  However, of course, the dog owner will likely not be happy and neighborly relationships can be damaged.  As always, its good to have a conversation with neighbors about dogs and livestock so that potential problems can be minimized.  For many farmers and ranchers, the “shoot, shovel and shut-up” approach may seem like the best and most practical approach.  But, it can lead to problems – both interpersonal and legal.

May 1, 2018 in Civil Liabilities | Permalink | Comments (0)

Friday, April 27, 2018

Post-Death Sale of Crops and Livestock

Overview

When a farmer sells an harvested crop, the tax rules surrounding the reporting of the income from the sale are fairly well understood.  But, what happens when a farmer dies during the growing season?  The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord.  If the decedent was a landlord, the type of lease matters. 

The tax rules involving the post-death sale of crops and livestock – that’s the focus of today’s post.

General Rule

For income tax  purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death.  I.R.C. §1014(a)(1).   But, there is an exception to this general rule.  Income in respect of decedent (IRD) property does not receive any step-up in basis.  I.R.C. §691.  IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.

In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.

  1. The decedent entered into a legal agreement regarding the subject matter of the sale.
  2. The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).
  3. No economically material contingencies that might have disrupted the sale existed at the time of death.
  4. The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.

The case involved the sale of calves by a decedent’s estate.  Two-thirds of the calves were deliverable on the date of the decedent’s death.  The other third were too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered.  The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death.  In addition, the estate’s activities with respect to the calves were substantial and essential.  The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied. 

Farmer or Landlord?

Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.

  1. Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters. 
  2. If the decedent was a farm landlord, was the decedent a materially participating landlord or a non-materially participating landlord?

For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366.  See also Estate of Burnett v. Comm’r, 2 TC 897 (1943).  The rule is the same if the decedent was a landlord under a material participation lease.  These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014.  No allocation  is made between the decedent’s estate and the decedent’s final income tax return.  Treas. Reg. §20.2031-1(b).

From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.

If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964).  That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death.  If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final return.  No prorations would have been required.  If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula. 

IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.

Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction.  Rev. Rul. 75-11, 1975-1 CB 27.

Character of Gain

Sale of grain.  Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes.   I.R.C. §§61(a)(2), 63(b). However, when a farmer dies and the estate sells grain inventory within six months after death, the income from the sale is treated as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule.  I.R.C. §1223(9).  However, ordinary income treatment occurs in the crop was raised on land that is leased to a tenant.  See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959). 

If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business.  Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.  

Conclusion

The sale of crops and livestock post-death are governed by specific tax rules.  Because death often occurs during a growing period, it’s important to know these unique rules.

April 27, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, April 25, 2018

Gifts of Ag Commodities To Children and the New Tax Law

Overview

Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous.  The commodity gifts can be used to shift income to minor children to take advantage of their lower tax rates.  Likewise, they could be used to assist with a child’s college costs or made to a child in return for the child support the donor-parents. 

How should commodity gift transactions be structured?  What are the tax consequences?  What is the impact of the Tax Cuts and Jobs Act (TCJA) on commodity gifts to children. 

Ag commodity gifts to children.  That’s the topic of today’s post.

Tax Consequences to the Donor. 

Avoid income and self-employment tax.  A donor does not recognize income upon a gift of unsold grain inventory.  Rev. Rul. 55-138, 1955-1 C.B. 223; Rev. Rul. 55-531, 1955-2 C.B. 520.   Instead, a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income.  Estate of Farrier v. Comr., 15 T.C. 277 (1950); SoRelle v. Comr., 22 T.C. 459 (1954); Romine v. Comr., 25 T.C. 859 (1956).  That means that the farmer, as the donor, sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, self-employment tax is also eliminated on the commodities.  That’s because excludable gross income is not considered in determining self-employment income.  Treas. Reg. 1.1402(a)-2(a).  This is particularly beneficial for donor-parents that have income under the Social Security wage base threshold.

Prior year’s crop.  The gifted commodities should have been raised or produced in a prior tax year.  If this is not the case, the IRS takes the position that a farmer is not 100 percent in the business of raising agricultural commodities for profit and will require that a pro rata share of the expenses of raising the gifted commodity will not be deductible on the farmer’s tax return.  According to the IRS, if a current year’s crop is gifted, the donor’s opening inventory must be reduced for any costs or undeducted expenses relating to the transferred property.  Rev. Rul. 55-138, 1955-1, C.B. 223.  That means that the donor cannot deduct current year costs applicable to the commodity.  See also Rev. Rul. 55-531, 1955-2 C.B. 522.  However, costs deducted on prior returns are allowed.  Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year).

Tax consequences to the Donee. 

The donor's tax basis in the commodity carries over to the donee.  I.R.C.  §1015(a).  Thus, in the case of raised commodities given in the year after harvest by a cash method producer, the donee receives the donor’s zero basis.  Conversely, an accrual method farmer will have an income tax basis in raised commodities.  If this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift.

Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity by the donee is treated as unearned income that is not subject to self-employment tax.  Even though the raised farm commodity was inventory in the hands of the farmer-donor, the asset will typically not have inventory status in the hands of the done.  That means the sale transaction is treated as the sale of a capital asset that is reported on Schedule D. 

The holding period of an asset in the hands of a donee refers back to the holding period of the donor.  I.R.C. §1223(2).   So, if the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss.

Gifts of Livestock? 

A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to self-employment tax.  To help avoid that result, physical segregation of the livestock at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees. See, e.g., Smith v. Comr., T.C. Memo. 1967-229; Alexander v. Comr., 194 F.2d 921 (5th Cir. 1952); Jones Livestock Feeding Co., T.C. Memo. 1967-57; Urbanovsky v. Comr., T.C. Memo. 1965-276.

Structuring the Transaction

Cash-method farm proprietors intending to gift raised commodities to a child or other non-charitable donee should structure the transaction in two distinct steps.  First, the donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee.  Second, the donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain.  The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity.   Make sure that the transaction is not a loan. 

“Kiddie Tax” Complications

Unearned income of a dependent child includes items such as interest, dividends and rents, as well as income recognized from the sale of raised grain received as a gift and not as compensation for services.  The “Kiddie Tax” has a small inflation-indexed exemption.  I.R.C. §1(g).  For dependent children who sell commodities received as a gift and are subject to the” Kiddie Tax,” a standard deduction offsets the first $1,000 of unearned income (2017 amount).  Then the next $1,000 of unearned income is subject to tax at the child’s single tax rate of 10 percent.  That means that the child’s unearned income in excess of $2,100 is taxed at the parents’ top tax rate.

The Kiddie Tax applies to a child who has not attained age 18 before the close of the year.  It also applies to a child who has not attained the age of 19 as of the close of the year or is at least age 19 and under 24 at the close of the year and is a full-time student at an educational organization during at least five months of the year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships). 

TCJA modification.  As noted above, under pre-TCJA law, the child who receives a commodity gift and then sells the commodity usually pays income taxes based on the parent’s tax rates (there is a smaller amount taxed at lower rates) on unearned income.  Earned income, such as wages, is always taxed at the child’s tax rates.  But, under the TCJA for tax years beginning after 2017, the child’s tax rates on unearned income are the same as the tax rates (and brackets) for estates and trusts.  That means that once the child’s unearned income reaches $12,500, the applicable tax rate is 37 percent on all unearned income above that amount.  This will make it much costlier for farm families to gift grain to their children or grandchildren and receive any tax savings.      

Conclusion

Gifting commodities to a family member can produce significant tax savings for the donor, and also provide assistance to the donee.  That was much more likely to be the result pre-2018.  The TCJA removes much of the tax benefit of commodity gifting to children.  In any event, however, the commodity gifting transactions must be structured properly to achieve the intended tax benefits. 

April 25, 2018 in Income Tax | Permalink | Comments (0)

Monday, April 23, 2018

Divorce and the New Tax Law – IRS Grants Some Relief

Overview

The Tax Cuts and Jobs Act (TCJA) constituted a major overhaul of the tax Code for both individuals and businesses.  In previous posts, I have examined some of those provisions.  In particular, I have taken a look at the new I.R.C. §199A and its impact on agricultural producers and cooperatives.  Recently the IRS Commissioner told the Senate Finance Committee that it would take “years” to finish writing all of the rules needed to clarify the many TCJA provisions and provide the interpretation of the IRS.  But, recently the IRS did clarify how “alimony trusts” are to work for divorces entered into before 2019.

The alimony tax rules and “alimony trusts”, that’s the focus of today’s blog post.

Pre-TCJA Law

Tax treatment of alimony.  For divorce agreements entered into before 2019, “alimony or separate maintenance payment” is taxable to the recipient and deductible to the payor.  I.R.C. §71.   What is an alimony or separate maintenance payment?  It’s any payment received by or on behalf of a spouse (or former spouse) of the payor under a divorce or separate maintenance agreement that meets certain basic requirements:  1) the payment is made in cash (checks and money orders) pursuant to a decree, court order or written agreement; 2) the payment is not designated as a payment which is excludible from the gross income of the payee and non-deductible by the payor; 3) for spouses legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time payment is made; 4) the payor has no liability to continue to make any payment after the payee’s death and the divorce or separation instrument states that there is no such liability.  I.R.C. §71(b)(1).  It’s also possible that a settlement requiring or allowing the paying spouse to make payments directly to third parties for the benefit of the other spouse (such as for medical treatment, life insurance premiums or mortgage payments, for example) can result in the payments being treated as alimony as long as they do not benefit the paying spouse or property owned by the paying spouse.

It is possible, however, to specify in a separation agreement or divorce decree that such payments escape taxation in the hands of the recipient (and not give rise to a deduction in the hands of the payor-spouse).  Conversely, child support and property settlements are tax neutral – neither party pays tax nor gets a deduction. I.R.C. §71(c).

Another rule specifies that if the payor owes both alimony and child support, but pays less than the total amount owed, the payments apply first to child support and then to alimony.  If the separation agreement does not specify separate alimony and child support payments, general “family support” payments are treated as child support for tax purposes, unless the alimony qualifications are met.

Planning point.  This tax treatment raises an interesting planning point.  In general, when the higher income spouse makes payments to the lower-income spouse, the payments should be structured as alimony because the deduction can be available to the spouse in the higher tax bracket and, concomitantly, the income will be taxable to the spouse in the lower tax bracket.  If the spouse making payments is not in the higher income tax bracket (perhaps because of high levels of tax-exempt income such as disability payments), it makes more sense to structure the payments as child support or as a property settlement, or simply specify in the agreement that the alimony is not taxable to the recipient.

What about trusts?  During marriage, one spouse may have created an irrevocable trust for the benefit of the other spouse.  In that situation, I.R.C. §672(e)(1)(A) makes the trust a “grantor” trust with the result that the income of the trust is taxed to the spouse that created the trust.  If the couple later divorces, the trust remains.  It’s an irrevocable trust.  The divorce doesn’t change the nature or tax status of the trust – the spouse (now ex-spouse) that created the trust must continue to pay tax on trust income.  That’s probably both an unexpected and unhappy result for the spouse that created the trust.  That’s why (at least through 2018) I.R.C. §682(a) provides that the spouse that didn’t create the trust is taxed on the trust income, except for capital gain.  Capital gain income remains taxable to the spouse that created the trust.  In essence, then, the “payee” spouse is considered to be the trust beneficiary.  I.R.C. §682(b). 

TCJA Modification

Reversing tax treatment of alimony.  Under the TCJA, for agreements entered into after 2018, alimony and separate maintenance payments are not deductible by the payor- spouse, and they are not included in the recipient-spouse’s income.  Title I, Subtitle A, Part V, Sec. 11051.   This modification conforms alimony tax provisions to the U.S. Supreme Court’s opinion in Gould v. Gould, 245 U.S. 151 (1917).  In that case, the Court held that alimony payments are not income to the recipient. 

Under the TCJA, income that is used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse.  The treatment of child support remains unchanged.

Impact on “alimony trusts.”  However, the TCJA also struck I.R.C. §682 from the Code as applied to any divorce or separation instrument executed after 2018, and any divorce or separation agreement executed before the end of 2018 that is modified after 2018 if the modification provides that the TCJA amendments are to apply to the modification. 

With the coming repeal of I.R.C. §682, what will happen to “alimony trusts” that were created before the repeal?  IRS has now answered that question.  According to IRS Notice 2018-37, IRB 2018-18, regulations will be issued stating that I.R.C. §682 will continue to apply to these trusts.  That means that the “beneficiary” spouse will continue to be taxed on the trust income.  But, the IRS points out that this tax treatment only applies to couples divorced (or legally separated) under a divorce or separation agreement executed on or before December 31, 2018.  The only exception is if such an agreement is modified after that date and the modification says that the TCJA provisions are to apply to the modification. 

What happens to “alimony trusts” executed after 2018?  The spouse that creates the trust will be taxed on the trust income under the “grantor trust” rules.  That’s because I.R.C. §672(e)(1) will continue to apply.  Some taxpayers finding themselves in this position may want to terminate grantor trust treatment in the event of divorce.  A qualified terminable interest property (QTIP) trust may be desired.  Another approach may be to have a provision drafted into the language of the trust that says that the spouse creating the trust will be reimbursed for any tax obligation post-divorce attributable to the trust. 

The IRS is requesting comments be submitted by July 11, 2018.

Conclusion

The TCJA changed many tax Code provisions.  The alimony rules are only a small sample of what was changed.  If you haven’t done so already, find a good tax practitioner and get to know them well.  Tax planning for 2018 and beyond has already begun.

April 23, 2018 in Income Tax | Permalink | Comments (0)

Thursday, April 19, 2018

Passive Activities and Grouping

Overview

It is not uncommon for a farmer or a higher-income taxpayer to invest in various activities in which they do not materially participate (as determined by a seven-factor test under Treas. Reg. §1.469-5T(a).  Examples of passive investments for farmers include rental activities, “condominium” grain storage LLCs and interests in ethanol and bio-diesel plants.  These investments generate either passive income or passive losses.  Passive income is subject to ordinary income tax and may also be subject to an additional 3.8 percent passive tax.  I.R.C. §1411.  When a passive activity generates losses, however, the passive activity rules limit the ability to deduct the losses to the extent the taxpayer has passive income in the current year.  Otherwise, they are deducted in the taxpayer’s final year of the investment.   

When a farmer (or other taxpayer) has investments in which they don’t materially participate and, hence, potentially face the impact of the passive activity rules can those investment activities be combined with an activity in which the taxpayer materially participates so that the limitation on deducting losses can be avoided?  There might be.  It might be possible to group activities.  A recent case shows how the grouping rules work.

That’s the topic of today’s post – grouping activities under the passive loss rules.

Grouping Activities 

An election can be made on the tax return to group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. Treas. Reg. §1.469-4.  Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.”  But, how is an appropriate economic unit determined?  The Treasury Regulations state that a taxpayer may use any reasonable method to make the grouping determination, although the following factors set forth in Treas. Reg. 1.469‑4(c)(2) are given the greatest weight:

  • Similarities and differences in types of business;
  • The extent of common control;
  • The extent of common ownership;
  • Geographical location; and
  • Interdependence between the activities

Grouping disclosure.  The IRS has issued final guidance on the disclosure reporting requirements of groupings (and regroupings). Rev. Proc. 2010-13, 2010-1 C.B. 329.  A grouping statement is to be filed with the tax return stating that the taxpayer is electing to group the listed activities together so that they are treated as a single activity for the tax year, and all years thereafter.  The taxpayer should also represent in the grouping statement that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.

A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, since 2013, a 3.8 percent net investment income tax applies to net rental income and other passive business income of upper income taxpayers.

Under the guidance, a written tax return statement is required for:

  • New groupings, such as in the first year of grouping two activities;
  • The addition of a new activity to an existing grouping; and
  • Regroupings, such as for an error or change in facts.

However, no written statement is required for:

  • Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
  • The disposition of an activity from a grouping; and
  • Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.

If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity.

Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer.  However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure.

Special Grouping Rules

A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity. Treas. Reg. §1.469-4(d)(1).

An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business. Treas. Reg. §1.469-4(d)(5)(ii).

An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. Treas. Reg. §1.469-4(d)(2).

Recent Case

A recent case illustrates the how the factors for grouping are applied.  In Brumbaugh v. Comr. T.C. Memo. 2018-40, the petitioner owned 60 percent of a C corporation that was engaged in developing real estate. The balance of the stock was owned by two others. The business had its headquarters in southern California and the plaintiff participated in the business for more than 500 hours in 2007, the year in issue. The business had a development project in 2007 in northern California several hundred miles away. The shareholders discussed buying an airplane for the trips to the project and back to southern California.

Ultimately, instead of the corporation buying the plane, the plaintiff bought it personally through his LLC. In 2006, the plaintiff had formed and LLC (taxed as a partnership) in which he owned 51 percent and his wife owned 49 percent. The LLC entered into a management agreement with an aviation company that provided that the aviation company was responsible for all managerial duties related to the plane and had the exclusive right to charter the plane for commercial flights by third parties whenever the petitioner did not need to use the plane. The plaintiff was also given access to other planes when his was being chartered. In 2007, the plaintiff used the plane on only one occasion. On four other occasions he used a different plane because his was being chartered. On petitioner’s 2007 return, he reported a $683,000 loss. Upon audit, the IRS recharacterized the loss as a passive loss on the basis that the plaintiff had not materially participated in the LLC’s activities.

The Tax Court agreed with the IRS and also concluded that the petitioner could not group the airplane activity with the real estate development activity because none of the Treas. Reg. §1.469-4(c)(2) factors favored grouping the two activities together. There was no functional similarity between the two activities and the plane was not integrated into the real estate activity in any way. While the factors for extent of common ownership and common control were neutral (the petitioner held controlling interests in both entities, but the interests were very different), there was no interdependence between the two businesses. In addition, the court noted that the petitioner did not materially participate in the aviation activity because there was no evidence to support the petitioner’s contention that he participated for at least 100 hours including no contemporaneous logs, appointment books, calendars or narrative summaries. In any event, the petitioner did not devote 500 or more hours in the aggregate to “significant participation activities.”  In addition, the real estate development activity did not qualify as a significant participation activity (another issue not discussed in this post). 

Conclusion

Farmers, ranchers and other taxpayers often engage (invest) in passive activities in addition to their business activity in which they materially participate.  While it is possible to group the investment activities with a farming business, for example, the factors set forth in the regulations for grouping must be satisfied.  The recent Tax Court case illustrates that it can be rather difficult to satisfying those factors.

April 19, 2018 in Income Tax | Permalink | Comments (0)

Tuesday, April 17, 2018

Modifying an Irrevocable Trust – Decanting

Overview

Trusts are a popular part of an estate plan for many people.  Trusts also come in different forms.  Some take effect during life and can be changed whenever the trust grantor (creator or settlor) desires.  These are revocable trusts.  Other trusts, known as irrevocable trusts, also take effect during life but can’t be changed when desired.  Or, at least not as easily.  That’s an issue that comes up often.  People often change their minds and circumstances also can change.  In addition, the tax laws surrounding estates and trust are frequently modified by the Congress as well as the courts.  Also, sometimes drafting errors occur and aren’t caught until after the irrevocable trust has been executed.

So how can a grantor of an irrevocable accomplish a “do over” when circumstances change?  It involves the concept of “decanting” and it’s the topic of today’s post.

Decanting 101

Trying to change the terms of an irrevocable trust is not a new concept.  “Decanting” involves pouring one trust into another trust with more favorable terms. To state it a different way, decanting involves distributing the assets of one trust to another trust that has the terms that the grantor desires with the terms that the grantor no longer wants remaining in the old trust.  

The ability to “decant” comes from either an express provision in the trust, or a state statute or judicial opinions (common law).  Presently, approximately 20 states have adopted “decanting” statutes, and a handful of others (such as Iowa and Kansas) allow trust modification under common law.  In some of the common law jurisdictions, courts have determined that decanting is allowed based upon the notion that the trustee’s authority to distribute trust corpus means that the trustee has a special power of appointment which allows the trustee to transfer all (or part) of the trust assets to another irrevocable trust for the same beneficiaries.

In terms of a step-by-step approach to decanting, the first step is to determine whether an applicable state statute applies.  If there is a statute, a key question is whether it allows for decanting.  Some statutes don’t so provide.  If it does, the statutory process must be followed.  Does the statute allow the trustee to make the changes that the grantor desires?  That is a necessary requirement to being able to decant the trust.  If there is no governing statute, or there is a statute but it doesn’t allow the changes that the grantor desires, a determination must be made as to what the state courts have said on the matter, if anything.  But, that could mean that litigation involving the changes is a more likely possibility with a less than certain outcome. 

If conditions are not favorable for decanting in a particular jurisdiction, it may be possible under the trust’s terms (or something known as a “trust protector”) to shift the trust to a different jurisdiction where the desired changes will be allowed.  Absent favorable trust terms, it might be possible to petition a local court for authority to modify the trust to allow the governing jurisdiction of the trust to be changed.

If decanting can be done, the process of changing the trust terms means that documents are prepared that will result in the pouring of the assets of the trust into another trust with different terms. Throughout the process, it is important to follow all applicable statutory rules.  Care must be taken when preparing deeds, beneficiary forms, establishing new accounts and conducting any other related business to complete the change. 

IRS Private Ruling

In the fall of 2015, the IRS released a Private Letter Ruling that dealt with the need to change an error in the drafting of an irrevocable trust in order to repair tax issues with the trust. Priv. Ltr. Rul. 201544005 (Jun. 19, 2015).  The private ruling involved an irrevocable trust that had a couple of flaws.  The settlors (a married couple) created the trust for their children, naming themselves as trustees.  One problem was that the trust terms gave the settlors a retained power to change the beneficial interests of the trust.  That resulted in an incomplete gift of the transfer of the property to the trust.  In addition, the retained power meant that I.R.C. §2036 came into play and would cause inclusion of the property subject to the power in the settlors’ estates.  The couple intended that their transfers to the trust be completed gifts that would not be included in their gross estates, so they filed a state court petition for reformation of the trust to correct the drafting errors.  The drafting attorney submitted an affidavit that the couple’s intent was that their transfers of property to the trust be treated as completed gifts and that the trust was intended to optimize their applicable exclusion amount.  The couple also sought to resign as trustees.   The court allowed reformation of the trust.  That fixed the tax problems.  The IRS determined that the court reformation would be respected because the reformation carried out the settlors’ intent.

When to Decant

So, it is possible that an irrevocable trust can be changed to fix a drafting error and for other reasons if the law and facts allow.

What are common reasons decant an irrevocable trust?  Some of the most common ones include the following:

  • To achieve greater creditor protection by changing, for example, a support trust to a discretionary trust (this can be a big issue, for example, with respect to long-term health care planning);
  • To change the situs (jurisdiction where the trust is administered) to a location with greater pro-trust laws;
  • To adjust the terms of the trust to take into account the relatively larger federal estate exemption applicable exclusion and include power of appointment language that causes inclusion of the trust property in the settlor’s estate to achieve an income tax basis “step-up” at death (this has become a bigger issue as the federal estate tax exemption has risen substantially in recent years);
  • To provide for a successor trustee and modify the trustee powers;
  • To either combine multiple trusts or separate one trust into a trust for each beneficiary;
  • To create a special needs trust for a beneficiary with a disability;
  • To permit the trust to be qualified to hold stock in an S corporation and, of course;
  • To correct drafting errors that create tax problems and, perhaps, in the process of doing so create a fundamentally different trust.

Conclusion

The ability to modify an irrevocable trust is critical.  This is particularly true with the dramatic change in the federal estate and gift tax systems in recent years.  Modification may also be necessary when desires and goals change or to correct an error in drafting.  Fortunately, in many instances, it is possible to make changes even though the trust is “irrevocable.”  If you need to “decant” a trust, see an estate planning professional for help.

April 17, 2018 in Estate Planning | Permalink | Comments (0)

Friday, April 13, 2018

End of Tax Preparation Season Means Tax Seminar Season Is About To Begin

Overview

Many readers of this blog are tax preparers.  Many focus specifically on returns for clients engaged in agricultural production activities.  As tax season winds down, at least for the time being, another season is about to begin.  For me, that means that tax seminar season is just around the corner.  Whether it’s at a national conference, state conference, in-house training for CPAs or more informal meetings, I am about to begin the journey which will take me until just about Christmas of providing CPE training for CPAs and lawyers across the country. 

CPAs and lawyers are always looking for high-quality and relevant tax and legal education events.  In today’s post I highlight some upcoming events that you might want to attend. 

Calendar of Events

Shortly after tax preparers come back from a well-deserved break from the long hours and weekends of preparing returns and dealing with tax client issues, many will be ready to continue accumulating the necessary CPE credits for the year.  This is an important year for CPE tax training with many provisions of the Tax Cuts and Jobs Act taking effect for tax years beginning after 2017.

If you are looking for CPE training the is related to agricultural taxation and agricultural estate and business planning below is a run-down of the major events I will be speaking at in the coming months.  Washburn Law School is a major player in agricultural law and taxation, and more details on many of these events can be found from the homepage of WALTR, my law school website – www.washburnlaw.edu/waltr.

May 9 – CoBank, Wichita KS

May 10 – Kansas Society of CPAs, Salina, KS

May 14 - Lorman, Co. Webinar

May 16 – Quincy Estate Planning Council, Quincy, IL

May 18 – Iowa Bar, Spring Tax Institute, Des Moines, IA

May 22 – In-House CPA Firm CPE training, Indianapolis, IN

June 7-8 – Summer Tax/Estate & Business Planning Conference, Shippensburg, PA

June 14-15 – In-House CPA Firm CPE training, Cedar Rapids, IA

June 22 - Washburn University School of Law CLE Event, Topeka, KS

June 26 - Washburn University School of Law/Southwest KS Bar Assoc, Dodge City, KS

June 27 – Kansas Society of CPAs, Topeka, KS

July 10 – Univ. of Missouri Summer Tax School, Columbia, MO

July 16-17 – AICPA Farm Tax Conference, Las Vegas, NV

July 19 – Western Kansas Estate Planning Council, Hays, KS

July 26 – Mississippi Farm Bureau Commodity Conference, Natchez, MS

August 14 – In-House training, Kansas Farm Bureau, Manhattan, KS

August 15 - Washburn University School of Law/KSU Ag Law Symposium, Manhattan, Kansas

August 16-17 – Kansas St. Univ. Dept. of Ag Econ. Risk and Profit Conference, Manhattan, KS

September 17-18 – North Dakota Society of CPAs, Grand Forks, ND

September 19 – North Dakota Society of CPAs, Bismarck, ND

September 21 – University of Illinois, Moline, IL

September 24 – University of Illinois, Champaign-Urbana, IL

September 26-27 – Montana Society of CPAs, Great Falls, MT

October 3 – CoBank, Wichita, KS

October 11-12 – Notre Dame Estate Planning Institute, South Bend, IN

The events listed above are the major events geared for practitioners as of this moment.  I am continuing to add others, so keep watching WALTR for an event near you.  Of course, I am doing numerous other events geared for other audiences that can also be found on WALTR’s homepage.  Once I get into mid-late October, then the annual run of tax schools begins with venues set for Kansas, North Dakota, Iowa and South Dakota. Added in there will also be the Iowa Bar Tax School in early December.

Special Attention – Summer Seminar

I would encourage you to pay particular attention to the upcoming summer seminar in Shippensburg, PA.  This two-day conference is sponsored by Washburn University School of Law and is co-sponsored by the Pennsylvania Institute of CPAs and the Kansas State University Department of Agricultural Economics.  I will be joined for those two days by Paul Neiffer, Principal with CliftonLarsonAllen, LLP.  On-site seating for that event is limited to 100 and the seminar is filling up fast.  After those seats are taken, the only way to attend will be via the simultaneous webcast.  More information concerning the topics we will cover and how to register can be found at:  http://washburnlaw.edu/employers/cle/farmandranchincometax.html.  We will be spending the first four hours on the first day of that conference on the new tax legislation, with particular emphasis on how it impacts agricultural clients.  We will also take a look at the determination of whether a C corporation is now a favored entity in light of the new, lower 21 percent rate.  On Day 2 of the conference, we will take a detailed look at various estate and business planning topics for farm and ranch operators.  The rules that apply to farmers and ranchers are often uniquely different from non-farmers, and those different rules mean that different planning approaches must often be utilized. 

Conclusion

If your state association has interest in ag-tax CPE topics please feel free to have them contact me.  I have some open dates remaining for 2018, and am already booking into 2019 and beyond.  The same goes for your firm’s in-house CPE needs.  In any event, I hope to see you down the road in the coming months at an event.  Push through the next few days and take that well-deserved break.  When you get back at it, get signed up for one of the events listed above. 

April 13, 2018 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, April 11, 2018

Distinguishing Between a Capital Lease and an Operating Lease

Overview

Economic conditions in much of agriculture have deteriorated in recent years. Prices for many crops have dropped, livestock prices have come down from recent highs, and cash rents and land values have leveled off or fallen. In some instances, agricultural producers leveraged to expand their operations during the good times, only to find that the tougher farm economy has made things financially difficult.

In the downturn, legal and tax issues become critically important for many farmers and ranchers. One of those involves the distinction between a capital lease and an operating lease.  That distinction and why it matters is the topic of today’s post.

The Basics

A capital lease is a lease in which the only thing that the lessor does is finance the “leased” asset, and all other rights of ownership transfer to the lessee. Conversely, with an operating lease the asset owner (lessor) transfers only the right to use the property to the lessee. Ownership is not transferred as it is with a capital lease, and possession of the property reverts to the lessor at the end of the lease term. As a result, if the transaction is a capital lease, the asset is the lessee’s property and, for accounting purposes, is recorded as such in the lessee’s general ledger as a fixed asset. For tax purposes, the lessee deducts the interest portion of the capital lease payment as an expense, rather than the amount of the entire lease payment (which can be done with an operating lease).

Distinguishing Characteristics

So, what distinguishes a capital lease from an operating lease and why is the distinction important? There are at least a couple of reasons for properly characterizing capital and operating leases. One reason involves the fact that leases can be kept off a lessee’s financial statements, which could provide a misleading picture of the lessee’s finances. Another reason involves the proper tax characterization of the transaction. With an operating lease, the lessee deducts the lease payment as an operating expense and there is no impact on the lessee’s balance sheet. With a capital lease, however, the lessee recognizes the lease as an asset and the lease payment as a liability on the balance sheet. Also, with a capital lease, the lessee claims an annual amount of depreciation and deducts the interest expense associated with the lease. Based on these distinctions, many businesses prefer to treat lease transactions as operating leases, sometimes when the structure of the transaction indicates that they should not.

For a capital lease, the present value of all lease payments is considered to be the asset’s cost which, as noted above, the lessee records as a fixed asset, with an offsetting credit to a capital lease liability account. For accounting purposes, as each lease payment is made, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lessor has revenue equal to the present value of the future cash flows from the lease, and records the expenses associated with the lease. For the lessor, a lease receivable is recorded on the lessor’s balance sheet and recognizes the interest income as it is paid.

FASB Standards

A transaction that is a capital lease has any one of the following features (according to the Financial Accounting Standards Board (FASB)):

  • Ownership of the asset shifted from the lessee by the end of the lease period; or
  • The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
  • The lease term is at least 75 percent of the estimated economic life of the asset (and the lease cannot be cancelled during that time); or
  • The value of the minimum lease payments (discounted to present value) required under the lease equals or exceeds 90 percent of the fair value of the asset at the time the lease is entered into.

If none of the above factors can be satisfied, the transaction is an operating lease. In that event, the lessee is able to deduct the lease payment as a business expense and the leased asset is not treated as an asset of the lessee.

In the typical example, a farmer “trades in” equipment in return for not having to pay any of the operating lease payments or make a large down payment on the lease. If the trade is for a capital lease, with the IRS treating the transaction as a financing arrangement (i.e., a loan), then no gain is triggered on the trade if no cash is received. But there also is no deduction for the lease payments (although interest may be deductible). If the trade constitutes an operating lease, the farmer has gain equal to the amount of “trade-in” value that is credited to the operating lease minus the farmer’s tax cost in the equipment. The gain can be offset (partially or fully) with the lease expense (lease cost amortized for the year of sale).

Example:

On June 1, 2016, a farmer trades in a used, fully depreciated, tractor worth $120,000 for a new tractor under an operating lease over four years. The farmer will have ordinary income of $120,000 in 2016 and can deduct the lease payments made in 2016 and later years as a business expense. Had the trade occurred late in 2016, it is possible that no lease expense could be claimed in 2016, but that $30,000 could be claimed as a lease expense deduction in each year of 2017- 2020.

TCJA Modification to Like-Kind Exchanges

While the above discussion focuses on a trade-in of equipment in return for a lease, it is useful to remember that the recently enacted tax bill modifies the like-kind exchange rules.  Under a provision include the “Tax Cut and Jobs Act,” for exchanges completed after December 31, 2017, I.R.C. §1031 is inapplicable to personal property exchanges.  Thus, for example, on the trade of an item of farm equipment, the transaction will be treated as a sale with gain recognition on the sale of the item “traded.”  The trade-in value is reported as the sales price (Form 4797), with no tax deferral for any I.R.C. §1231 gain or I.R.C. §1245 recapture. The typical result will be that gain will result because most farm equipment has been fully depreciated via expense method or bonus depreciation.    The taxpayer’s income tax basis in the new item of farm equipment acquired in the “trade” will be the new item’s purchase price.  That amount will then be eligible for a 100 percent deduction (“bonus” depreciation) through 2022.  The “bonus” percentage is reduced 20 percentage points annually through 2026.  In 2027, a taxpayer would have to report 100 percent of the gain realized on a “trade” of personal property, but could deduct the cost of the item acquired in the “trade” under the expense method depreciation provision of I.R.C. §179 (presently capped at $1 million).  The gain on the “trade” is not subject to self-employment tax, and the depreciation deduction on the item acquired in the trade reduces self-employment tax. A further complication, beginning in 2018, is that net operating losses can only offset 80 percent of taxable income.  Thus, a taxpayer may want to elect out of bonus depreciation on the newly acquired asset and use just enough expense method depreciation to get taxable income to the desired level.

Conclusion

Understanding the difference between a capital lease and an operating lease, is helpful to avoiding bad tax and legal results in agricultural transactions.  The proper classification is very important.  It’s a big deal particularly when the agricultural economy turns south.

April 11, 2018 in Income Tax | Permalink | Comments (0)

Monday, April 9, 2018

Non-Tax Ag Provisions in the Omnibus Bill

Overview

In late March, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625.  This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains several ag-related provisions.  I looked at one of those a couple of weeks ago – the modification to I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017.  I.R.C. §199A, known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses.  However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives.  Before the modification, those sales generated a tax deduction from gross sales for the seller.  But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income.  That tax advantage for sales to cooperatives was deemed to be a drafting error and was modified by a provision that provides greater equity between sales to agricultural cooperatives and non-cooperatives. 

The modification to I.R.C. §199A received a lot of attention.  However, there were a couple of other provisions in the Omnibus bill that are also ag-related.  Today’s blog post examines those other two provisions. 

Animal Waste Air Reporting Exemption For Farms

Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the Environmental Protection Agency (EPA) has discretion to take remedial actions or order further monitoring or investigation of the situation. In 2008, the EPA issued a final regulation exempting farms from the reporting/notification requirement for air releases from animal waste on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for Confined Animal Feeding Operations (CAFOs) under EPCRAs public disclosure rule. Various environmental groups challenged the exemption on the basis that the EPA acted outside of its delegated authority to create the exemption. Agricultural groups claimed that the retained reporting requirement for CAFOs was also impermissible. The environmental groups claimed that emissions of ammonia and hydrogen sulfide (both hazardous substances under CERCLA) should be reported as part of furthering the overall regulatory objective. The court noted that there was no clear way to best measure the release of ammonia and hydrogen sulfide, but did determine that continuous releases are subject to annual notice requirements. The court held that the EPA’s final regulation should be vacated as an unreasonable interpretation of the de minimis exception in the statute. As such, the challenge brought by the agriculture groups to the CAFO carve out was mooted and dismissed. Waterkeeper Alliance, et al. v. Environmental Protection Agency, No. 09-1017, 2017 U.S. App. LEXIS 6174 (D.C. Cir. Apr. 11, 2017).

The court’s order potentially subjected almost 50,000 farms to the additional reporting requirement. As such, the court delayed enforcement of its ruling by issuing multiple stays, giving the EPA additional time to write a new rule. The EPA issued interim guidance on October 25, 2017. The court issued its most recent stay in the matter on February 1, 2018, with the expiration scheduled for May 1. However, Division S, Title XI, Section 1102 of the Omnibus bill, entitled the Fair Agricultural Reporting Method Act (FARM Act), modifies 42 U.S.C. §9603 to include the EPA exemption for farms that have animal waste air releases. Specifically, 42 U.S.C. §9603(e) is modified to specify that “air emissions from animal waste (including decomposing animal waste) at a farm” are exempt from the CERCLA Sec. 103 notice and reporting requirements. “Animal waste” is defined to mean “feces, urine, or other excrement, digestive emission, urea, or similar substances emitted by animals (including any form of livestock, poultry, or fish). The term animal waste “includes animal waste that is mixed or commingled with bedding, compost, feed, soil or any other material typically found with such waste.” A “farm” is defined as a site or area (including associated structures) that is used for “the production of a crop; or the raising or selling of animals (including any form of livestock, poultry or fish); and under normal conditions, produces during a farm year any agricultural products with a total value equal to not less than $1,000.”

ELD Rule Involving Agricultural Commodities Defunded

The Omnibus bill also addresses an Obama-era regulation involving truckers that is of particular importance to the livestock industry.  On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) was set to go into effect. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule was issued in late 2015. The new rule would require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18, 2017. The devices connect to the vehicle's engine and automatically record driving hours. There are numerous exceptions to the ELD final rule.

While the mandate was set to go into effect December 18, 2017, the Federal Motor Carrier Safety Administration (FMCSA) granted a 90-day waiver for all vehicles carrying agricultural commodities. That 90-day delay was later extended. Other general exceptions to the final rule exist for vehicles built before 2000; vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)); drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)); and drivers who maintain HOS logs for no more than eight days during any 30-day period.

Under the Omnibus legislation, the ELD rule was defunded through the end of the government's current fiscal year - September 30, 2018. Under Division L, Title I, Section 132, specifies that, “None of the funds appropriated or otherwise made available to the Department of Transportation by this Act or any other Act may be obligated or expended to implement, administer, or enforce the requirements of 5 section 31137 of title 49, United States Code, or any regulation issued by the Secretary pursuant to such section, with respect to the use of electronic logging devices by operators of commercial motor vehicles, as defined in section 31132(1) of such title, transporting livestock as defined in section 602 of the Emergency Livestock Feed Assistance Act of 1988 (7 U.S.C. 1471) or insects.” 

Conclusion

The Omnibus bill is a conglomeration of many provisions, most of which don’t have a direct impact on agricultural producers or agribusinesses.  However, there were a few provisions included of importance to agriculture.  While very few people, if any, have read and understand all of the provisions in the 2,232-page bill, it is important for those in the agricultural industry to have an understanding of the provisions that apply to them.

April 9, 2018 in Environmental Law, Regulatory Law | Permalink | Comments (0)

Thursday, April 5, 2018

Federal Crop Insurance - Some Recent Case Developments

Overview

When the Congress eventually gets around to debating the next Farm Bill, I suspect that crop insurance will comprise a significant part of the discussion.  In certain parts of the country in recent years, crop insurance comprised the largest portion of farm income.  Given that one of those areas, Kansas, is represented in the Senate by the chair of the Senate Ag Committee, that practically guarantees that crop insurance will get plenty of attention by the politicians during the Farm Bill debate. 

The Federal Crop Insurance Corporation (FCIC) was created in 1938 to carry out the fledgling crop insurance program.  That program was basically an experimental one until the Congress passed the Federal Crop Insurance Act (FCIA) of 1980.  Changes were made to the crop insurance program on multiple occasions and, in 1994, the program underwent a major overhaul with the Federal Crop Insurance Reform Act of 1994 which made it mandatory for farmers to participate in the program to qualify for various federal farm program benefits. 

With the 1996 Farm bill, the mandatory participation in crop insurance was repealed, so to speak.  However, if a farmer received other farm program benefits the farmer had to buy crop insurance for the crop year or waive eligibility for disaster benefits for that year.  In addition, the Risk Management Agency (RMA) was also created in 1996 as a part of the United States Department of Agriculture (USDA).  The RMA administers the FCIC programs and other risk management programs in conjunction with private sector entities to develop insurance products for farmers. 

In recent months, the courts have decided numerous cases involving crop insurance.  In today’s post, I take a look at three of them.  Each of them involves unique issues.

RMA and Freedom of Information Act (FOIA) Requests

In Bush v. United States Department of Agriculture, No. 16-CV-4128-CJW, 2017 U.S. Dist. LEXIS 131381 (N.D. Iowa Aug. 17, 2017), the RMA pursuant to the FOIA. The plaintiff was seeking the disclosure of soybean and corn yield within four townships in Cherokee County, Iowa. The RMA provided a no records in response to the plaintiff’s request explaining that it did not have the information available by section for townships within a county. The court determined that the purpose of the FOIA is to give the public greater access to governmental records. However, there are exceptions to this rule. The court determined that summary judgment for an agency is appropriate when the agency shows that it made a good faith effort to conduct a search for the requested records, using methods which can reasonably be expected to produce the information requested. However, the agency does not have to search every record system. In addition, the court pointed out that the FOIA neither requires an agency to answer questions disguised as FOIA requests or to create documents or opinions in response to an individual’s request for information.

The court concluded that the evidence illustrated that RMA did not maintain records matching the description of the plaintiff’s requests. Although it did collect some information from the records of insurance companies which would contain some of the information the plaintiff sought, it did not maintain records containing the precise information requested. As a result, the RMA was not required to provide information that it did not have to the plaintiff, and the court granted RMA’s motion for summary judgment. 

Actual Production History

In Ausmus v. Perdue, No. 16-cv-01984-RBJ, 2017 U.S. Dist. LEXIS 169305 (D. Colo. Oct. 13, 2017), the plaintiffs, farmers who produce winter what in Baca County, Colorado, sought judicial review of an adverse decision of the RMA which was subsequently affirmed by the National Appeals Division (NAD). Section 11009 of the 2014 Farm Bill amended subparagraph 1508(g)(4)(C) of the FCIA to add an APH Yield Exclusion to give crop producers the opportunity to exclude uncharacteristically bad crop years from the RMA’s calculation of how much crop insurance coverage they are entitled to. The plaintiffs wished to insure their 2015 winter wheat crop. Believing that they were eligible to invoke the APH Yield Exclusion, they gave their crop insurance agents letters electing to exclude all eligible crop years for purposes of calculating their coverage. After receiving the letters from the plaintiff and other crop producers, crop insurance providers contacted the RMA requesting guidance on how to handle the APH Yield Exclusion elections concerning the 2015 winter wheat crop. The RMA informed insurance providers that it had authorized the APH Yield exclusion for most crops for 2015, but it did not authorize the APH Yield Exclusion for winter wheat. As a result, the Agency directed insurance providers to deny winter wheat producers’ requests for the APH Yield Exclusion.

The plaintiffs challenged the directive as an adverse decision appealable to NAD. A NAD Hearing Officer conducted a hearing and issued a determination that NAD did not have jurisdiction over the matter and did not reach the merits. The plaintiffs then requested NAD Director Review of the Hearing Officer’s Determination pursuant to 7 C.F.R. § 11.9. The NAD Director reversed the Hearing Officer’s determination as to jurisdiction, but also held that the RMA has discretion to determine the appropriate time to implement the APH Yield Exclusion with regard to 2015 winter wheat. This decision effectively affirmed the RMA’s decision not to authorize the APH Yield exclusion. The plaintiffs appealed, and the trial court determined that, absent clear direction by Congress to the contrary, a law takes effect on the date of its enactment. The court noted that there was no statutory indication that it would take effect other than on the date of its enactment. The court viewed Congress’ silence as an expression that it meant the APH Yield Exclusion to be immediately available to producers on the date the Farm Bill was signed into law. Consequently, the court reversed the NAD Director’s decision and remanded this case for the proper application of the APH Yield Exclusion. 

Criminal Investigations

In POCO, L.L.C. v. Farmers Crop Ins. All., Inc., No. 16-35310, 2017 U.S. App. LEXIS 20853 (9th Cir. Oct. 23, 2017), the defendant was a federal crop insurer and the plaintiff was a farming operation that raised potatoes and onions. The plaintiff claimed that it purchased a federal crop insurance policy from the defendant and tendered an insurance claim to the defendant in 2004. The defendant denied the claim and the plaintiff demanded arbitration. The arbitrator found for the plaintiff, requiring the defendant to pay $1,454,450 plus interest on the claim. The defendant appealed the arbitrator’s award, but the trial court affirmed the award for the plaintiff. While the claim was in dispute the USDA was, unbeknownst to the plaintiff, conducting a criminal investigation of the plaintiff for an alleged scheme to profit from the filing of false federal crop insurance claims. Ultimately, the plaintiff and its principal were indicted based on their acceptance of the arbitration award which the government claimed constituted a criminal act. At the subsequent trial, the court dismissed all of the counts with prejudice.

The plaintiff had also sued the defendant for breach of contract, negligent misrepresentation, and violation of the Washington Consumer Protection Act (WCPA). The plaintiff claimed that the defendant had acted as the USDA’s agent and, as a result, the arbitration award was simply a ruse to entrap the plaintiff. The plaintiff claimed that if it had known about the criminal investigation that it could have required the USDA’s direct involvement in the arbitration process and be assured that no criminal charges were pending.  The plaintiff also claimed that USDA's direct involvement would have allowed it to get a court order that the plaintiff had a right to recover on its claims. The trial court granted summary judgment for the defendant holding that a private insurance company has no authority to bind the federal government from pursuing a criminal prosecution, absent involvement from a party with the requisite authority. The trial court ruled that it was unreasonable as a matter of law for a settlement agreement between private parties which clearly defines the subject matter of the agreement, to preclude criminal prosecution by the government. The plaintiff appealed.

The Mutual Release in the parties’ contract provided that the defendant, “for itself and for its insurance companies, and related companies” releases the plaintiff from liability for claims arising out of the plaintiff’s claim for indemnity under the 2003 crop insurance policies issued by the defendant. The plaintiff argued that “its insurance companies” included the Federal Crop Insurance Company and, therefore, the federal government. However, the appellate court held that the phrase could not reasonably be interpreted to bind the federal government and prevent the Department of Justice from pursing a criminal prosecution against the plaintiff for events related to the 2003 policies. Furthermore, the limited scope of the release could not be reasonably read to encompass the criminal charges filed against the plaintiff, which dealt with inflating crop baseline prices to increase eventual payouts on numerous insurance policies. Thus, the appellate court affirmed the trial court’s grant of summary judgment on the breach of contract claim. The plaintiff also alleged misrepresentation of a material fact. The appellate court determined, however, that the plaintiff failed to demonstrate a genuine factual dispute as to whether the defendant knew that the plaintiff was under a criminal investigation. The plaintiff’s evidence in support of that proposition stemmed from a 2004 insurance policy, rather than the 2003 insurance policy at issue in this case.

Consequently, the appellate court agreed with the trial court that, as a matter of law, the plaintiff could not have reasonably relied on the purported misrepresentation. Therefore, the trial court’s grant of summary judgment on the plaintiff’s misrepresentation claim was granted. Finally, the plaintiff’s WCPA claim failed because there was no misrepresentation, deception or unfairness. The terms of the contract were not deceptive and the plaintiff did not make a showing that there was a genuine dispute over whether the defendant knew about the criminal investigation. 

Conclusion

These cases are just three of those that have been recently decided by the federal courts involving crop insurance.  Crop insurance is important, but it is imperative to follow the rules.  Because those rules are often complex and difficult to understand, it is important for a farmer to have competent legal counsel to provide guidance through the issues.

April 5, 2018 in Regulatory Law | Permalink | Comments (0)

Tuesday, April 3, 2018

Refundable Fuel Credits - Following the Rules Matters

Overview

The Congress, through numerous tax and other legislative bills that have been enacted since the 1970s, has provided numerous subsidies designed to stimulate the production, sale and use of alternative fuels.  In addition to the production-related subsidies, alternative fuel infrastructure subsidies also exist.  In addition to the tax subsidies, Title IX of the 2014 Farm Bill included $694 million of mandatory funding and $765 million of discretionary funding for biofuels.    In addition to tax subsidies and other funding mechanisms, the Renewable Fuel Standard provides preferential treatment for corn and soybean production.  Many farmers, particularly in the Midwest, view the credits as important to their businesses (by removing supply and creating demand) and as an investment opportunity (“fueled” as it is, by government mandates).

The Internal Revenue Code (Code) provisions concerning the tax credits for alternative fuels are complex and must be precisely followed.  The fact that many of these credits are refundable (can reduce the tax liability below zero and allow a tax refund to be obtained) increases the likelihood of fraud with respect to their usage.  As a consequence, the IRS can levy huge penalties for the misuse of the credits.  A recent federal case from Iowa illustrates how the alternative fuel credit can be misused, and the penalties that can apply for such misuse.

The alternative fuel credit – that’s the topic of today’s post.

The Alternative Fuel Credit

Section 6426 of the Code provides for several alternative fuel credits.  Subsection (d) specifies the details for the alternative fuel credit.  The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004.  That initial version provided credits for alcohol and biodiesel fuel mixtures.  In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures.  The credits proved popular with taxpayers.  During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.”  That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy).  The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy.  C.C.M. AM2010-001 (Mar. 12, 2010).  However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit.

As modified, I.R.C. §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used.  In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business. 

For purposes of I.R.C. §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3).  I.R.C. §6426(d)(2)(G).  “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.”  An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel.  See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b).  An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer.  Id.  In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS.  I.R.C. 6426(a)(2). 

Recent Case

In Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018), the plaintiff was a Pella, IA firm that produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business.  Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the I.R.C. §6426 refundable credit for alternative fuel production.

To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries.  In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day.

The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction.  The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code.  The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.”  A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit.  C.C.A. 201133010 (Jul. 12, 2011).  The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”

The plaintiff claimed a refundable alternative fuel mixture credit in accordance with I.R.C. §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014.  The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (I.R.C. §6675); civil fraud penalty (I.R.C. §6663) and failure-to-file and failure-to-pay penalties (I.R.C. 6651).

The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied.

In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits.

The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice.  In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon.  Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon.

The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786.  A large part of the other penalties had already been abated.  The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff. 

Conclusion

Initially, the refundable credits were presented to Congress as incubators. As the business and demand grew, there would be less need for the subsidy. The initial tax subsidies are critical for these business models to succeed. Unknown is whether any of the business models wean themselves off of the credit to be successful without taxpayer subsidy.

Each year, the IRS releases a list of the “Dirty Dozen” tax scams.  On the current list are “excessive claims for business credits.”  That includes alternative fuel tax credits.  The fact that the alternative fuel credit is refundable makes it even more enticing to those that are seeking to scam the system.  While alternative fuel credits may have their place, extreme care must be taken to ensure that appropriate business models and transactions are utilized to properly claim them. In the recent case, a local municipality (the WRA) was brought in to help make the scam look legitimate.

April 3, 2018 in Income Tax | Permalink | Comments (0)

Friday, March 30, 2018

Tax Issues Associated With Oil and Gas Production

Overview

The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies. It is important to understand the various types of payments that a landowner might receive and the tax consequences that may apply due to the nature of the income received.

Sorting through the various types of payments associated with an oil and gas lease and their tax implications is the topic of today’s post.

Relationship of the Parties

The income from the oil and gas property is commonly divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In the typical lease arrangement, the royalty owner retains one-eighth (12.5 percent) and the working interest owner holds the other 87.5 percent (the balance of the portion of production or income that remains after the royalty interest owner’s share is satisfied).

The working interest owner bears the entire cost of exploration for minerals, as well as the development and production costs. The royalty owner bears none of the exploration, development, or operational costs. The funding necessary for the working interest owner to develop the oil and gas property is provided by investors who receive an interest in the activity in exchange for their capital investment. The costs of the activity borne by the working interest owner are allocated to the investors. These include geological survey costs, tangible costs (the drilling equipment and well), and intangible drilling costs (IDC).  These costs can be currently deducted rather than capitalized.

This relationship between the working interest owner and the investors is typically a joint venture that is classified as a partnership for tax purposes. Thus, the partnership passes through the costs separately to the investors on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. In the early years of the activity, the partnership typically passes through large losses to the partners. Because the partners are merely investors in the activity, the losses in their hands are passive losses. These losses are limited under the passive loss rules (I.R.C. §1411) such that they are only deductible to the extent the investor has passive income.

The working interest owner (who owns the interest either directly or through an entity that does not limit liability for the interest), however, is treated as being engaged in a non-passive activity regardless of the participation of the working interest owner. Temp. Treas. Reg. §1.469-1T(e)(4)(i).   Likewise, for an investor who holds both a general and limited partnership interest, the investor’s entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity regardless of whether the investor is materially participating.

Note:  Investors in the working interest activity, given the broad definition of “partnership” contained in the Code, will likely have income from the activity that is subject to self-employment tax even though they are not materially participating in the activity.  See, e.g., Methvin v. Comm’r, T.C. Memo 2015-81, aff’d., 653 Fed. Appx. 616 (10th Cir. 2016). 

Types of Payments

Bonus payment.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014). 

For the lessee, a bonus payment is not deductible even if it is paid in installments. It must be capitalized as a leasehold acquisition cost. However, the bonus payment may be subject to cost depletion.

Installment bonus payments. A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.

A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Delay rentals.  A delay rental is paid for the privilege of deferring development of the property by extending the primary term to allow additional time for drilling operations to begin. It can be avoided either by abandonment of the lease or by starting development operations (i.e., drilling for oil or obtaining production). A delay rental payment is “pure rent.” It is simply a payment to defer development rather than a payment for oil.

Delay rentals are ordinary income regardless of whether they are based on production. However, if they are not based on production, they are not depletable gross income to the lessor.  Treas. Reg. §1.612-3(c)(2).    Depletable gross income for the lessor is the royalty income received. Royalty income is based on production.  If the delay rentals paid are not based on production, they do not reduce the lessee’s depletable gross income.  Treas. Reg. §1.613-2(c)(5).

Delay rental payments are reported in the same manner as bonus payments. They are reported to the lessor in box 1 of Form 1099-MISC and constitute NII potentially subject to the additional 3.8 percent NIIT. The lessor reports the payments on Schedule E, with the amount flowing to line 17 of Form 1040, and are potentially subject to the NIIT.

Under Treas. Reg. §1.612-3(c), delay rentals are in the nature of rent that the lessee can deduct as a current expense.  However, the IRS maintains that I.R.C. §263A applies to delay rentals, which requires that the payments be capitalized.  The only exception to capitalization applies if the taxpayer has credible evidence establishing that the leasehold was acquired for some reason other than development.

Royalty income.  A landowner royalty is the right to the oil, gas, or minerals “in place” that entitles the owner to a specified percentage of gross production (if and when production occurs) free of the expenses of development and operations. A royalty interest is a continuing non-operating interest in oil and gas. Thus, a royalty payment is a payment for oil and gas.

Royalty payments are payments received for the extraction of minerals from the property that the landowner, as lessor, owns.   Royalties are paid as an agreed-upon percentage of the resource extracted (i.e., based on production).

Royalty payments are ordinary income that is reported to the lessor in box 2 of Form 1099-MISC. Royalty payments may be reduced by percentage or cost depletion. The lessor reports the royalty income on Schedule E, are they are included in NII and are subject to the additional 3.8 percent NIIT if the taxpayer’s gross income is above the applicable threshold ($200,000 single; $250,000 MFJ).

The lessee can deduct royalty payments as a trade or business expense. In addition, if the lessee pays the ad valorem taxes (taxes based on the property’s value) on mineral property, the payment constitutes an additional royalty to the lessor to the extent that income from production covers the tax payment.

Advance royalties. Although it is not commonly included in oil and gas leases, the lease may contain a provision providing the mineral owner with an advance royalty of the operating interest. Thus, an advance royalty is paid before the production of minerals occurs, and can be paid to the lessor either in a lump sum or periodically until production begins. The lessee deducts the advance royalty payments in the year in which the mineral production (on account of which it was paid) is sold.

Advance royalties are ordinary income to the lessor, and the lessor is not entitled to percentage depletion on the payments. However, the lessor is entitled to cost depletion in the year the payments are made to the extent they exceed production.

Advance minimum royalties. Advance minimum royalties meet the same conditions as an advanced royalty, but there is also a minimum royalty provision in the contract. This provision requires that a substantially uniform amount of royalties be paid at least annually over the life of the lease or for a period of at least 20 years.

The tax treatment to the lessor for advance minimum royalties is the same as with advanced royalties.  The lessee can deduct the advance royalties from gross income in the year the oil or gas is sold or recovered. The lessee also has the option to deduct the payments in the year they are paid or accrued.

Shut-in royalties. The lease may provide for payments to be made to the lessor when a well is shut- in (turned off because of lack of market or marketing facilities) but the well is still capable of producing in commercial quantities. The lessee is entitled to deduct the shut-in royalty payment and the lessor must report the payment as income.

Damage payments.  When a well is drilled, the nearby surface area can suffer damages that may entitle the landowner to compensation. To determine the income tax consequences of any payment for surface damages, the governing instrument (lease, etc.) may provide guidance.

Compensatory damages associated with lost profit (e.g., crop damage payments) are taxable as ordinary income (treated as a sale of the crop). To the extent the damage payment represents damages for destruction of business goodwill, the payment is nontaxable up to the taxpayer’s basis in the affected property. The amount of the damage payment that exceeds the taxpayer’s basis is taxable as I.R.C. §1231 gain. Payments for anticipated damages (but when no actual damage occurs) are reported as ordinary income.  See, e.g., Gilbertz v. U.S., 808 F.2d 1374 (10th Cir. 1987), rev’g 574 F. Supp. 177 (Wyo. 1983).

Production payments.  Most landowners retain only a royalty interest in minerals. However, landowners who have a working (operating) interest in the production may also receive a “production payment.” A production payment arises from a transaction in which the owner of an oil and gas interest sells a specific volume of production from an identifiable property until a specified amount of money or minerals has been received. A production payment is payable only out of the working interests’ share of production.

There are two types of production payments.  Retained production payments result when the mineral interest owner assigns the interest and retains a production payment. The payment is payable out of future production from the assigned property interest.  A carved-out production payment is created when an owner of a mineral interest assigns a production payment to another person but retains the interest in the property from which the production payment is assigned.

Generally, a carved-out production payment is treated under I.R.C. §636 as a mortgage (nonrecourse) loan on the property. As such, it does not qualify as an economic interest in the property. The lessee treats the payments as principal repayment and interest expense, and the lessor treats the payments received as principal and interest income. Thus, the producer does not recognize taxable income at the time the transaction is entered into. The lessor continues to be treated as the owner of the burdened properties. As the production occurs and is delivered to the holder of the production payment, the lessor is treated as having sold the production for its FMV and having applied the proceeds to repay the principal and interest due to the holder.

However, if the consideration given for the production payment is pledged for development of the property or if the production payment is retained when the property is leased, the payment qualifies as an economic interest. In this situation, the payments that the lessor receives via the production payment agreement are ordinary income that are subject to cost or percentage depletion.  The lessee capitalizes the payments.  The transaction may be treated as the sale of an overriding royalty interest in some instances, however.

Treas. Reg. §1.636-3 requires that the life of the production payment be shorter than the life of the property. Thus, for an unexplored property, if no minerals are discovered or the reserves are in such small quantities that they will never pay off the production payment, the production payment’s life will exist until the lease is abandoned.  Once the lease is abandoned, the transaction is treated by the lessee as a purchase of an overriding royalty interest. It is capitalized by the lessee and treated as capital gain by the lessor.

Payments for “shooting rights.”  In some situations, an operator may not want to incur the costs of entering into a lease on the property (to avoid lease bonuses, for example). Consequently, the operator may enter into a contract with the landowner to pay a smaller amount under a contract that gives the operator a right to enter onto the property to conduct exploration activities. The contract does not grant any drilling or production rights. The payments that the landowner receives under this type of arrangement are reportable as ordinary income.

Conclusion

Sorting out the proper tax treatment of various payments associated with an oil and gas lease is important and can be somewhat complex.  For those receiving (or paying) such amounts, competent tax counsel should be consulted to ensure proper reporting.  Today's post was just a quick summary of some of the tax issues associated with oil and gas production.  

March 30, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, March 28, 2018

IRS Collections – The Basics

Overview

An issue that I sometimes get into when dealing with practitioner questions concerns the IRS collections process.  What can the IRS reach?  What’s the process for establishing an IRS lien?  What’s the levy process?  What planning steps should a taxpayer take to protect assets within the limits of applicable law?  These, and similar questions are important when a taxpayer finds themselves on the wrong end of an IRS audit.

The basics of the IRS collection process and related issues – that’s the topic of today’s post.  This is not intended as a comprehensive review of the IRS procedures.  Instead, today’s post is merely a primer dealing with some of the more common questions.  Also, not discussed is a taxpayer’s option of contesting an IRS determination in Tax Court.

Basics

IRS notices.  When the IRS, upon audit, determines that a tax liability exists for any individual or taxpaying entity, the IRS collection process begins.  The process is basically the same for an individual taxpayer as it is for any taxpaying entity.  The IRS will send at least two notices requesting payment.  The verbiage becomes increasingly urgent with each notice.  The last notice sent before any action can be taken will be labeled “Final” and will sent via certified mail.  It is important to note that the IRS cannot take any action or file a notice of federal tax lien until 30 days have expired from that final notice. 

The IRS automated collection system.  After the final notice goes out and the 30-day period elapses, regardless of whether a lien is filed, the initial IRS contact will be by IRS collection personnel in what is known as the Automated Collection System (ACS).  The ACS will provide notice and make demand for payment and try to get as much financial information from the taxpayer as possible to document possible sources for future collection actions.  Depending on personnel resources and workload priorities, if ACS cannot resolve the delinquency, it would be assigned to a “queue” of collection cases that would then be assigned to field collection personnel for face-to-face contact.  Cases are assigned to the field based on workload priorities.  There are maximum caseload inventories for collection personnel, so the case could conceivably sit dormant for a period of time before being assigned to the field.  Of course, the collection statute of limitations (10 years from the date of assessment) continues to toll even though the case is not being actively pursued.

Tax lien.  Subsequent to the final IRS notice and the expiration of the 30-day period, if the delinquent taxes remain unpaid, the IRS will provide notice of an intent to levy and notice of a Collection Due Process hearing.  Typically, the IRS provides taxpayers with notice of each of these steps by sending multiple letters as part of the ACS.  Once the last notice is received (it will signify that it is the last) and the unpaid tax balance isn’t paid (or other arrangements aren’t made to pay the balance), the IRS can levy the taxpayer’s income or other assets.  This levy power also includes the ability to garnish wages as well as self-employment income and the seizure of bank accounts.

A federal tax lien can be filed with the appropriate office determined by the taxpayer’s residence.  Where that lien is filed is determined by state law.  In general, filing will be in the office of the County Recorder for the county of the taxpayer’s residence.  Once the asserted tax liability reaches a certain point, the filing of the lien is a foregone conclusion and it will likely be an automated process.  Where that point is at is discretionary with the IRS, but certainly if the asserted tax liability is $50,000 and greater, a federal tax lien will be filed.   

The lien is a general lien and attaches to all property, both personal and real.  The lien must be filed in the jurisdiction where the real property is located.   Thee lien is good for 10 years from the date of assessment and will not be extended, although exceptions do exist in the event of bankruptcy or mutual agreement between the taxpayer and IRS. 

What about a lien on the taxpayer’s personal residence?  The likelihood of IRS seizing a personal residence and offering it for sale is extremely small unless, of course, the taxpayer is living an opulent lifestyle.  But, unless there are exigent circumstances, there is a virtually no chance that the IRS would take enforcement action against the taxpayer’s personal residence.  That’s because there are several layers of authorization that an IRS Revenue Officer must receive to get approval to proceed to enforce a tax lien on a taxpayer’s personal residence by virtue of a tax sale.  The IRS simply doesn’t operate like a county does for nonpayment of real estate taxes. The IRS will collect on the lien, however, if the taxpayer sells the residence.

Offers in Compromise

Offer in Compromise (OIC) acceptances, contrary to all the media advertisements, are generally not accepted unless it works to the government’s best interests for collection.  When determining whether to compromise a tax debt, the IRS takes into consideration numerous factors.  The taxpayer’s age is one of those as it relates to the likelihood that the taxpayer will outlive the collection statute and make payment.  In general, the IRS will always determine to what extent the taxpayer has equity in their assets. In general, if the taxpayer has equity in the property that gave rise to the tax liability, that property could be subject to enforcement actions.  But, not only must the taxpayer have equity in the property, there must be a market for the property. 

The IRS will also see whether the taxpayer has income in excess of necessary living expenses.  Those are all factors that the IRS will use to determine an acceptable amount to compromise a tax debt.  All of the factors are tied to the likelihood of the ability of the IRS to collect on the tax debt. 

Note:  The IRS Collection Financial Standards should can be reviewed to help determine what goes into the IRS calculation of the collectability of a tax debt:  https://www.irs.gov/businesses/small-businesses-self-employed/collection-financial-standards.

Other Points

Social Security benefits are subject to levy actions on a monthly basis, but are limited to 15 percent of the individual taxpayer’s Social Security benefit.  Disability payments under Social Security are not subject to levy.  If the taxpayer has only social security and pension benefits, then it is probably in the taxpayer’s best interest to complete a Collection Information Statement to determine if there is any monthly income after allowable living expenses.  If there is, it may be possible for the taxpayer to enter into an installment agreement to pay-off the tax debt.  If there is no excess income or assets, the IRS will report the account as “currently not collectible” and the taxpayer’s case would be designated as having a “dormant” status (with the collection statute still running).  At the end of 10 years, the lien would be automatically released.

 The IRS can also levy pension benefits, but they are limited to allow for necessary living expenses.  The amounts of the limitation are generally revised annually to take into account cost of living variations. 

Note:  The IRS chart for the income exemption from levies can be found at the following link: https://www.irs.gov/pub/irs-pdf/p1494.pdf.

Tax overpayments will almost always be utilized to offset a tax delinquency.

Conclusion

A taxpayer, in general, doesn’t ever want communication from the IRS.  That’s especially the case for communication asserting a tax deficiency.  But, if it occurs, knowledge of the basics of the IRS collection process is important in order to determine the best course of action to take in getting the alleged tax debt eliminated.

March 28, 2018 in Income Tax | Permalink | Comments (1)