Thursday, October 18, 2018
For the Spring 2019 academic semester, Kansas State University will be offering my Agricultural Law and Economics course online. No matter where you are located, you can enroll in the course and participate in it as if you were present with the students in the on-campus classroom.
Details of next spring’s online Ag Law course – that’s the topic of today’s post.
The course provides a broad overview of many of the issues that a farmer, rancher, rural landowner, ag lender or other agribusiness will encounter on a daily basis. As a result, the course looks at contract issues for the purchase and sale of agricultural goods; the peril of oral contracts; the distinction between a lease and a contract (and why the distinction matters); and the key components of a farm lease, hunting lease, wind energy lease, oil and gas lease, and other types of common agricultural contractual matters. What are the rules surrounding ag goods purchased at auction?
Ag financing situations are also covered – what it takes to provide security to a lender when financing the purchase of personal property to be used in the farming business. In addition, the unique rules surrounding farm bankruptcy is covered, including the unique tax treatment provided to a farmer in Chapter 12 bankruptcy.
Of course, farm income tax is an important part of the course. Tax planning is perhaps the most important aspect of the farming business that every day decisions have an impact on and are influenced by. As readers of this blog know well, farm tax issues are numerous and special rules apply in many instances. The new tax law impacts many areas of farm income tax.
Real property legal issues are also prevalent and are addressed in the course. The key elements of an installment land contract are covered, as well as legal issues associated with farm leases. Various types of interests in real estate are explained – easements; licenses; profits, fee simples, remainders, etc. Like-kind exchange rules are also covered as are the special tax rules (at the state level) that apply to farm real estate. A big issue for some farmers and ranchers concerns abandoned railways, and those issues are covered in the course. What if an existing fence is not on the property line?
Farm estate and business planning is also a significant emphasis of the course. What’s the appropriate estate plan for a farm and ranch family? How should the farming business be structured? Should multiple entities be used? Why does it matter? These questions, and more, are addressed.
Agricultural cooperatives are important for the marketing of agricultural commodities. How a cooperative is structured and works and the special rules that apply are also discussed.
Because much agricultural property is out in the open, that means that personal liability rules come into play with respect to people that come onto the property or use farm property in the scope of their employment. What are the rules that apply in those situations? What about liability rules associated with genetically modified products? Ag chemicals also pose potential liability issues, as do improperly maintained fences? What about defective ag seed or purchased livestock that turns out to not live up to representations? These issues, and more, are covered in the scope of discussing civil liabilities.
Sometimes farmers and ranchers find themselves in violation of criminal laws. What are those common situations? What are the rules that apply? We will get into those issue too.
Water law is a very big issue, especially in the western two-thirds of the United States. We will survey the rules surrounding the allocation of surface water and ground water to agricultural operations.
Ag seems to always be in the midst of many environmental laws – the “Clean Water Rule” is just one of those that has been high-profile in recent years. We will talk about the environmental rules governing air, land, and water quality as they apply to farmers, ranchers and rural landowners.
Finally, we will address the federal (and state) administrative state and its rules that apply to farming operations. Not only will federal farm programs be addressed, but we will also look at other major federal regulations that apply to farmers and ranchers.
Further Information and How to Register
Information about the course is available here:
You can also find information about the text for the course at the following link (including the Table of Contents and the Index):
If you are an undergraduate student at an institution other than Kansas State, you should be able to enroll in this course and have it count as credit towards your degree at your institution.
If you have questions, you can contact me directly, or submit your questions to the KSU Global Campus staff at the link provided above.
I hope to see you in January!
Checkout the postcard (401 KB PDF) containing more information about the course and instructor.
October 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Friday, October 12, 2018
Interest in the corporate form of farm or ranch organization has varied over the years. That interest has generally peaked when corporate rates are lower compared to rates applicable to individuals and pass-through entities. In the 1970s, many farming operations were incorporated for succession planning reasons. But, with the Tax Cuts and Jobs Act (TCJA) establishing a flat C corporate rate of 21 percent effective for tax years beginning after 2017, some taxpayers may be enticed to structure their business in the C corporate form.
Is the C corporation a good business format for a farming operation? As with many tax planning considerations, numerous factors must be accounted for. Farming C corporations post-TCJA – that’s the topic of today’s post.
For tax years beginning before 2018, corporations paid tax on income at progressive marginal rates, with the first $50,000 of taxable income taxed at 15 percent. Dividends paid by a corporation (if any) to its shareholders were (and still are) generally taxed to the shareholder at a 15 percent or 20 percent rate. That combined 30 percent rate (15 percent on corporate income and 15 percent rate on the dividend) was less than the 39.6 rate which was the highest marginal rate for individuals. Thus, if a farm corporation’s income could be kept at approximately $50,000 of taxable income a year, tax savings could be achieved in the corporate structure. The tax planning for many farming C corporations was designed to accomplish that objective.
For tax years beginning after 2017, however, the C corporate rate is a flat 21 percent and no domestic production deduction of nine percent (I.R.C. §199) is available. In addition, for tax years beginning after 2017, a C corporation cannot claim the 20 percent deduction for qualified business income. I.R.C. §199A. This all means that for many farming corporations, the effective tax rate in 2018 could be at least 40 percent higher than it was in 2017 (at least through 2025).
But, it is also true that many farm C corporations were established as means of providing tax-deductible meals and lodging to the owners on a tax-free (to the owners) basis. That can still be done post-2017, except that the deduction for the cost of meals is only 50 percent rather than being fully deductible.
In general, firms turn to the corporation because they are seeking a collection of advantages they cannot achieve with a partnership, joint venture, limited partnership or limited liability company. For instance, the corporation provides a means for simplified internal accounting, extension of the planning horizon and a way to keep the business together beyond the present generation. Also, if plans are not made for continuity of the farm or ranch business, there is a tendency for individuals, over time, to focus less on the future. This causes decision making to be less than optimal. The corporation, as an entity of perpetual existence, helps to extend the planning horizon over which decisions are made which may result in a more rational set of economic decisions.
The corporation also tends to smooth the family farm cycle and make it possible for the continuation of the operation into subsequent generations with greater efficiency. Empirical studies in several states reveal that four major factors account for most of the decisions to incorporate in those states. These factors are: (1) ease of transferring interests in property by transferring shares of stock to accomplish specific estate planning objectives; (2) possibilities for planning management and ownership succession to make continuation of the business easier after death of the original owners; (3) avoidance of full owner liability for obligations of the business through shareholder limited liability; and (4) opportunities for income tax saving.
Thus, there still exist significant non-tax reasons to form a farming C corporation. However, it may not be the best entity structure for federal farm program payment limitation purposes. If a C corporation (or any other entity that limits liability) is the farming entity, the Farm Service Agency will limit the eligibility for payment limitations to the entity itself. Then, the owners of that entity will have to split the amount of government payments attributable to the one “person” determination between themselves. If a pass-through entity were utilized that did not limit owner liability at the entity level, then each owner (member) of the entity would be entitled to its own payment limit.
Anti-Corporate Farming Laws
When it comes to agricultural law and agricultural taxation, special rules apply in many situations. One of those special situations involves farming corporations. Historically, the first significant wave of interest in the corporate form for farm and ranch businesses dates back to the 1920s at a time when change was occurring very rapidly in the agricultural industry. The prevailing belief at the time was that the mechanization of agriculture was going to produce a few large “factories in the field.” This widespread belief produced a wave of state legislation, much of it still in existence today, limiting the use of the farm or ranch corporation. Kansas was the first state to legislate anti-corporate farming restrictions. Other states, primarily in the Midwest and the Great Plains, followed suit. Restrictions were enacted (in addition to Kansas) in North Dakota, Oklahoma, Minnesota, South Dakota, Missouri, Wisconsin, Nebraska and Iowa. Other restrictions were enacted in Colorado, Texas, West Virginia and South Carolina. In many of these states, the restrictions remain on the books (albeit modified in some states).
Recent case. The North Dakota anti-corporate farming restriction bars corporations, other than family farming corporations, from owning farm land and engaging in farming or agriculture. The specific statutory language states: “All corporations and limited liability companies, except as otherwise provided in this chapter, are prohibited from owning or leasing land used for farming or ranching and from engaging in the business of farming or ranching. A corporation or a limited liability company may be a partner in a partnership that is in the business of farming or ranching only if that corporation or limited liability company complies with this chapter.” However, by virtue of a 1981 amendment, the statute also states: “This chapter does not prohibit a domestic corporation or a domestic limited liability company from owning real estate and engaging in the business of farming or ranching, if the corporation meets all the requirements of chapter 10-19.1 or the limited liability company meets all the requirements of chapter 10-32.1 which are not inconsistent with this chapter.” This amended language became known as the “family farm exception” because it requires shareholders to have a close family relation who is actively engaged in the operation. Historically, the state attorney general and secretary of state have interpreted the “family farming” exception as a way to allow out-of-state family farming corporations to own farm land and conduct agricultural operations in North Dakota. However, in North Dakota Farm Bureau, Inc. v. Stenehjem, No. 1:16-cv-137, 2018 U.S. Dist. LEXIS 161572 (D. N.D. Sep. 21, 2018), the plaintiff, North Dakota’s largest farm group along with other family farming corporations challenged the law as written on the basis that the law violated the “Dormant Commerce Clause” as discriminating against interstate commerce. The court agreed, enjoining the State from enforcing the family farm exception against out-of-state corporations that otherwise meet the statutory requirements (which the State didn’t do anyway).
The C corporation remains a viable entity structure for the farm or ranch business. While some of the tax advantage has been reduced, other factors indicate that the C corporation still has its place. In any event, wise tax and legal counsel should be consulted to determine the right approach for any particular situation
Tuesday, October 2, 2018
Many farmers and ranchers are reaching retirement age for Social Security benefit purposes. That raises numerous questions involving such things as benefits, earnings, what counts as “wages” and the cash renting of farmland. These are all important questions for farmers and ranchers to have answers to so that appropriate planning can be engaged in and expectations realized.
Social Security benefit planning – that’s the topic of today’s post.
For 2009-2020, the full retirement age for persons born in 1943-1954 is 66. Under present rules, in 2027, the full retirement age will be 67.
During the calendar year in which an individual reaches age 66, an earnings limit applies for the months before the individual reaches full retirement age. For example, for an individual that turns age 66 during 2018, there is a monthly earnings limit of $3,780 ($45,360 ¸ 12 months) for the months before full retirement age is reached. Excess earnings for this period result in a $1 reduction in benefits for each $3 of excess earnings received before attaining the age of 66 years. But, for a person that hasn’t reached full retirement age, benefits are reduced by $1 for every $2 of earnings over the annual limit of $17,040 for 2018. For those drawing benefits after reaching full retirement age, there is no limit on earnings – benefits are not reduced.
An individual can receive full Social Security benefits if they aren’t drawn until full retirement age is achieved. Another way to state it is that if an individual delays taking social security benefits until reaching full retirement age, the individual receives additional benefits for each year of postponement until reaching age 70. The rate of increase is a fraction of one percent per month. In essence, the impact of drawing Social Security benefits before reaching full retirement age is that such a person must live longer to equalize the amount of benefits received over their lifetime compared to waiting until full retirement age to begin drawing benefits.
Taxability of Benefits
About 20 million people each year, some that are undoubtedly farmers and ranchers, pay tax on their Social Security benefits. These people are commonly in the 62-70 age range. Taxing Social Security benefits seems harsh, inasmuch as the person has already paid income tax and Social Security payroll taxes on the earnings that generated the benefits. But, not every dollar of benefits is taxed. What matters is a person’s total income from non-Social Security sources such as wages and salaries, investment income (and capital gains on those investments) and pension income. To that amount is added one-half of the person’s Social Security income. The total amount then is measured against a limit. For example, a person that files as married-filing-jointly (MFJ) will subject 50 percent of their Social Security benefits to tax if the total amount exceeds $32,000 for 2018 (it’s $25,000 for a single filer). The 50 percent changes to 85 percent once the total amount exceeds $44,000 (MFJ) or $34,000 (single) for 2018. Those are the maximum percentages in theory. In reality, however, there is a complex formula that often results in less Social Security benefits being taxed than that maximum percentage. To boil it down, the formula often results in about 20 percent of Social Security benefits being taxed once the total amount threshold is exceeded.
Some farmers receive wages in-kind rather that in cash. In-kind wages such as crops or livestock, count toward the earnings limitations test. The earnings limit test includes all earnings, not just those that are subject to Social Security (FICA/Medicare) tax. But, employer-provided health insurance benefits are not considered to be “earnings” for purposes of the earnings limitation test. They are not taxed as wages. I.R.C. §3121; SSA Program Operations Manual System, §§RS 01402.040; 01402,048.
Federal farm program payments that a farmer receives are not deemed to be “earnings” when calculating each calendar year's earnings limitation. SSA Program Operations Manual System §RS 02505.115. That is the case except for the initial year of Social Security benefit application. In that initial year, all FSA program payments are counted along with other earned income and earnings for purposes of the annual earnings limitation test.
For farmers that cash rent farm ground to their employer, the cash rental income that the farmer receives will likely be treated as “earnings” even though the farmer is getting a wage from the employer. This is particularly the case if the farmer is farming the ground on the employer’s behalf. The result would be a “doubling-up” of the wage income and the cash rent income for purposes of the age 62-66 earnings test.
For a farmer that is drawing Social Security benefits, whether retired or not, Conservation Reserve Program Payments received are not subject to Social Security tax. I.R.C. §1402(a)(1).
Social Security benefit planning is an item that is often overlooked by farmers and ranchers. However, it is useful to know how such planning may fit into the overall retirement plan of a farmer or rancher. It is just one piece of the retirement, succession, estate plan that should be considered in terms of how it fits in with other strategies. While a farmer or rancher may never actually “retire,” there is a benefit to properly timing the drawing of Social Security benefits. In addition, as noted above, there are some special situations that a farmer or rancher should be aware of.
The Social Security Administration website (ssa.gov) has some useful online calculators that can aid in estimating retirement benefits. It may be worth checking out.
Monday, September 24, 2018
The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption to $11.18 million for deaths in or gifts made in 2018. That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning. However, business succession planning remains as important as ever. Last month, I wrote about one possible strategy, the intentionally defective grantor trust. Today, I discuss another possible succession planning concept – the grantor-retained annuity trust (GRAT). It’s another technique that can allow the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.
Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – that’s the topic of today’s post.
GRAT - Defined
A GRAT is an irrevocable trust to which assets (those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate applied to the annual annuity payment the GRAT will make) are transferred and the grantor receives the right to a fixed annuity payment for a term of years, with the remainder beneficiaries receiving any remaining assets at the end of the GRAT term. The fixed payment is typically a percentage of the asset’s initial fair market value computed so as to not trigger gift tax. The term of the annuity is fixed in the instrument and is either tied to the annuitant’s life, a specified term of years or a term that is the shorter of the two. The annuity payment can be structured to remain the same each year or it can increase up to 120 percent annually. However, once the annuity is established, additional property cannot be added to the GRAT.
A GRAT can accomplish two important estate planning objectives. The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at today’s value, and it provides the senior family member with an annuity payment for a term of years. Thus, the GRAT can deliver benefits without potential transfer tax disadvantages. Clearly, the lower the interest rate, the more attractive a GRAT is.
A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from either the GRAT’s income or principal. There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement. The window runs from the GRAT creation date, which is based on state law. Notes cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make payments to any person other than the annuitant during the qualified interest term.
A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust. There is also a formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for gift tax purposes. The provision must require adjustment of the annuity amount.
From a financial accounting standpoint, the GRAT is a separate legal entity. The GRAT’s bank account is established using the grantor’s social security number as the I.D. number. Annual accounting is required, including a balance sheet and an income statement.
Tax Consequences of Creating, Funding, Administering and Terminating a GRAT
For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained interest exceeds five percent of the value of the trust at the time the trust is created. I.R.C. §673. Thus, there is no gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity. There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s basis. Also, when a partnership interest is contributed there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities exceeds the partner’s share of the tax basis in the partnership assets).
Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership. The grantor also can claim the GRAT’s deductions. However, the grantor is not taxed on annuity payments, and transactions between the GRAT and the grantor are ignored for income tax purposes. A significant tax benefit of a GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or loss. The transaction is treated as a tax-free installment sale of the asset. Also, the GRAT is permitted to hold “S” corporation stock as the trust is a permitted S corporation shareholder, and the GRAT assets grow without the burden of income taxes.
For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest. In essence, the transferred assets are treated as a gift of the present value of the remainder interest in the property. That allows asset appreciation to be shifted (net of the assumed interest rate that is used to compute present value) from the grantor’s generation to the next generation.
If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax consequences (assuming the GRAT is a wholly-owned grantor trust. Rev. Rul. 85-13, 1985-1 C.B. 184. Then, the repurchased property can be placed in a new GRAT with a lower annuity payment. The original GRAT would then pay out its remaining cash and collapse.
It is possible to “zero-out” the gift value so there is no taxable gift. An interest rate formula determined by I.R.C. §7520 is used to calculate the value of the remainder interest. If the income and appreciation of the trust assets exceed the I.R.C. §7520 rate, assets remain at the end of the GRAT term that will pass to the GRAT beneficiaries. The basic idea is to transfer wealth to the subsequent generation with little or no gift tax consequences.
The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries. Rev. Rul. 2004-64, 2004-27 I.R.B. 7. Also, if the trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax, the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the grantor’s estate. But, it’s important that the trustee is an independent trustee.
Death of Grantor During GRAT Term
If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the grantor’s gross estate. The amount included in the grantor’s estate is the lesser of the fair market value of the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in effect during the month of the grantor’s death). Rev. Rul. 82-105, 1982-1 C.B. 133.
Example: Bubba died in June 2018 with $700,000 of assets held in a 10-year GRAT. At the time the GRAT was created in June of 2010 with a contribution of $1.5 million, the annuity was calculated to be $183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift). The amount included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the time of death) or $5,385,255.88 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.034)). Thus, the amount included in Bubba’s estate would be $700,000.
To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are generally selected for older individuals. There is no restriction in the law as to how long a GRAT term must be. For example, Kerr v. Comr., 113 T.C. 449 (1999), aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the court’s opinion that the term was challenged. In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT with a two-year term. See also Walton v. Comr., 115 T.C. 589 (2000).
GRAT Advantages and Disadvantages
To summarize the above discussion the following is a brief listing of advantages and disadvantages of a GRAT.
Advantages: 1) there is a reduced gift tax cost as compared to a direct gift; 2) the GRAT receives grantor trust status; 3) the grantor can borrow funds from the GRAT and the GRAT can borrow money from third parties (however, the grantor must report as income the amount borrowed - Tech. Adv. Memo. 200010010 (Nov. 23, 1999)); and 4) the GRAT term can safely be as short as two years.
Disadvantages: 1) upon formation, some of the grantor’s applicable exclusion might be utilized; 2) the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate; 3) notes or other forms of indebtedness cannot be used to satisfy the required annuity payments; and 4) grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term.
The GRAT is another way to pass interests in the farming or ranching operation to the next generation. While it’s not a technique for everyone, it can be helpful for those with substantial estates. Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $11.18 million is scheduled to “sunset” after 2025. After that, under present law, the exclusion will drop to $5 million with an inflation adjustment. Also, if the political landscape changes to a significant enough degree the exemption could fall sooner and to a greater degree.
Thursday, September 6, 2018
One of the reasons for the formation of a corporation is to achieve liability protection. Liability of corporate shareholders is limited to the extent of their individual investment in the corporation. In a farm and ranch setting, while a corporation may not actually be utilized as the operating entity, it is commonly used to hold operating assets as a means of shielding the shareholders from personal liability against creditor claims arising from operations.
But, creditor protection is not absolute. In certain circumstances the corporate “veil” can be “pierced” with the result that a shareholder can be held personally liable for corporate liabilities.
Corporate veil-piercing – that’s the topic of today’s post.
Factors for “Piercing”
Corporate “veil piercing” is generally a matter of state law. A state’s corporate code sets forth the rules for properly forming a corporation and the ongoing conduct of the corporate business. It is critical for a corporation and its shareholders to follow those rules. For instance, shareholder limited liability can be lost if the corporation is not validly organized in accordance with state law. In addition, to maintain limited liability the corporation must comply with certain corporate formalities such as conducting an annual meeting, filing an annual report with a designated state office, and electing directors and officers. If these corporate formalities are not complied with, limited liability for shareholders is sacrificed.
Also, a reasonable amount of equity or risk capital must be committed to the corporation. Shareholder limited liability is lost if the corporation is inadequately capitalized. Courts will “pierce the corporate veil” unless a reasonable amount of equity capital is committed to the business to serve as a cushion to absorb the liability shocks of the business. See, e.g., Dewitt Truck Brokers v. W. Ray Flemming Fruit Co., 540 F.2d 681 (4th Cir. 1976).
Illustrative Cases on Veil Piercing
The following cases are a small sample that show the various ways in which corporate veil piercing can arise:
- In Juniper Investment Co v. United States, 338 F2d 356 (Cl. Ct. 1964), a personal holding company’s separate existence was disregarded because it acted as the alter ego of the shareholders.
- Listing corporate assets as those of the shareholder on the shareholder’s personal loan application resulted in the court finding that the corporation was merely created for the taxpayer to avoid tax and was not a separate entity from the shareholder in Wenz v. Comr., T.C. Memo. 1995-277.
- In Foxworthy, Inc. v. Comr., T.C. Memo. 2009-203, the court held that the corporation at issue was the taxpayer’s alter ego that couldn’t be disregarded for tax purposes. The court pointed out that the taxpayer was neither an owner, director or corporate employee. Even so, the taxpayer had complete control over the corporation and used the corporation to buy the taxpayer’s personal resident and maintain it. The court noted that the corporation had no real business purposes and was used in an attempt to convert personal living expenses into deductible business expenses.
- Veil piercing was the result where a corporation’s funds and a shareholder’s funds were comingled and the shareholder controlled and managed the corporation’s accounts as his own. Pollack v. Comr., T.C. Memo. 1982-638.
- In Pappas v. Comr., T.C. Memo. 2002-127, the corporate veil was pierced because there was no real distinction between the taxpayer and the corporation. The taxpayer used corporate funds for personal expenses, the corporation didn’t file federal or state tax returns. In addition, corporate formalities were ignored, and the corporation did not have a separate office apart from the taxpayer’s home address. Also, the taxpayer was the only corporate employee and corporate records were not maintained.
In Woodruff Construction, L.L.C. v. Clark, No. 17-1422, 2018 Iowa App. LEXIS 765 (Iowa Ct. App. Aug. 15, 2018), the defendant formed a corporation and filed articles of incorporation in 1997. The corporation was reincorporated in 2001 after an administrative dissolution. The corporation was engaged in the business of biosolids management. The defendant was the sole owner and director of the corporation along with being the corporation’s secretary and treasurer. The plaintiff contracted with a small town to be the general contractor during the construction of a wastewater treatment facility for the town. In early 2010, the plaintiff contracted with the defendant for lagoon sludge removal. The defendant began work, but then ceased work after determining that project would cost more to complete that what the contract was bid for.
In 2012, the plaintiff sued for breach of contract and obtained a judgment of $410,066.83 plus interest in 2014. The corporation failed to pay the judgment and the plaintiff sued in 2015 to pierce the corporate veil and recover the judgment personally from the defendant. The trial court refused to pierce the corporate veil and also denied a request to impose a constructive trust and equitable lien on the corporate assets. The plaintiff appealed the denial of piercing the corporate veil.
The appellate court determined that the plaintiff had failed to establish that the corporation was undercapitalized – it had assets and was profitable. The plaintiff also did not show that the corporation was undercapitalized at the time it entered into the contract with the plaintiff. There also was no evidence showing that the corporation changed the nature of its work or engaged in an inadequately-capitalized expansion of the business. It was also unclear, the appellate court noted, that the capital transfers from the corporation to the defendant rendered the initial adequate capitalization irrelevant. Thus, the plaintiff failed to establish that the corporation was undercapitalized to an extent that merited piercing the corporate veil.
However, the appellate court noted that the evidence illustrated that the defendant commingled personal funds with corporate funds. The defendant used corporate funds for personal purposes, and also failed to maintain separate books and records that sufficiently distinguished them from the defendant personally. In addition, the appellate court noted that the corporation did not follow corporate formalities. The corporation had been dissolved administratively by the Secretary of State in 1998 due to the failure to file a biennial report, but the corporation continued operations during the time it was dissolved as if the corporation were active. When the new corporation began in 2001, no bylaws, corporate minute book or shareholder ledger were produced. In addition, the new corporation (operating under the same name as the old corporation) was administratively dissolved three times for failure to submit the biennial report (the corporation used the statutory procedure to apply for reinstatement each time). The appellate court determined that the corporation was not considered by the defendant to be a separate entity from himself. Accordingly, the appellate court reversed the trial court and allowed the corporate veil to be pierced and the defendant to be held personally responsible for the judgment.
To obtain creditor protection that the limited liability feature of a corporation can provide, it’s critical to follow corporate formalities and respect the corporation as an entity distinct from the shareholder. Failure to do so can result in personal liability for corporate debts and obligations. With machinery, equipment, livestock and unique features on farm and ranch land, achieving liability protection for farmers and ranchers is a big deal. Respecting the corporate entity is key to achieving that protection. Good legal counsel can make sure these requirements are satisfied.
Thursday, August 23, 2018
If you are looking for additional training on the new tax law (Tax Cuts and Jobs Act (TCJA)) and, in addition, how the TCJA applies to your farming or ranching operation, there are several opportunities for you that I am participating in that are open to the public. In addition, I continue to do in-house CPA/law firm training on the new law. If your firm has an interest in some in-house training, please contact me.
Today’s post contains a listing of those seminars coming up over the next couple of months.
For those of you in the western South Dakota area, eastern Wyoming, northwest Nebraska and Montana, I have the following events coming up. Tomorrow afternoon (Aug. 24), I will be making an hour-long presentation on how the new tax law applies to agricultural producers in Rapid City, SD. That event is open to the public. If you are in the area, stop in for a brief discussion of the new law. You can learn more about the event here: https://www.r-calfusa.com/event/annual-convention/.
On September 17-19, I will be conducting tax seminars for the North Dakota Society of CPAs in Grand Forks and Bismarck. The September 17 and 18 events will be in Grand Forks, and the second day there will be a day devoted to farm and ranch estate and business planning. For more information on the North Dakota events, you can find it here: https://www.ndcpas.org/courses.
Later in September I will be presenting a two-day seminar in Great Falls, Montana for the Montana Society of CPAs with my co-speaker, Paul Neiffer. The first day on September 26 will be devoted to farm income tax issues and day 2 on September 27 will focus on Farm Estate and Business Planning. For more information, click here: https://www.mscpa.org/professional_development/course/2518/farm_ranch_income_tax_estate_business_planning.
Illinois, Iowa and Indiana
If you are in eastern Iowa or western Illinois, on September 21, I will be presenting a farm tax seminar in Rock Island, Illinois, with Bob Rhea of the Illinois Farm Business Management Association. Details about that seminar can be found here: https://taxschool.illinois.edu/merch/2018farm.html. We will repeat that seminar on September 24 in Champaign, Illinois. So, if you are in central, southern or eastern Illinois or western Indiana, this seminar is in your area. Again, details on the Champaign event can be found here: https://taxschool.illinois.edu/merch/2018farm.html.
On October 12, I will be making a presentation on estate planning issues that are unique to farmers and ranchers at the 44th Annual Notre Dame Tax and Estate Planning Institute in South Bend, Indiana. Information about the Institute can be found here: https://law.nd.edu/for-alumni/alumni-resources/tax-and-estate-planning-institute/.
Fall Tax Schools – South Dakota/Northwest Iowa Event
In the near future, I will do a post on the fall tax schools that I conduct in various states. One new one this year will be in Sioux Falls, South Dakota on November 8 and 9. That event is sponsored by the American Society of Tax Professionals and will be held at the Ramada Inn & Suites. For information on that event call 1-877-674-1996. The seminar will be a two-day school taught by myself and Paul Neiffer. We will be teaching from the tax workbook produced by the University of Illinois that many of you may be familiar with. For those of you in northwest Iowa, northeast Nebraska, eastern SD and southwestern MN, these two days are for you.
The events mentioned above are the major events coming up over the next couple of months. I haven’t listed the in-house private seminars that I have scheduled in September and October. I have room for a couple more of those if your firm is interested. Also, most of my speaking events are listed on my website, www.washburnlaw.edu/waltr.
I hope to see you at one or more of the events this fall.
Friday, August 17, 2018
An important concern for many farm and ranch families is how to keep the business in the family and operating as a viable economic enterprise into subsequent generations. Of course, economics and family relationships are very important to accomplishing this objective. So are various types of planning vehicles.
One of those vehicles that can work for some families is an intentionally defective grantor trust (IDGT). It allows the creator of the trust (grantor) to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period. The “freeze” is achieved by capitalizing on the mismatch between interest rates used to value transfers and the actual anticipated performance of the transferred asset.
The use of an IDGT as part of a plan to transfer business assets from one generation to the next – that’s the topic of today’s post.
IDGT - Defined
An IDGT is a specially type of irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. For federal income tax purposes, the trust is designed as a grantor trust (as far as the grantor is concerned) under I.R.C. §671 for income tax purposes because of the powers the grantor retains. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. The trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
The trust is “defective” because the seller (grantor) and the trust are treated as the same taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected (e.g., they are effective) for federal estate and gift tax purposes. The “defective” nature of the trust meant that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments (discussed below) are paid to the grantor in-kind and makes the trust an eligible S corporation shareholder. Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A)(i).
The IDGT Transaction
The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. The grantor makes an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor. Typically, the IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. That also means, however, that the transfer is a completed gift and the trust will receive a carryover basis in the gifted assets.
The trust language is carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate. This is what makes the IDGT a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death.
Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term. The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Given the current low interest rates (but they have been rising), it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).
The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 (Priv. Ltr. Rul. 9535026 (May 31, 29915)) that took the position that I.R.C. §2701 would not apply because a debt instrument is not an “applicable retained interest.” I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an “applicable retained interest” is not a creditor interest in bona fide debt. The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.
If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments.
How It Works
If for example, a multi-dimensional farming operation is valued at $15 million and is transferred to a family limited partnership (FLP), a valuation discount for lack of marketability and/or minority interest might approximate 30 percent.
Note: A few months ago, the Treasury announced that it was not finalizing regulations that would tighten the ability to valuation discounts in such situations. So, a discount of 30-40 percent would be reasonable for such a transfer.
A 30 percent discount on a $15 million transfer would be $4.5 million. So, the transfer to the FLP would be valued at $11.5 million. Then an IDGT could be created and the $11.5 million FLP interest would be sold to the IDGT in exchange for a note with the installment payments to the grantor under the note being established based on the $11.5 million value rather than the $15 million value. This means that, in effect, $4.5 million has been transferred tax-free the transferors’ heirs.
The installment note can be structured in various ways, with the approach chosen generally tied to the cash flow that the assets generate that have been transferred to the IDGT. In addition, the income from the property contained in the IDGT is the grantor’s tax responsibility (with those taxes paid annually from a portion of the installment sale payments from the note), but it’s not a gift for estate and gift tax purposes. That means, then, that additional assets can be shifted to the IDGT which will further reduce the grantor’s taxable estate at death. The heirs benefit and the grantor gets a reduced taxable estate value. That could be a big issue if the current level of the federal estate tax exemption goes back down starting in 2026 (or sooner on account of a political change in philosophy).
When the grantor of the IDGT dies, the only item included in the grantor’s gross estate is the installment note. It is included at its fair market value. That means that the IDGT “froze” the value of the assets as of the sale date with any future appreciation in asset value occurring outside of the decedent’s estate.
Pros and Cons of IDGTs
As noted above, an IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the interest rate on the installment note payable. Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes.
On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death. Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.
Proper Structuring of the Sale to the IDGT
Thee installment note must constitute bona fide debt. That is the key to the IDGT transaction from an income tax and estate planning or business succession standpoint. If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate. I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it. In the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.
All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note represents bona fide debt.
Administrative Issues with IDGT’s
An IDGT is treated as a separate legal entity. Thus, a separate bank account is opened for the IDGT in order to receive the “seed” gift and annual cash inflows and outflows. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Farmers and ranchers that intend to keep the farming or ranching business in the family for subsequent generations are searching for ways to accomplish that goal. The IDGT is one tool in the planner’s arsenal to accomplish that goal.
Monday, August 13, 2018
As a result of the Tax Cuts and Jobs Act (TCJA), for tax years beginning after 2017 and before 2026, a non C corporate business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the taxpayer’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States. I.R.C. 199A. The QBID replaces the DPAD, which applied for tax years beginning after 2004. The TCJA repealed the DPAD for tax years beginning after 2017.
The basic idea behind the provision was to provide a benefit to pass-through businesses and sole proprietorships that can’t take advantage of the lower 21 percent corporate tax rate under the TCJA that took effect for tax years beginning after 2017 (on a permanent basis). The QBID also applies to agricultural/horticultural cooperatives and their patrons.
Last week, the Treasury issued proposed regulations on the QBID except as applied to agricultural/horticultural cooperatives. That guidance is to come later this fall. The proposed regulations did not address how the QBID applies to cooper
The proposed regulations for the QBID – that the topic of today’s post.
The QBI deduction (QBID) is subject to various limitations based on whether the entity is engaged manufacturing, producing, growing or extracting qualified property, or engaged in certain specified services (known as a specified service trade or business (SSSB)), or based on the amount of wages paid or “qualified property” (QP) that the business holds. These limitations apply once the taxpayer’s taxable income exceeds a threshold based on filing status. Once the applicable threshold is exceeded the business must clear a wages threshold or a wages and qualified property threshold.
Note: If the wages or wages/QP threshold isn’t satisfied for such higher-income businesses, the QBID could be diminished or eliminated.
What is the wage or wage/QP hurdle? For farmers and ranchers (and other taxpayers) with taxable income over $315,000 (MFJ) or $157,500 (other filing statuses), the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all QP. But those limitations don’t apply if the applicable taxable income threshold is not met. In addition, the QBID is phased out once taxable income reaches $415,000 (MFJ) or $207,500 (all others).
On August 8, the Treasury issued proposed regulations on the QBID. Guidance was needed in many areas. For example, questions existed with respect to the treatment of rents; aggregation of multiple business activities; the impact on trusts; and the definition of a trade or business, among other issues. The proposed regulations answered some questions, left some unanswered and raised other questions.
Rental activities. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations do confirm that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s the case if the rental is between “commonly controlled” entities – defined as common ownership of 50 percent or more in each entity (e.g., between related parties). This part of the proposed regulations is generous to taxpayers, and will be useful for many rental activities. It’s also aided by the use of I.R.C. §162 for the definition of a “trade or business” as opposed to, for example, the passive loss rules of I.R.C. §469.
But, the proposed regulations may also mean that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation is correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.
The proposed regulations use an example or a rental of bare land that doesn’t require any cost on the landlord’s part. This seems to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. There is another example in the proposed regulations that also seems to support this conclusion. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. That means it may be crucial to be able to aggregate (group) those activities together.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations creates confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also states that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, does that mean that those separate rental activities can’t be aggregated (discussed below) unless each rental activity is a trade or business? If the Treasury is going to be making the trade or business determination on an entity-by-entity basis, triple net leases might be problematic.
Perhaps the final regulations will clarify whether rentals, regardless of the lease terms, will be treated as a trade or business (and can be aggregated).
Aggregation of activities. Farmers and ranchers often utilize more than a single entity for tax as well as estate and business planning reasons. The common technique is to place land into some form of non C corporate entity (or own it individually) and lease that land to the operating entity. For example, many large farming and ranching operations have been structured to have multiple limited liability companies (LLCs) with each LLC owning different tracts of land. These operations typically have an S corporation or some other type of business entity that owns the operating assets that are used in the farming operation. It appears that these entities can be grouped under the aggregation rule. For QBID purposes (specifically, for purposes of the wages and qualified property limitations) the proposed regulations allow an election to be made to aggregate (group) those separate entities. Thus, the rental income can be combined with the income from the farming/ranching operation for purposes of the QBID computation. Grouping allows wages and QP to also be aggregated and a single computation used for purposes of the QBID (eligibility and amount). In addition, taxpayers can allocate W2 wages to the appropriate entity that employs the employee under common law.
Note: The wages and QP from any trade or business that produces net negative QBI is not taken into account and is not carried over to a later year. The taxpayer has to offset the QBI attributable to each trade or business that produced net positive QBI.
Without aggregation, the taxpayer must compute W-2 wages for each trade or business, even if there is more than one within a single corporation or partnership. That means a taxpayer must find a way to allocate a single payroll across different lines.
To be able to aggregate businesses, they must meet several requirements, but the primary one is that the same person or group of persons must either directly or indirectly own 50 percent or more of each trade or business. For purposes of the 50 percent test, a family attribution rule applies that includes a spouse, children, grandchildren and parents of the taxpayer. However, siblings, uncles, and aunts, etc., are not within the family attribution rule. To illustrate the rule, for example, the parents and a child could own a majority interest in three separate businesses and all three of those businesses could be aggregated. But, the bar on siblings, etc., counting as "family" is a harsh rule for agricultural operations in particular. Perhaps the final regulations will modify the definition of "family."
Note: A ”group of persons” can consist of unrelated persons. It is important that the “group” meet the 50 percent test. It is immaterial that no person in the group meets the 50 percent test individually.
Common ownership is not all that is necessary to be able to group separate trade or business activities. The businesses to be grouped must provide goods or services that are the same or are customarily offered together; there must be significant centralized business elements; and the businesses must operate in coordination with or reliance upon one another. Meeting this three-part test should not be problematic for most farming/ranching operations, but there is enough "wiggle room" in those definitions for the IRS to create potential issues.
Once a taxpayer chooses to aggregate multiple businesses, the businesses must be aggregated for all subsequent tax years and must be consistently reported. The only exception is if there is a change in the facts and circumstances such that the aggregation no longer qualifies under the rules. So, disaggregation is generally not allowed, unless the facts and circumstances changes such that the aggregation rules no longer apply.
Losses. If a taxpayer’s business shows a loss for the tax year, the taxpayer cannot claim a QBID and the loss carries forward to the next tax year where it becomes a separate item of QBI. If the taxpayer has multiple businesses (such as a multiple entity farming operation, for example), the proposed regulations require a loss from one entity (or multiple entities) to be netted against the income from the other entity (or entities). If the taxpayer’s income is over the applicable threshold, the netting works in an interesting way. For example, if a farmer shows positive income on Schedule F and a Schedule C loss, the Schedule C loss will reduce the Schedule F income. The farmer’s QBID will be 20 percent of the resulting Schedule F income limited by the qualified wages, or qualified wages and the QP limitation. Of course, the farmer may be able to aggregate the Schedule F and Schedule C businesses and would want to do so if it would result in a greater QBID.
Note: A QBI loss must be taken and allocated against the other QBI income even if the loss entity is not aggregated. However, wages and QP are not aggregated.
If the taxpayer had a carryover loss from a pre-2018 tax year, that loss is not taken into account when computing income that qualifies for the QBID. This can be a big issue if a taxpayer had a passive loss in a prior year that is suspended. That's another taxpayer unfriendly aspect of the proposed regulations.
Trusts. For trusts and their beneficiaries, the QBID can apply if the $157,500 threshold is not exceeded irrespective of whether the trust pays qualified wages or has QP. But, that threshold appears to apply cumulatively to all trust income, including the trust income that is distributed to trust beneficiaries. In other words, the proposed regulations limit the effectiveness of utilizing trusts by including trust distributions in the trust’s taxable income for the year for purposes of the $157,500 limitation. Prop. Treas. Reg. §1.199A-6(d)(3)(iii). This is another taxpayer unfriendly aspect of the proposed regulations.
Based on the Treasury's position, it will likely be more beneficial for parents, for example, for estate planning purposes, to create multiple trusts for their children rather than a single trust that names each of them as beneficiaries. The separate trusts will be separately taxed. The use of trusts can be of particular use when the parents can't utilize the QBID due to the income limitation (in other words, their income exceeds $415,000). The trusts can be structured to qualify for the QBID, even though the parents would not be eligible for the QBID because of their high income. However, the proposed regulations state that, “Trusts formed or funded with a significant purpose of receiving a deduction under I.R.C. §199A will not be respected for purposes of I.R.C. §199A.” Again, that's a harsh, anti-taxpayer position that the proposed regulations take.
Under I.R.C. §643(f) the IRS can treat two or more trusts as a single trust if they are formed by substantially the same grantor and have substantially the same primary beneficiaries, and are formed for the principle purpose of avoiding income taxes. Does the statement in the proposed regulations referenced above mean that the Treasury is ignoring the three-part test of the statute? By itself, that would seem to be the case. However, near the end of the proposed regulations, there is a statement reciting the three-part test of I.R.C. §643(f). Prop. Treas. Reg. §1.643(f)-1). Hopefully, that means that any trust that has a reasonable estate/business planning purpose will be respected for QBID purposes, and that multiple trusts will not be aggregated that satisfy I.R.C. §643(f). Time will tell what the IRS position on this will be.
Unfortunately, the proposed regulations do not address how the QBID is to apply (or not apply) to charitable remainder trusts.
Here are a few other observations from the proposed regulations:
- Guaranteed payments in a partnership and reasonable compensation in an S corporation are not qualified wages for QBID purposes.
- Inherited property that the heir immediately places in service gets a fair market value as of date of death basis, but the proposed regulations don’t mention whether this resets the property’s depreciation period for QP purposes (as part of the 2.5 percent computation).
- For purposes of the QP computation, the 2.5 percent is multiplied by the depreciated basis of the asset on the day it is transferred to an S corporation, for example, but it’s holding period starts on the day it was first used for the business before it is transferred.
- A partnership’s I.R.C. §743(b) adjustment does not count for QP purposes. In other words, the adjustment does not add to UBIA. Thus, the inheritance of a fully depreciated building does not result in having any QP against which the 2.5 percent computation can be applied. That's a harsh rule from a taxpayer's standpoint.
- R.C. §1231 gains are not QBI. But, any portion of an I.R.C. §1231 gain that is taxed as ordinary income will qualify as QBI.
- Preferred allocations of partnership income will not qualify as QBI to the extent the allocation is for services. This forecloses a planning opportunity that could have been achieved by modifying a partnership agreement to provide for such allocations.
The proposed regulations are now subject to a 45-day comment period with a public hearing to occur in mid-October. The proposed rules do not have the force of law, but they can be relied on as guidance until final regulations are issued. From a practice standpoint, rely on the statutory language when it is more favorable to a client than the position the Treasury has taken in the proposed regulations.
Numerous questions remain and will need to be clarified in the final regulations. The Treasury will be hearing from the tax section of the American Bar Association, the American Institute of CPAs, other tax professionals and other interested parties. Hopefully, some of the taxpayer unfavorable positions taken in the proposed regulations can be softened a bit in the final regulations. In addition, it would be nice to get some guidance on how the rules will apply to cooperatives and their patrons.
Also, this post did not exhaust all of the issues addressed in the proposed regulations, just the one that are most likely to apply to farming and ranching businesses. For example, a separate dimension of the proposed regulations deals with “specialized service businesses.” That was not addressed.
Friday, August 3, 2018
The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under IRC §179 to $1 million. The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017. The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018.
Is property held in trust eligible to be expensed under I.R.C. §179? That’s a big issue for farm and ranch families (and others). Trusts are a popular part of many estate and business plans, and if property contained in them is not eligible for I.R.C. §179 their use could be costly from an income tax standpoint.
Trusts and eligibility for I.R.C. §179 - that’s the topic of today’s post.
Does the Type of Trust Matter?
I.R.C. §179(d)(4) states that an estate or trust is not eligible for I.R.C. §179. That broad language seems to be all inclusive – all types of trusts and in addition to estates are included. If that is true, that has serious implications for estate planning for farmers and ranchers (and others). Revocable living trusts are a popular estate planning tool in many estate planning situations, regardless of whether there is potential for federal estate tax. If property contained in a revocable trust (e.g., a “grantor” trust) is not eligible for I.R.C. §179, that can be a significant enough income tax difference that would mean that the estate plan should be changed to not utilize a revocable trust.
Grantor trusts. A grantor trust is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust. Because of this retained power, the trust's income is taxable to the grantor. From a tax standpoint, the grantor is treated as the owner of the trust with the result that all items of income, loss, deduction and credit flowing through to the grantor during the period for which the grantor is treated as the owner of the trust. I.R.C. §671; Treas. Reg. § 1.671-3(a)(1); Rev. Rul. 57-390, 1957-2 C.B. 326. Another way of stating the matter is that a grantor trust is a disregarded entity for federal income tax purposes. C.C.A. 201343021 (Jun. 17, 2013). Effectively, the grantor simply treats the trust property as their own.
This is the longstanding position of the IRS. In Rev. Rul 85-13, 1985-1 C.B. 184, the IRS ruled that a grantor of a trust where the grantor retains dominion and control resulted in the grantor being treated as the trust owner. In other words, a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under I.R.C. §§671-677. In the ruling, the IRS determined that a transfer of trust assets to the grantor in exchange for the grantor's unsecured promissory note did not constitute a sale for federal income tax purposes. The facts of the ruling are essentially the same as those at issue in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984). In Rothstein, while the court found the trust at issue to be a grantor trust, the court concluded that the trust was separate from the taxpayer. But, in the 1985 ruling based on the same facts, the IRS stated that it would not follow Rothstein and reasserted its position that a taxpayer is deemed to own the assets contained in a grantor trust for federal tax purposes.
Thus, there is substantial authority for the position that property contained in a grantor trust, such as a revocable living trust, is eligible for expense method depreciation under I.R.C. §179. The grantor is the same thing for tax purposes as the grantor trust.
Irrevocable trusts. An irrevocable trust can't be modified or terminated without the beneficiary's permission. The grantor, having transferred assets into the trust, effectively removes all rights of ownership to the assets and control over the trust assets. This is the opposite of a revocable trust, which allows the grantor to modify the trust. That means that an irrevocable trust is a different entity from the taxpayer and the property contained in the trust is not eligible for expense method depreciation under I.R.C. §179 pursuant to I.R.C. §179(d)(4), unless the grantor retains some degree of power over trust income or assets. For instance, a common situation when an irrevocable trust will be treated by the IRS as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property. The same result occurs when the grantor retains any significant level of administrative control over the trust such as discretionary authority to distribute trust property to the grantor or the power to borrow money from the trust without paying a market rate of interest.
Pass-Through Entities and Irrevocable Trusts
The 20 percent deduction for qualified business income under I.R.C. §199A in effect for tax years beginning after 2017 and before 2026 for taxpayers with business income that are not C corporations, may spark increased interest in pass-through entities. With respect to a pass-through entity, though, questions concerning the use of I.R.C. §179 arise when an irrevocable trust has an ownership interest in the entity. Under Treas. Reg. § 1.179-1(f)(3), a trust that is a partner or S corporation shareholder is barred from deducting its allocable share of the I.R.C. §179 depreciation that is elected at the entity level. The pass-through entity’s basis in the I.R.C. §179 property is not reduced to reflect any portion of the I.R.C. §179 expense that is allocable to the trust or estate. Consequently, the entity claims a regular depreciation deduction under I.R.C. §168 with respect to any depreciable basis that results from the inability of a non-grantor irrevocable trust or the estate to claim its allocable portion of the I.R.C. §179 depreciation. Id. The irrevocable trust or estate does not benefit from the entity’s I.R.C. §179 election.
A revocable living trust, as a grantor trust, can claim I.R.C. §179 depreciation. Thus, that common estate planning vehicle won’t present an income tax planning disadvantage by taking I.R.C. §179 depreciation off of the table. However, when an irrevocable trust is involved, the result is different, unless the trust contains language that gives the grantor sufficient control over trust income or assets. Business property that is contained in an irrevocable trust is generally not eligible for I.R.C. §179 depreciation. But, trust language may change that general result. In addition, if a pass-through entity claims I.R.C. §179 depreciation, none of that depreciation flows to the irrevocable trust (or estate). That means that the entity will need to make special basis adjustments so that the deduction (or a portion thereof) is not wasted. Likewise, the depreciation should be “separately stated items” on the K-1 whenever an irrevocable trust or an estate owns an interest in the entity. Likewise, existing partnership agreements may need to be modified so that I.R.C. §179 deductions are allocated to non-trust partners and other expenses to owners of interests that are irrevocable trusts and estates.
This potential difference in tax treatment between revocable grantor trusts and irrevocable trusts should be considered as part of the overall tax planning and estate/business planning process.
Wednesday, July 18, 2018
Next month, Washburn Law School and Kansas State University (KSU) will team up for its annual symposium on agricultural law and the business of agriculture. The event will be held in Manhattan at the Kansas Farm Bureau headquarters. The symposium will be the first day of three days of continuing education on matters involving agricultural law and economics. The other two days will be the annual Risk and Profit Conference conducted by the KSU Department of Agricultural Economics. That event will be on the KSU campus in Manhattan. The three days provide an excellent opportunity for lawyers, CPAs, farmers and ranchers, agribusiness professionals and rural landowners to obtain continuing education on matters regarding agricultural law and economics.
This year’s symposium on August 15 will feature discussion and analysis of the new tax law, the Tax Cuts and Jobs Act, and its impact on individuals and businesses engaged in agriculture; farm and ranch financial distress legal issues and the procedures involved in resolving debtor/creditor disputes, including the use of mediation and Chapter 12 bankruptcy; farm policy issues at the state and federal level (including a discussion of the status of the 2018 Farm Bill); the leasing of water rights; an update on significant legal (and tax) developments in agricultural law (both federal and state); and an hour of ethics that will test participant’s negotiation skills.
The symposium can also be attended online. For a complete description of the sessions and how to register for either in-person or online attendance, click here: https://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
Risk and Profit Conference
On August 16 and 17, the KSU Department of Agricultural Economics will conduct its annual Risk and Profit campus. The event will be held at the alumni center on the KSU campus, and will involve a day and a half of discussion of various topics related to the economics of the business of agriculture. One of the keynote speakers at the conference will be Ambassador Richard T. Crowder, an ag negotiator on a worldwide basis. The conference includes 22 breakout sessions on a wide range of topics, including two separate breakout sessions that I will be doing with Mark Dikeman of the KSU Farm Management Association on the new tax law. For a complete run down of the conference, click here: https://www.agmanager.info/risk-and-profit-conference
The two and one-half days of instruction is an opportunity is a great chance to gain insight into making your ag-related business more profitable from various aspects – legal, tax and economic. If you are a producer, agribusiness professional, or a professional in a service business (lawyer; tax professional; financial planner; or other related service business) you won’t want to miss these events in Manhattan. See you there, or online for Day 1.
July 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engaged in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners were a married couple who lived in the San Francisco Bay area. The husband worked in the technology sector, and during the years in issue (2010-2014) the husband’s salary ranged from $1.4 million to $10.5 million. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The wife sold her physical therapy practice to focus her time on the administrative side of their new ranching activity.
The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of a woodshop and cement factory as the property’s remote location made repair work and build-out necessary to conduct on-site. The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually, and presumably because of the continued claimed losses, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also determined that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, the couple moved to Park City, Utah, with the husband devoting full-time to the ranching activity along with his wife. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS hired an expert who spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. The expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. They had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions. However, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible. Indeed, on the material participation issue, due to the presence of the ranch manager, all of the personal actions and involvement of the petitioners on which the court based its determination of their profit motive were dismissed as “investor” hours.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.
Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.
Thursday, June 28, 2018
The needs and capabilities of a farming or ranching business (or any business for that matter) need to be integrated with business and estate plans, and the retirement needs, of each of the owners. A buy-sell agreement is a frequently used mechanism for dealing with these issues. For many small businesses, a well-drafted buy-sell agreement is perhaps just as important as a will or trust. It can be the key to passing on the business to the next generation successfully. For most farming and ranching operations, succession planning is now more important than estate tax planning. That makes a good buy-sell agreement an important document.
Buy-sell agreements – the basics of what they are and how they work, that’s the topic of today’s post.
A buy-sell agreement is typically a separate document, although some (or all) of its provisions may be incorporated in its bylaws, the partnership agreement, the LLC operating agreement and, on occasion, in an employment agreement with owner-employees. Major reasons for having a buy-sell agreement include: establishing continuity of business ownership; providing a market for otherwise illiquid closely held shares; establishing a funding source and a mechanism for share purchase; establishing certainty as to the value of the shares for estate purposes; and providing restrictions on operational matters, e.g. voting control and protection of S corporation status.
Establishment of Estate Tax Value
While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are. For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.
There are six basic requirements for a buy-sell agreement to establish value of a deceased owner’s interest: (1) the interest must be subject to an option to purchase that is a binding obligation on the estate; (2) the purchase price must be established with certainty; (3) the interest must not be subject to lifetime transfers that could defeat the obligation to purchase; (4) there must be a “ bona fide business arrangement”; (5) the agreement cannot be a device to transfer at lower than fair market value; and (5) the agreement must be comparable to similar arrangements between persons in an arms-length transaction.
The estate must be obligated to sell; however, there is no requirement for the purchaser to buy. However, there is often an additional provision in such agreements to provide that if adequate funding is available, the survivors are obligated to purchase in order to provide estate liquidity, and often to protect the deceased shareholder’s family from the vagaries of the ongoing business.
To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of § 2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.
A key point is that, to be effective in establishing a value for estate tax purposes, the buy-sell agreement must provide that the corporation or shareholders are either obligated or have an option to purchase the shares of a holder who desires to sell within his lifetime, at the same price and on the same terms as provided for upon the death of the shareholder. A right of first refusal will not accomplish the same objective and will potentially contravene the requirements of I.R.C. §2031. From the selling shareholder’s viewpoint, either an option or right of first refusal may not be acceptable because of their failure to guarantee a market for the shares.
The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth”. Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167(2001), aff’d 390 F. 3d 1210 (2004), and Estate of Blount v. Comr., T.C. Memo 2004-116(2004).
Valuation methods. There are several general valuation methods for buy-sell agreements.
One method is the fixed value method. Under this method, the value of the interest being valued doesn’t change. It is not used much, and would not meet most IRS requirements under IRC §2703(b) and the regulations.
Another approach is one that uses an appraisal to value the underlying business interest. This method is also rarely used for operating businesses, but may be appropriate for certain types of business such as real estate. If this method is used it is often a triple appraisal approach, where the purchaser and estate each appoint an appraiser who appoints a third if the first two cannot agree. A drawback is that the valuation is left until the triggering event (death, disability, etc.), leaving the owners with little guidance for the necessary funding decisions.
The formula method uses book value from the financial statements of the business to value the interest. That is relatively easy to determine, but it will result in a significant deviation from fair market value unless adjusted for such matters as the company’s accounting method, differences between book and fair market value for real estate, equipment, other tangible assets and intangible assets. Other adjustments may include accounts receivable to reflect collectability, and an examination of the adequacy of reserve accounts.
Another formula method is one based on earnings which are then capitalized to arrive at a proper value. The selection of an appropriate capitalization rate is an important determination, and it must be recognized that a rate appropriate at the time of the agreement may not be appropriate later due to a change in business or the economic environment.
Agreed value is another frequently used method of valuation, usually combined with periodic adjustments by the parties. This is often coupled with a back-up valuation method to take effect within a certain period of time if a value has not been adopted.
Another commonly used provision is one that requires any outside purchaser of the business to adopt the buy-sell agreement. In the case of a limited liability company, the requirement may be to adopt the operating agreement before becoming a member. Either of these provisions serves to protect the remaining owners.
Who Will Be the Buyer?
When setting up a buy-sell agreement for your farm/ranch (or other) business, an important decision at the beginning is to determine who will be the purchaser. Not only is establishing a purchase price important, but determining how the purchase price will be paid is also important. This is a function of the type of buy-sell agreement that is utilized. With a “redemption’ type agreement, the corporation is the buyer. With a “cross-purchase” agreement, the other shareholders are the buyers. A buy-sell agreement can also be a combination of a redemption and cross-purchase agreement.
Since life insurance on the lives of the shareholders is often used to partially or fully fund a buy-sell agreement, the availability and affordability of insurance, the number of policies needed, and the source of funds to pay the premiums will often dictate the type of agreement selected. The amount will depend upon the valuation of the company, the limits on corporate or shareholder finances to pay the premiums, and the extent to which both the shareholders and the seller are willing to assume an unfunded liability if the buy-sell is not fully funded by insurance. Multiple policies may be required for a cross-purchase agreement unless a partnership can be utilized to hold the insurance (e.g. if three shareholders, there would be six separate policies; if four shareholders, twelve policies) so that beyond a few shareholders may make this approach impractical. However, a single policy on each shareholder would suffice when funding a corporate redemption. Another possible solution is a buy-out insurance trust which owns the policies.
If the farming business owns the policy, the business can borrow against any cash value if needed. If no trust or partnership is used, a cross-purchase agreement leaves the payment of premiums in the control of the individual shareholder, and potentially subjects any cash value to creditor claims. This factor alone may determine which form of agreement is most desirable.
If there is a disparity in ownership shares (and there often is), a minority shareholder may be required to fund the much higher interest of the majority shareholder(s) in a cross-purchase agreement. In a corporate redemption, however, the funding of the purchase, either from insurance or other corporate assets, is being born by the shareholders in proportion to their relative stock interests.
While life insurance will often solve the funding problem for purchasing a deceased shareholders stock, and disability insurance is available for permanent disability, insurance proceeds are generally not available in lifetime purchase situations. Thus, the funding capability of the parties is critical since there may not be an alternative funding method available that will satisfy all parties. However, in many situations non-insurance methods of funding coupled with installment payments of the purchase price will meet most of the major needs of the parties.
Today’s post was only a surface-level discussion on buy sell agreements. A good buy-sell agreement is an essential part of transitioning a business to the next generation of owners. But, it is complex and a great deal of thought must be given to the proper crafting of the agreement. Of course, there are associated tax considerations which were not covered in this post. In addition, there are numerous financial and personal factors that also come into play. Likewise, significant thought must be given to the events that can trigger the operation of the agreement.
Like other estate planning documents, a buy-sell agreement should be reviewed regularly even in the absence of any potentially triggering event, and particularly when there is any change in the business structure or ownership.
Wednesday, May 23, 2018
The Tax Cuts and Jobs Act (TCJA) that was signed into law on December 22, 2017, represents a major change to many provisions of the tax Code that impact individuals and business entities. I have discussed of the major changes impacting farm and ranch taxpayers and businesses in prior posts. But, the TCJA also makes substantial changes with respect to the income taxation of trusts and estates. Those changes could have an impact on the use of trusts as an estate planning/wealth transfer device. Likewise, the TCJA changes that impact decedent’s estate must also be noted.
The TCJA’s changes that impact trusts and estates – that’s the focus of today’s post.
While the media has largely focused on the TCJA’s rate reductions for individuals and C corporations, the rates and bracket amounts were also modified for trusts and estates. The new rate structure for trusts and estates are located in I.R.C. §1(j)(2)(E) and are as follows: 10%: $0: $2,550; 24%: $2,551-$9,150; 35%: $9,151-$12,500; 37% - over $12,500. As can be noted, the bracket structure for trusts and estates remains very compressed. Thus, the pre-TCJA planning approach of not trapping income or gains inside a trust or an estate remains the standard advice. That’s because the TCJA did not change the tax rates for qualified dividends and long-term capital gains, although the bracket cut-offs are modified slightly as follows: 0%: $0-$2,600; 15%: $2,601-$12,700; 20%: Over $12,700. Those rates and brackets remain advantageous compared to having the income or gain taxed at the trust or estate level.
Other Aspects of Trust/Estate Taxation
Post-TCJA, it remains true that an estate or trust’s taxable income is computed in the same manner as is income for an individual. I.R.C. §641(b). However, the TCJA amends I.R.C. §164(b) to limit the aggregate deduction for state and local real property taxes and income taxes to a $10,000 maximum annually. But, this limit does not apply to any real estate taxes or personal property taxes that a trust or an estate incurs in the conduct of a trade or business (or an activity that is defined under I.R.C. §212). Thus, an active farm business conducted by a trust or an estate will not be subject to the limitation.
The TCJA also suspends miscellaneous itemized deductions for a trust or an estate. That means, for example, that investment fees and expenses as well as unreimbursed business expenses are not deductible. This will generally cause an increased tax liability at the trust or estate level as compared to prior law. Why? With fewer deductions, the adjusted taxable income (ATI) of a trust or an estate will be higher. For simple trusts, this is also a function of distributable net income (DNI) which, in turn, is a function of the income distribution deduction (IDD). I.R.C. §651(b) allows a simple trust to claim an IDD limited to the lesser of fiduciary accounting income (FAI) or DNI. Under prior law, all trust expenses could be claimed when determining DNI, but only some of those expenses were allocated to principal for purposes of calculating FAI. Now, post-TCJA, ATI for a trust or an estate will be higher due to the loss of various miscellaneous itemized deductions (such as investment management fees). As ATI rises, DNI will decline but FAI won’t change (the allocation of expenses is determined by the trust language or state law). The more common result is likely to be that FAI will be the actual limitation on the IDD, and more income will be trapped inside the estate or the trust. That’s what will cause the trust or the estate to pay more tax post-TCJA compared to prior years.
But, guidance is needed concerning the deductibility of administrative expenses such as trustee fees. It’s not clear whether the TCJA impacts I.R.C. §67. That Code section does not apply the two percent limitation to administrative expenses that are incurred solely because the property is held inside a trust or an estate. There is some support for continuing to deduct these amounts. I.R.C. §67(g) applies to miscellaneous itemized deductions, but trustee fees and similar expenses are above-the-line deductions for a trust or an estate that impact the trust or estate’s AGI. Thus, I.R.C. §67 may not apply. I am told that guidance will be forthcoming on that issue during the summer of 2018. We shall see.
A trust as well as an estate can still claim a $600 personal exemption (with the amount unchanged) under I.R.C. §642. Don’t confuse that with the TCJA’s suspension of the personal exemption for individuals. Also, don’t confuse the removal of the alternative minimum tax (AMT) for corporations or the increased exemption and phaseout range for individuals with the application of the AMT to trusts and estates. No change was made concerning how the AMT applies to a trust or an estate. See I.R.C. §55.(d)(3). The exemption stays at $24,600 with a phaseout threshold of $82,050. Those amounts apply for 2018 and they will be subsequently adjusted for inflation (in accordance with the “chained” CPI).
Other TCJA Impacts on Trusts and Estates
The new 20 percent deduction for pass-through entities under I.R.C. §199A can be claimed by an estate or a trust with non-C corporate business income. The deduction is claimed at the trust or the estate level, with the $157,500 threshold that applies to a taxpayer filing as a single person applying to a trust or an estate. The rules under the now-repealed I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital. There is no separate computation required for alternative minimum tax purposes.
The eligibility of a trust or an estate for the I.R.C. §199A deduction may provide some planning opportunities to route pass-through income from a business that is otherwise limited or barred from claiming the deduction through a non-grantor trust so that the deduction can be claimed or claimed to a greater extent. For example, assume that a sole proprietorship farming operation nets $1,000,000 annually, but pays no qualified wages and has no qualifying property (both factors that result in an elimination of the deduction for the business). If business income is routed through a trust (or multiple truss) with the amount of trust income not exceeding the $157,500 threshold, then an I.R.C. §199A deduction can be generated. However, before this strategy is utilized, there are numerous factors to consider including overall family estate planning/succession planning goals and the economics of the business activity at issue.
Clarification is needed with respect to a charitable remainder trust (CRT) that has unrelated business taxable income (UBIT). UBIT is income of the CRT that comes from an unrelated trade or business less deductions “allowed by Chapter 1 of the Code” that are “directly connected” with the conduct of a trade or business. Treas. Reg. §1.512(a)-1(a). Is the new I.R.C. §199A deduction a directly connected deduction? It would seem to me that it is because it is tied to business activity conducted by the trust. If that construction is correct, I.R.C. §199A would reduce the impact of the UBIT on a CRT. Certainly, guidance is needed from the Treasury on this point.
Related to the CRT issue, the TCJA would appear to allow an electing small business trust (ESBT) to claim the I.R.C. §199A deduction on S corporate income. But, again, guidance is needed. An ESBT calculates the tax on S corporate income separately from all other trust income via a separate schedule. The result is then added to the total tax calculated for the trust’s non-S corporate income. Thus, the ESBT pays tax on all S corporate income. It makes no difference whether the income has been distributed to the ESBT beneficiaries. Also, in computing its tax, the deductions that an ESBT can claim are set forth in I.R.C. §641(c)(2). However, the TCJA does not include the I.R.C. §199A deduction in that list. Was that intentional? Was that an oversight? Your guess is as good as mine.
Another limiting factor for an ESBT is that an ESBT can no longer (post-2017 and on a permanent basis) deduct 100 percent of charitable contributions made from the S corporation’s gross income. Instead, the same limitations that apply to individuals apply to an ESBT – at least as to the “S portion” of the ESBT. But, the charitable contribution need not be made from the gross income of the ESBT. In addition, the charitable contribution must be made by the S corporation for the ESBT to claim the deduction. If the ESBT makes the contribution, it is reported on the non-ESBT portion of the return. It is not allocated to the ESBT portion.
Under the TCJA, an ESBT can have a nonresident alien as a potential current beneficiary.
If a trust or an estate incurs a business-related loss, the TCJA caps the loss at $250,000 for 2018 (inflation-adjust for future years). The $250,000 amount is in the aggregate – it applies at the trust or estate level rather than the entity level (if the trust or estate is a partner of a partnership or an S corporation shareholder). I.R.C. §461(l)(2). Amounts over the threshold can be carried over and used in a future year.
The TCJA impacts a broad array of taxpayers. Its impacts are not limited to individuals and corporate taxpayers. Trusts and estates are also affected. For those with trusts or involved with an estate, make sure to consult tax counsel to make sure the changes are being dealt with appropriately.
Monday, May 21, 2018
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.
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.
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.
Thursday, May 17, 2018
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.
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.
Tuesday, May 15, 2018
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.
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.
Friday, April 13, 2018
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: https://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.
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.
Wednesday, February 28, 2018
Monday’s post on whether the new tax law indicates that a C corporation should be the entity form of choice generated a lot of interest. Some of the questions that came in surrounded what the tax consequences are when a C corporation is formed. That’s a good question. The tax Code does have special rules that apply when forming a C corporation. If those rules are followed, forming a C corporation can be accomplished without tax consequences.
The tax rules surrounding C corporation formation, that’s the topic of today’s post.
Tax-Free Incorporation Rules
Incorporation of an existing business, such as a sole-proprietorship farming or ranching operation, can be accomplished tax-free. A tax-free incorporation is usually desirable. That’s particularly the case for farming and ranching businesses because farm and ranch property typically has a fair market value substantially in excess of basis. That’s usually the result of substantial amounts of depreciation having been taken on farm assets.
For property conveyed to the corporation, neither gain nor loss is recognized on the exchange if three conditions are met. I.R.C. § 351. First, the transfer must be solely in exchange for corporate stock. Second, the transferor (or transferors as a group) must be “in control” of the corporation immediately after the exchange. This requires that the transferors of property end up with at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of the total number of shares of all classes of stock. Third, the transfer must be for a “business purpose.”
Be careful of stock transfers. Because of the 80 percent control test, if it is desirable to have a tax-free incorporation, there can be no substantial stock gifting occurring simultaneously with, or near the time of, incorporation. For example, parents who transfer all of their property to a corporation can destroy tax-free exchange status by gifting more than 20 percent of the corporate stock to children and other family members simultaneously with incorporation or shortly thereafter.
How long is the waiting period before gifts of stock can be made? There is no bright line rule. Certainly, a month is better than a week, and six weeks are better than a month. In addition, care should also be given to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation. See, e.g., Ltr. Rul. 9405007 (Oct. 19, 1993).
Income Tax Basis Upon Incorporation
The income tax basis of stock received by the transferors is the basis of the property transferred to the corporation, less boot received, plus gain recognized, if any. If the corporation takes over a liability of the transferor, such as a mortgage, the amount of the liability reduces the basis of the stock or securities received. Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash. The corporation's income tax basis for property received in the exchange is the transferor's basis plus the amount of gain, if any, recognized to the transferor.
When Is Incorporation A Taxable Event?
If the sum of the liabilities assumed or taken subject to by the corporation exceeds the aggregate basis of assets transferred, a taxable gain is incurred as to the excess. I.R.C. § 357(c). Bonus depreciation and I.R.C. §179 may have been taken on equipment resulting in little-to-no remaining tax basis. This, combined with an operating line, prepaid expenses and deferred income result in taxable income recognition upon the incorporation of a farm. Thus, for those individuals who have refinanced and have increased their debt level to a level that exceeds the income tax basis of the property, a later disposition of the property by installment sale or transfer to a partnership or corporation, will trigger taxable gain as to the excess.
Technique to avoid tax? The liability in excess of basis problem has led to creative planning techniques in an attempt to avoid the taxable gain incurred upon incorporation. One of those strategies involves the transferor giving the corporation a personal promissory note for the difference and claiming a basis in the note equivalent to the note's face value. The IRS has ruled that this technique will not work because the note has a zero basis. Rev. Rul. 68-629, 1968-2 C.B. 154.
While one court, in 1989, held that a shareholder's personal note, while having a zero basis in the shareholder's hands, had a basis equivalent to its face amount in the corporation's hands (Lessinger v. United States, 872 F.2d 519 (2d Cir. 1989), rev'g, 85 T.C. 824 (1985)), that is not a view held by the other courts that have addressed the issue. For example, in Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191, the taxpayer contributed two parcels of real estate to the taxpayer's closely-held corporation. The transferred properties were encumbered with liabilities that together exceeded the taxpayer's total basis of the properties by more than $500,000. In order to avoid immediate gain recognition as to the amount of excess liabilities over basis, the taxpayer also executed a promissory note, promising to pay the corporation $1,060,000 over a term of ten years at eleven percent interest. The taxpayer remained personally liable on the encumbrances even though the corporation took the properties subject to the debt. The taxpayer did not make any payments on the note until after being audited, which was approximately three years after the note was executed. The IRS argued that the note was not genuine indebtedness and should be treated as an enforceable gift. In the alternative, the IRS argued that even if the note were genuine, its basis was zero because the taxpayer incurred no cost in issuing the note to the corporation. As such, the IRS argued, the note did not increase the taxpayer's basis in the contributed property.
The Peracchi court held that the taxpayer had a basis of $1,060,000 (face value) in the note. As such, the aggregate liabilities of the property contributed to the corporation did not exceed aggregate basis, and no gain was triggered. The court reasoned that the IRS's position ignored the possibility that the corporation could go bankrupt, an event that would suddenly make the note highly significant. The court also noted that the taxpayer and the corporation were separated by the corporate form, which was significant in the matter of C corporate organization and reorganization. Contributing the note placed a million dollar “nut” within the corporate “shell,” according to the court, thereby exposing the taxpayer to the “nutcracker” of corporate creditors in the event the corporation went bankrupt. Without the note, the court reasoned, no matter how deeply the corporation went into debt, creditors could not reach the taxpayer's personal assets. With the note on the books, however, creditors could reach into the taxpayer's pocket by enforcing the note as an unliquidated asset of the corporation. The court noted that, by increasing the taxpayer's personal exposure, the contribution of a valid, unconditional promissory note had substantial economic effect reflecting true economic investment in the enterprise. The court also noted that, under the IRS's theory, if the corporation sold the note to a third party for its fair market value, the corporation would have a carryover basis of zero and would have to recognize $1,060,000 in phantom gain on the exchange even if the note did not appreciate in value at all. The court reasoned that this simply could not be the correct result. In addition, the court noted that the taxpayer was creditworthy and likely to have funds to pay the note. The note bore a market rate of interest related to the taxpayer's credit worthiness and had a fixed term. In addition, nothing suggested that the corporation could not borrow against the note to raise cash. The court also pointed out that the note was fully transferable and enforceable by third parties.
The court did acknowledge that its assumptions would fall apart if the shareholder was not creditworthy, but the IRS stipulated that the shareholder's net worth far exceeded the value of the note. That seems to be a key point that the court overlooked. If the taxpayer was creditworthy, then a legitimate question exists concerning why the taxpayer failed to make payments on the note before being audited. Clearly, the taxpayer never had any intention of paying off the note. Thus, a good argument could have seemingly been made that the note did not represent genuine indebtedness. The court also appears to have overlooked the different basis rules under I.R.C. § 1012 and I.R.C. § 351. An exchanged basis is obtained in accordance with an I.R.C. § 351 transaction which precludes application of the basis rules of I.R.C. § 1012.
Note: After Lessinger and Peracchi were decided, I.R.C. §357 was amended to include subsection (d). That subsection specifies that a recourse liability is to be treated as having been assumed if the facts and circumstances indicate that the transferee has agreed to, and is expected to, satisfy the liability (or a portion thereof) regardless of whether the transferor has been relieved of the liability. Non-recourse liabilities are to be treated as having been assumed by the transferee of any asset subject to the liability.
What about other entities? The Peracchi court was careful to state that the court's rationale was limited to C corporations. Thus, the opinion will not apply in the S corporation setting for shareholders attempting to create basis to permit loss passthrough. However, Rev. Rul. 80-235, 1980-2 C.B. 229, specifies that a partner in a partnership cannot create basis in a partnership interest by contributing a note. This all means that the IRS is likely to continue challenging “basis creation” cases on the ground that the contribution of a note is not a bona fide transfer.
Different strategy? A similar technique designed to avoid gain recognition upon incorporation of a farming or ranching operation (where liabilities exceed basis) is for the transferors to remain personally liable on the debt assumed by the corporation, with no loan proceeds disbursed directly to the transferors. However, gain recognition is not avoided unless the corporation does not assume the indebtedness. Seggerman Farms, Inc. v. Comm’r, 308 F.3d 803 (7th Cir. 2002), aff’g, T.C. Memo. 2001-99.
As the above discussion indicates, a good rule of thumb is that property should never be transferred to a new entity without first determining whether there is enough basis to absorb the debt. If it is discovered that the debt exceeds the aggregate basis of the property being transferred to the entity, several options should be considered for their potential availability. These include not transferring some of the low basis assets to the new entity or consulting with the lender and leaving some of the debt out of the entity, permitting it instead to run against the individual shareholders, or having the shareholders later pledge their stock to secure the debt. Alternatively, cash can be contributed to the entity in lieu of some of the low basis assets or in addition to the assets. Cash is all basis.
Monday, February 26, 2018
The “Tax Cuts and Jobs Act” (TCJA) enacted in late 2017, cuts the corporate tax rate to 21 percent. That’s 16 percentage points lower than the highest individual tax rate of 37 percent. On the surface, that would seem to be a rather significant incentive to form a C corporation for conducting a business rather than some form of pass-through entity where the business income flows through to the owners and is taxed at the individual income tax rates. In addition, a corporation can deduct state income taxes without the limitations that apply to owners of pass-through entities or sole proprietors.
Are these two features enough to clearly say that a C corporation is the entity of choice under the TCJA? That’s the focus of today’s post – is forming a C corporation the way to go?
The fact that corporations are now subject to a corporate tax at a flat rate of 21 percent is not the end of the story. There are other factors. For instance, the TCJA continues the multiple tax bracket system for individual income taxation, and also creates a new 20 percent deduction for pass-through income (the qualified business income (QBI) deduction). In addition, the TCJA doesn’t change or otherwise eliminate the taxation on income distributed (or funds withdrawn) from a C corporation – the double-tax effect of C-corporate distributions. These factors mute somewhat the apparent advantage of the lower corporate rate.
Under the new individual income tax rate structure, the top bracket is reached at $600,000 for a taxpayer filing as married filing joint (MFJ). For those filing as single taxpayers or as head-of household, the top bracket is reached at $500,000. Of course, not every business structured as a sole-proprietorship or a pass-through entity generates taxable income in an amount that would trigger the top rate. The lower individual rate brackets under the TCJA are 10, 12, 22, 24, 32 and 35 percent. Basically, up to about $75,000 of taxable income (depending on filing status), the individual rates are lower than the 21 percent corporate rate. So, just looking at tax rates, businesses with relatively lower levels of income will likely be taxed at a lower rate if they are not structured as a C corporation.
As noted, under the TCJA, for tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of business taxable income. However, the deduction comes with a limitation. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. I.R.C. §199A. Architects and engineers can claim the QBI deduction, but other services business are limited in their ability to claim it. For them, the QBI deduction starts to disappear once taxable income exceeds $315,000 (MFJ).
Clearly, the amount of income a business generates and the type of business impacts the choice of entity.
Another factor influencing the choice between a C corporation or a flow-through entity is whether the C corporation distributes income, either as a dividend or when share of stock are sold. The TCJA, generally speaking, doesn’t change the tax rules impacting qualified dividends and long-term capital gains. Preferential tax rates apply at either a 15 percent or 20 percent rate, with a possible “tack-on” of 3.8 percent (the net investment income tax) as added by Obamacare. I.R.C. §1411. So, if the corporate “double tax” applies, the pass-through effective rate will always be lower than the combined rates applied to the corporation and its shareholders. That’s true without even factoring in the QBI deduction for pass-through entities. But, for service businesses that have higher levels of income that are subject to the phase-out (and possible elimination) of the QBI deduction, the effective tax rate is almost the same as the rate applying to a corporation that distributes income to its shareholders, particularly given that a corporation can deduct state taxes in any of the 44 states that impose a corporate tax (Iowa’s stated corporate rate is the highest).
C corporations that have taxable income are also potentially subject to penalty taxes. The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531. The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments. I.R.C. §535. There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment. Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders. This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions. Consequently, this leads to a build-up of earnings and profits within the corporation.
The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year. Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business. So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax. I.R.C. §535(c)(2)(A). However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway. I.R.C. §535(c)(2)(B). But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. That’s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business.
The other penalty tax applicable to C corporations is the PHC tax. I.R.C. §§541-547. This tax is imposed when the corporation is used as a personal investor. The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).
To be a PHC, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources. See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991).
What if the Business Will Be Sold?
If the business will be sold, the tax impact of the sale should be considered. Again, the answer to whether a corporation or pass-through entity is better from a tax standpoint when the business is sold is that it “depends.” What it depends upon is whether the sale will consist of the business equity or the business assets. If the sale involves equity (corporate stock), then the sale of the C corporate stock will likely be taxed at a preferential capital gain rate. Also, for a qualified small business (a specially defined term), if the stock has been held for at least five years at the time it is sold, a portion of the gain (or in some cases, all of the gain) can be excluded from federal tax. Any gain that doesn’t qualify to be excluded from tax is taxed at a 28% rate (if the taxpayer is in the 15% or 20% bracket for regular long-term capital gains). Also, instead of a sale, a corporation can be reorganized tax-free if technical rules are followed.
If the sale of the business is of the corporate assets, then flow-through entities have an advantage. A C corporation would trigger a “double” tax. The corporation would recognize gain taxed at 21 percent, and then a second layer of tax would apply to the net funds distributed to the shareholders. Compare this result to the sale of assets of a pass-through entity which would generally be taxed at long-term capital gain rates.
Use of the C corporation may provide the owner with more funds to invest in the business. Also, a C corporation can be used to fund the owner’s retirement plan in an efficient manner. In addition, fringe benefits are generally more advantageous with a C corporation as compared to a pass-through entity (although the TCJA changes this a bit). A C corporation is also not subject to the alternative minimum tax (thanks to the TCJA). There are also other minor miscellaneous advantages.
So, what’s the best entity choice for you and your business? It depends! Of course, there are other factors in addition to tax that will shape the ultimate entity choice. See your tax/legal advisor for an evaluation of your specific facts.