Wednesday, May 23, 2018

The Impact of the TCJA on Estates and Trusts

Overview

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.

In General

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.

Conclusion

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.

May 23, 2018 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, May 21, 2018

Valuation Discounting - Part Two

Overview

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

I.R.C. §2036 – The Basics

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

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

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

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

(b) Voting rights

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

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

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

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

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

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

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

I.R.C. §2703 and Indirect Gifts

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

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

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

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

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

    (1) It is a bona fide business arrangement.

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

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

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

Recent Cases

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

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

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

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

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

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

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

Conclusion

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

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

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

Thursday, May 17, 2018

Valuation Discounting

Overview

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

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

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

Valuation Discounting – Interests in Family Limited Partnerships

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

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

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

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

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

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

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

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

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

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

FLPs and the IRC §2036 Problem

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

Conclusion

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

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

Tuesday, May 15, 2018

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

Overview

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

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

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

S Corporation Passive Income

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

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

How Can Passive Income Be Avoided?

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Friday, April 13, 2018

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

Overview

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

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

Calendar of Events

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

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

May 9 – CoBank, Wichita KS

May 10 – Kansas Society of CPAs, Salina, KS

May 14 - Lorman, Co. Webinar

May 16 – Quincy Estate Planning Council, Quincy, IL

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

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

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

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

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

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

June 27 – Kansas Society of CPAs, Topeka, KS

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

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

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

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

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

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

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

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

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

September 21 – University of Illinois, Moline, IL

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

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

October 3 – CoBank, Wichita, KS

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

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

Special Attention – Summer Seminar

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

Conclusion

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

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

Wednesday, February 28, 2018

Tax Issues When Forming A C Corporation

Overview

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.

Summary

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. 

February 28, 2018 in Business Planning | Permalink | Comments (0)

Monday, February 26, 2018

Form a C Corporation – The New Vogue in Business Structure?

Overview

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?

Tax Comparisons

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). 

Other Considerations

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. 

Other Considerations

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. 

Conclusion

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.

February 26, 2018 in Business Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 20, 2018

Summer Farm Income Tax/Estate and Business Planning Conference

Overview

For over the past decade I have conducted at least one summer tax conference addressing farm income tax and farm estate and business planning. The seminars have been held from coast-to-coast in choice locations – from North Carolina and New York in the East to California and Alaska in the West, and also from Michigan and Minnesota in the North to New Mexico in the South.  This summer’s conference will be in Shippensburg, Pennsylvania on June 7-8 and is sponsored by the Washburn University School of Law.  Our co-sponsors are the Kansas State University Department of Agricultural Economics and the Pennsylvania Institute of CPAs.  My teaching partner again this year will be Paul Neiffer, the author of the Farm CPA Today blog.  If you represent farm clients or are engaged in agricultural production and are interested in ag tax and estate/succession planning topics, this is a must-attend conference.

Today’s post details the seminar agenda and other key details of the conference.

Agenda

The first day of the seminar will focus on ag income tax topics.  Obviously, a major focus will be centered on the new tax law and how that law, the “Tax Cuts and Jobs Act” (TCJA), impacts agricultural producers, agribusinesses and lenders.  One of points of emphasis will be on providing practical examples of the application of the TCJA to common client situations.  Of course, a large part of that discussion will be on the qualified business income (QBI) deduction.  Perhaps by the time of the seminar we will know for sure how that QBI deduction applies to sales of ag products to cooperatives and non-cooperatives. 

Of course, we will go through all of the relevant court cases and IRS developments in addition to the TCJA.  There have been many important court ag tax court decisions over the past year, as those of your who follow my annotations page on the “Washburn Agricultural Law and Tax Report” know first-hand. 

Many agricultural producers are presently having a tough time economically.  As a result, we will devote time to financial distress and associated tax issues – discharged debt; insolvency; bankruptcy tax; assets sales, etc.

We will also get into other issues such as tax deferral issues; a detailed discussion of self-employment tax planning strategies; and provide an update on the repair/capitalization regulations. 

On Day 2, the focus shifts to estate and business planning issues for the farm client. Of course, we will go through how the TCJA impacts estate planning and will cover the key court and IRS developments that bear on estate and business planning.  We will also get into tax planning strategies for the “retiring” farmer and farm program payment eligibility planning. 

The TCJA also impacts estate and business succession planning, particularly when it comes to entity choice.  Should a C corporation be formed?  What are the pros and cons of entity selection under the TCJA?  What are the options for structuring a farm client’s business?  We will get into all of these issues.

On the second day we will also get into long-term care planning options and strategies, special use valuation, payment federal estate tax in installments, and the income taxation of trusts and estates.

Location

The seminar will be held at the Shippensburg University Conference Center.  There is an adjacent hotel that has established a room block for conference attendees at a special rate.  Shippensburg is close to the historic Gettysburg Battlefield and is not too far from Lancaster County and other prime ag production areas.  Early June will be a great time of the year to be in Pennsylvania.

Attend In-Person or Via the Web

The conference will be simulcast over the web via Adobe Connect.  If you attend over the web, the presentation will be both video and audio.  You will be able to interact with Paul and I as well as the in-person attendees.  On site seating is limited to the first 100 registrants, so if you are planning on attending in-person, make sure to get your spot reserved. 

More Information

You can find additional information about the seminar and register here:       http://washburnlaw.edu/employers/cle/farmandranchincometax.html 

Conclusion

If you have ag clients, you will find this conference well worth your time. We look forward to seeing you at the seminar either in-person or via the web.

February 20, 2018 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Thursday, February 8, 2018

The Spousal Qualified Joint Venture – Implications for Self-Employment Tax and Federal Farm Program Payment Limitations

 Overview

As noted in Part 1 of this two-part series on the spousal qualified joint venture (QJV), some spousal business ventures can elect out of the partnership rules for federal tax purposes as a QJV.  I.R.C. §761(f).  In Part 1, I looked at the basics of the QJV election and how it can ease the tax reporting requirements for spousal joint ventures that can take advantage of the election.  Today, in Part 2, I look at how the election impacts self-employment tax and, for farmers, eligibility for federal farm program payments.   

The QJV Election and Self-Employment Tax

Under I.R.C. §1402(a), net earnings from self- employment are subject to self-employment tax. Net earnings from self-employment are defined as income derived by an individual from any trade or business carried on by such individual.  But, real estate rental income is excluded from the general definition of net earnings from self-employment.  I.R.C. §1402(a)(1). Thus, for rental property in a partnership (or rental real estate income of an individual), self- employment tax is not triggered.

The QJV election and rental real estate.  I.R.C. §1402(a)(17) specifies that when a QJV election has been made, each spouse’s share of income or loss is taken into account as provided for in I.R.C. §761(f) in determining self-employment tax.  I.R.C. §761(f)(1)(C) specifies that, “each spouse shall take into account such spouse’s respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor.”  That means that the QJV election does not avoid the imposition of self-employment tax.

However, the exception from self-employment tax for rental real estate income remains intact.  The IRS instructions to Form 1065 state that if the QJV election is made for a spousal rental real estate business, "you each must report your share of income and deductions on Schedule E.  Rental real estate income generally isn’t included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive loss limitation rules.  Electing qualified joint venture status doesn’t alter the application of the self-employment tax or the passive loss limitation rules.”  See also CCA Ltr. Rul. 200816030 (Mar. 18, 2008).

While the QJV election may not be a problem in a year when a loss results, the self-employment tax complication can be problematic when there is positive income for the year. That’s because it is not possible to simply elect out of QJV treatment in an attempt to avoid self-employment tax by filing a Form 1065.  The QJV election cannot be revoked without IRS consent.   Likewise, it’s probably not possible to intentionally fail to qualify for QJV status (by transferring an interest in the business to a non-spouse, for example) to avoid self-employment tax in an income year after a year (or years) of reducing self-employment by passed-through losses.  Such a move would allow IRS to assert that the transfer of a minimal interest to a disqualified person or entity violates the intent of Subchapter K

Tax Reporting and Federal Farm Program Participation - The "Active Engagement" Test 

For farm couples that participate in federal farm programs where both spouses satisfy the “active

engagement” test, each spouse may qualify for a payment limitation. 7 U.S.C. §§1308-1(b); 1308(e)(2)(C)(ii); 1400.105(a)(2). To be deemed to be actively engaged in farming as a separate person, a spouse must satisfy three tests: (1) the spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation; (2) the spouse’s contributions must be “at risk;” and (3) the spouse must make a significant contribution of capital, equipment or land (or a combination thereof) and active personal labor or active personal management (or a combination thereof). For the spouse’s contribution to be “at risk,” there must be a possibility that a non-recoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor or management must be material to the operation to be “significant contribution.” Thus, the spouse’s involvement, to warrant separate person status, must not be passive.

While the active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. That’s because, the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.

What this all means is that for spouses who sign up for two separate payment limitations under the farm programs, they are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear risk of loss.

From a tax standpoint, however, the couple may have a single enterprise the income from which is reported on Form 1040 as a sole proprietorship or on a single Schedule F with the income split into two equal shares for self- employment tax purposes. In these situations, IRS could assert that a partnership filing is required (in common-law property states). That’s where the QJV election could be utilized with the result that two proprietorship returns can be filed. As mentioned above that’s a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return. But, the filing of the QJV election will subject the income of both spouses (including each spouse’s share of government payments) to self-employment tax.  That will eliminate any argument that at least one spouse’s income should not be subjected to self-employment tax on the basis that the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for self-employment tax purposes).

Separate “person” status and material participation.  Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction is meaningless on the self-employment tax issue according to the U.S. Tax Court.

In Vianello v. Comr., T.C. Memo. 2010-17, the taxpayer was a CPA that, during the years in issue, operated an accounting firm in the Kansas City area. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant would deduct the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one- third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002. Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions with respect to raising and marketing the crop, and paid the petitioner one-third of the net proceeds. As for the pasture, the tenant mowed it and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. Also, the petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003, and bought another 50 acres from in late 2003.

The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year - as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on a reading of IRS Pub. 225 (Farmer’s Tax Guide) that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda grass planting with the tenant.  The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules as having satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical cost.

The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest.  Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active engagement test and was a co- producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…”.  The Tax Court specifically noted that the Treasury Regulations under I.R.C. §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard” [emphasis added].         That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or self-employment tax purposes.   As noted below, however, the USDA’s determination of participation is not controlling on the IRS.

Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented, and provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for self-employment tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for self-employment tax purposes. The case may also support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes.  But that is probably a weaker argument – Vianello did not involve a spousal farming situation.

So, while Vianello may eliminate the need to make a QJV election in spousal farming situations, without the election it is possible that IRS could deem spouses to be in a partnership triggering the requirement to file a partnership return.

Summary

The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. That includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. But, the election does not eliminate self-employment tax on each spouse’s share of income.

February 8, 2018 in Business Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 6, 2018

The Spousal Qualified Joint Venture

Overview

Some spousal business ventures can elect out of the partnership rules for federal tax purposes as a qualified joint venture (QJV).  I.R.C. §761(f).  While the election will ease the tax reporting requirements for husband-wife joint ventures that can take advantage of the election, the Act also makes an important change to I.R.C. §1402 as applied to rental real estate activities that can lay a trap for the unwary.

When is making a QJV election a good planning move?  When should it be avoided?  Are their implications for spousal farming operations with respect to farm program payment limitation planning?  Is there any impact on self-employment tax?  This week I am taking a look at the QJV.  Today’s post looks at the basics of the election.  On Thursday, I will look at its implications for farm program payment limitation planning as well as its impact on self-employment tax.

The QJV election is the topic of today’s post.

Joint Ventures and Partnership Returns

A joint venture is simply an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. That is similar to the Uniform Partnership Act’s definition of a partnership.  UPA §101(6).  The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership (I.R.C. §§761(a) and 7701(a)(2)), and the IRS follows the UPA definition of a partnership by specifying that a business activity conducted in a form jointly owned by spouses (including a husband-wife limited liability company (LLC)) creates a partnership that requires the filing of an IRS Form 1065 and the issuance to each spouse of separate Schedules K-1 and SE, followed by the aggregation of the K-1s on the 1040 Schedule E, page 2.  The Act does not change the historic IRS position.

Note: Thus, for a spousal general partnership, each spouse’s share of partnership income is subject to self-employment tax. See, e.g., Norwood v. Comr., T.C. Memo. 2000-84.

While the IRS position creates a tax compliance hardship, in reality, a partnership return does not have to be filed for every husband-wife operation. For example, if the enterprise does not meet the basic requirements to be a partnership under the Code (such as not carrying on a business, financial operation or venture, as required by I.R.C. §7701(a)(2)), no partnership return is required. Also, a spousal joint venture can elect out of partnership treatment if it is formed for “investment purposes only” and not for the active conduct of business if the income of the couple can be determined without the need for a partnership calculation. I.R.C. §761(a).

The QJV

A spousal business activity (in which both spouses are materially participating in accordance with I.R.C. §469(f)) can elect to be treated as a QJV which will not be treated for tax purposes as a partnership.  In essence, the provision equates the treatment of spousal LLCs in common-law property states with that of community property states. In Rev. Proc. 2002-69, 2002-2 C.B. 831, IRS specified that husband-wife LLCs in community property states can disregard the entity.

Note:  The IRS claims on its website that a qualified joint venture, includes only those businesses that are owned and operated by spouses as co-owners, and not those that are in the name of a state law entity (including a general or limited partnership or limited liability company). So, according to the IRS website, spousal LLCs, for example, would not be eligible for the election.  However, this assertion is not made in Rev. Proc. 2002-69.  There doesn’t appear to be any authority that bars a spousal LLC from making the QJV election. 

With a QJV election in place, each spouse is to file as a sole proprietor to report that spouse’s proportionate share of the income and deduction items of the business activity. To elect QJV status, five criteria must be satisfied: (1) the activity must involve the conduct of a trade or business; (2) the only members of the joint venture are spouses; (3) both spouses elect the application of the QJV rule; (4) both spouses materially participate in the business; and (5) the spouses file a joint tax return for the year I.R.C. §761(f)(1).

Note:  “Material participation” is defined in accordance with the passive activity loss rules of I.R.C. §469(h), except I.R.C. §469(h)(5). Thus, whether a spouse is materially participating in the business is to be determined independently of the other spouse. 

The IRS instructions to Form 1065 (the form, of course, is not filed by reason of the election) provide guidance on the election.  Those instructions specify that the election is made simply by not filing a Form 1065 and dividing all income, gain, loss, deduction and credit between the spouses in accordance with each spouse’s interest in the venture.  Each spouse must file a separate Schedule C, C-EZ or F reporting that spouse’s share of income, deduction or loss.  Each spouse also must file a separate Schedule SE to report their respective shares of self-employment income from the activity with each spouse then receiving credit for their share of the net self-employment income for Social Security benefit eligibility purposes.  For spousal rental activities where income is reported on Schedule E, a QJV election may not be possible.  That’s because the reporting of the income on Schedule E constitutes an election out of Subchapter K, and a taxpayer can only come back within Subchapter K (and, therefore, I.R.C. §761(f)) with IRS permission that is requested within the first 30 days of the tax year.

Conclusion

In general, electing QJV status won’t change a married couple’s total federal income tax liability or total self-employment tax liability, but it will eliminate the need to file Form 1065 and the related Schedules K-1.  In that regard, the QJV election can provide a simplified filing method for spousal businesses.  It can also remove a potential penalty for failure to file a partnership return from applying.  That penalty is presently $200 per partner for each month (or fraction thereof) the partnership return is late, capped at 12 months. 

February 6, 2018 in Business Planning, Estate Planning | Permalink | Comments (0)

Monday, January 1, 2018

The “Almost Top Ten” Agricultural Law and Tax Developments of 2017

Overview

This week I will be writing about what I view as the most significant developments in agricultural law and agricultural taxation during 2017. There were many important happenings in the courts, the IRS and with administrative agencies that have an impact on farm and ranch operations, rural landowners and agribusinesses. What I am writing about this week are those developments that will have the biggest impact nationally. Certainly, there were significant state developments, but they typically will not have the national impact of those that result from federal courts, the IRS and federal agencies.

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

Almost, But Not Quite

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

  • Withdrawal of Proposed I.R.C. §2704 Regulations. In the fall of 2016, the Treasury Department issued proposed regulations (REG-16113-02) involving valuation issues under I.R.C. §2704. The proposed regulations would have established serious limitations on the ability to establish valuation discounts (e.g., minority interest and lack of marketability) for estate, gift and generation-skipping transfer tax purposes via estate and business planning techniques. In early December of 2016, a public hearing was held concerning the proposed regulations.  However, the proposed regulations were not finalized before President Trump took office. In early October of 2017, the Treasury Department announced that it was pulling several tax regulations identified as burdensome under President Trump’s Executive Order 13789, including the proposed I.R.C. §2704 regulations. Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Oct. 4, 2017).

    Note: While it is possible that the regulations could be reintroduced in the future with revisions, it is not likely that the present version will ultimately be finalized under the current Administration.

  • IRS Says There Is No Exception From Filing a Partnership Return. The IRS Chief Counsel’s Office, in response to a question raised by an IRS Senior Technician Reviewer, has stated that Rev. Prov. 84-35, 1984-2 C.B. 488, does not provide an automatic exemption from the requirement to file Form 1065 (U.S. Return of Partnership Income) for partnerships with 10 or fewer partners. Instead, the IRS noted that such partnerships can be deemed to meet a reasonable cause test and are not liable for the I.R.C. §6698 penalty. IRS explained that I.R.C. §6031 requires partnerships to file Form 1065 each tax year and that failing to file is subject to penalties under I.R.C. §6698 unless the failure to file if due to reasonable cause. Neither I.R.C. §6031 nor I.R.C. §6698 contain an automatic exception to the general filing requirement of I.R.C. §6031(a) for a partnership as defined in I.R.C. §761(a). IRS noted that it cannot determine whether a partnership meets the reasonable cause criteria or qualifies for relief under Rev. Proc. 84-35 unless the partnership files Form 1065 or some other document. Reasonable cause under Rev. Proc. 84-35 is determined on a case-by-case basis and I.R.M. Section 20.1.2.3.3.1 sets forth the procedures for applying the guidance of Rev. Proc. 84-35. C.C.A. 201733013 (Jul. 12, 2017); see also Roger A. McEowen, The Small Partnership 'Exception,' Tax Notes, April 17, 2017, pp. 357-361.

  • “Qualified Farmer” Definition Not Satisfied; 100 Percent Deductibility of Conservation Easement Not Allowed. A “qualified farmer” can receive a 100 percent deduction for the contribution of a permanent easement to a qualified organization in accordance with I.R.C. §170(b)(1)(E). However, to be a “qualified farmer,” the taxpayer must have gross income from the trade or business of farming that exceeds 50 percent of total gross income for the tax year. In a 2017, the U.S. Tax Court decided a case where the petitioners claimed that the proceeds from the sale of the property and the proceeds from the sale of the development rights constituted income from the trade or business of farming that got them over the 50 percent threshold.  The IRS disagreed, and limited the charitable deduction to 50 percent of each petitioner’s contribution base with respect to the conservation easement. The court agreed with the IRS. The court noted that the income from the sale of the conservation easement and the sale of the land did not meet the definition of income from farming as set forth in I.R.C. §2032A(e)(5) by virtue of I.R.C. §170(b)(1)(E)(v). The court noted that the statute was clear and that neither income from the sale of land nor income from the sale of development rights was included in the list of income from farming. While the court pointed out that there was no question that the petitioners were farmers and continued to be after the conveyance of the easement, they were not “qualified farmers” for purposes of I.R.C. §170(b)(1)(E)(iv)(I). Rutkoske v. Comr., 149 T.C. No. 6 (2017).

  • Corporate-Provided Meals In Leased Facility Fully Deductible. While the facts of the case have nothing to do with agriculture, the issues involved are the same ones that the IRS has been aggressively auditing with respect to farming and ranching operations – namely, that the 100 percent deduction for meals provided to corporate employees for the employer’s convenience cannot be achieved if the premises where the meals are provided is not corporate-owned. In a case involving an NHL hockey team, the corporate owner contracted with visiting city hotels where the players stayed while on road trips to provide the players and team personnel pre-game meals. The petitioner deducted the full cost of the meals, and the IRS limited the deduction in accordance with the 50 percent limitation of I.R.C. §274(n)(1). The court noted that the 50 percent limitation is inapplicable if the meals qualify as a de minimis fringe benefit and are provided in a nondiscriminatory manner. The court determined that the nondiscriminatory requirement was satisfied because all of the staff that traveled with the team were entitled to use the meal rooms. The court also determined that the de minimis rule was satisfied if the eating facility (meal rooms) was owned or leased by the petitioner, operated by the petitioner, located on or near the petitioner’s business premises, and the meals were furnished during or immediately before or after the workday. In addition, the court determined that the rules can be satisfied via contract with a third party to operate an eating facility for the petitioner’s employees. As for the business purpose requirement, the court noted that the hotels where the team stayed at while traveling for road games constituted a significant portion of the employees’ responsibilities and where the team conducted a significant portion of its business. Thus, the cost of the meals qualified as a fully deductible de minimis fringe benefit. Jacobs v. Comr., 148 T.C. No. 24 (2017).

    Note: The petitioner’s victory in the case was short-lived. The tax bill enacted into law on December 22, 2017, changes the provision allowing 100 percent deductibility of employer-provided meals to 50 percent effective Jan. 1, 2018, through 2025. After 2025, no deduction is allowed.

  • Settlement Reached In EPA Data-Gathering CAFO Case. In 2008, the Government Accounting Office (GAO) issued a report stating that the Environmental Protection Agency (EPA) had inconsistent and inaccurate information about confined animal feeding operations (CAFOs), and recommended that EPA compile a national inventory of CAFO’s with NPDES permits. Also, as a result of a settlement reached with environmental activist groups, the EPA agreed to propose a rule requiring all CAFOs to submit information to the EPA as to whether an operation had an NPDES permit. The information required to be submitted had to provide contact information of the owner, the location of the CAFO production area, and whether a permit had been applied for. Upon objection by industry groups, the proposed rule was withdrawn and EPA decided to collect the information from federal, state and local government sources. Subsequent litigation determined that farm groups had standing to challenge the EPA’s conduct and that the EPA action had made it much easier for activist groups to identify and target particular confined animal feeding operations (CAFOs). On March 27, 2017, the court approved a settlement agreement ending the litigation between the parties. Under the terms of the settlement, only the city, county, zip code and permit status of an operation will be released. EPA is also required to conduct training on FOIA, personal information and the Privacy Act. The underlying case is American Farm Bureau Federation v. United States Environmental Protection Agency, 836 F.3d 963 (8th Cir. 2016).

  • Developments Involving State Trespass Laws Designed to Protect Livestock Facilities.

    • Challenge to North Carolina law dismissed for lack of standing. The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a NC employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act stifled their ability to investigate NC employers for illegal or unethical conduct and restricted the flow of information those investigations provide in violation of the First and Fourteenth Amendments of the U.S. Constitution and various provisions of the NC Constitution.  The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).

    • Utah law deemed unconstitutional. Utah law (Code §76-6-112) (hereinafter Act) criminalizes entering private agricultural livestock facilities under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility.  Anti-livestock activist groups sued on behalf of the citizen-activist claiming that the Act amounted to an unconstitutional restriction on speech in violation of the First Amendment. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist”. For those reasons, the court determined that the act was unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017).

    • Wyoming law struck down. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" includes numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech under the First Amendment in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection or resource data. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016).

  • GIPSA Interim Final Rule on Marketing of Livestock and Poultry Delayed and Withdrawn.In the fall of 2016, the USDA sent to the Office of Management and Budget (OMB) interim final rules that provide the agency’s interpretation of certain aspects of the Packers and Stockyards Act (PSA) involving the buying and selling of livestock and poultry. The interim final rules concern Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) which makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. The “effect” language of the statute would seem to eliminate any requirement that the producer show that the packer acted with the intent to control or manipulate prices. However, the federal courts have largely interpreted the provision to require a plaintiff to show an anti-competitive effect in order to have an actionable claim. Under the proposed regulations, "likelihood of competitive injury" is defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer, swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The proposed regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations also note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue. On April 11, 2017, the USDA announced that it was delaying the effective date of the interim final rule for 180 days, until October 19, 2017. However, on October 18, 2017, GIPSA officially withdrew the proposed rule. Related to, but not part of, the GIPSA Interim Final Rule, a poultry grower ranking system proposed rule was not formally withdrawn.

  • Syngenta Settlement. In late 2017, Syngenta publicly announced that it was settling farmers’ claims surrounding the alleged early release of Viptera and Duracade genetically modified corn. While there are numerous cases and aspects of the litigation involving Syngenta, the settlement involves what is known as the “MIR 162 Corn Litigation” and a Minnesota state court class action. The public announcement of the settlement indicated that Syngenta would pay $1.5 billion.

  • IRS To Finalize Regulations on the Tax Status of LLC and LLP Members. In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules that were initially proposes in 2011. That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction? Only time will tell, but the issue is important for LLC and LLP members. The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership. That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities. The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue. Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement. Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.

  • Fourth Circuit Develops New Test for Joint Employment Under the FLSA. The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§ 201 et seq.) as originally enacted, was intended to raise the wages and shorten the working hours of the nation's workers. The FLSA is very complex, and not all of it is pertinent to agriculture and agricultural processing, but the aspect of it that concerns “joint employment” is of major relevance to agriculture. Most courts that have considered the issue have utilized an “economic realities” or “control” test to determine if one company’s workers are attributable to another employer for purposes of the FLSA. But, in a 2017 case, the U.S. Court of Appeals for the Fourth Circuit, created a new test for joint employment under the FLSA that appears to expand the definition of “joint employment” and may create a split of authority in the Circuit Courts of Appeal on the issue. The court held that the test under the FLSA for joint employment involved two steps. The first step involved a determination as to whether two or more persons or entities share or agree to allocate responsibility for, whether formally or informally, directly or indirectly, the essential terms and conditions of a worker’s employment. The second step involves a determination of whether the combined influence of the parties over the essential terms and conditions of the employment made the worker an employee rather than an independent contractor. If, under this standard, the multiple employers were not completely disassociated, a joint employment situation existed. The court also said that it was immaterial that the subcontractor and general contractor engaged in a traditional business relationship. In other words, the fact that general contractors and subcontractor typically structure their business relationship in this manner didn’t matter. The Salinas court then went on to reason that separate employment exists only where the employers are “acting entirely independent of each other and are completely disassociated with respect to” the employees. The court’s “complete disassociation” test appears that it could result in a greater likelihood that joint employment will result in the FLSA context than would be the case under the “economic realities” or “control” test. While the control issue is part of the “complete disassociation” test, joint determination in hiring or firing, the duration of the relationship between the employers, where the work is performed and responsibility over work functions are key factors that are also to be considered. Salinas v. Commercial Interiors, Inc., 848 F.3d 125 (4th Cir. 2017), rev’g, No. JFM-12-1973, 2014 U.S. Dist. LEXIS 160956 (D. Md. Nov. 17, 2014).

  • Electronic Logs For Truckers. On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) was set to go into effect.  80 Fed. Reg. 78292 (Dec.16, 2015).  The final rule, which was issued in late 2015, could have a significant impact on the livestock industry and livestock haulers. The new rule will require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18. The devices connect to the vehicle's engine and automatically record driving hours. The Obama Administration pushed for the change to electronic logs purportedly out of safety concerns. The Trump Administration has instructed the FMCSA (and state law enforcement officials) to delay the December 18 enforcement of the final rule by delaying out-of-service orders for ELD violations until April 1, 2018, and not count ELD violations against a carrier’s Compliance, Accountability, Safety Score. Thus, from December 18, 2017 to April 1, 2018, any truck drivers who are caught without an electronic logging device will be cited and allowed to continue driving, as long as they are in compliance with hours-of-service rules. In addition, the FMCSA has granted a 90-day waiver for all vehicles carrying agricultural commodities. Other general exceptions to the final rule exist for vehicles built before 2000, vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)), drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)), and drivers who maintain HOS logs for no more than eight days during any 30-day period. One rule that is of particular concern is an HOS requirement that restricts drive time to 11 hours. This rule change occurred in 2003 and restricts truck drivers to 11 hours of driving within a 14-hour period. Ten hours of rest is required. That is a tough rule as applied to long-haul cattle transports. Unloading and reloading cattle can be detrimental to the health of livestock.

  • Dicamba Spray-Drift Issues. Spray-drift issues with respect to dicamba and the use of  XtendiMax with VaporGrip (Monsanto) and Engenia (BASF) herbicides for use with Xtend Soybeans and Cotton were on the rise in 2017. , 2017Usage of dicamba has increased recently in an attempt to control weeds in fields planted with crops that are engineered to withstand it. But, Missouri (effective July 7) and Arkansas (as of June 2017) took action to ban dicamba products because of drift-related damage issues. In addition, numerous lawsuits have been filed by farmers against Monsanto, BASF and/or DuPont alleging that companies violated the law by releasing their genetically modified seeds without an accompanying herbicide and that the companies could have reasonably foreseen that seed purchasers would illegally apply off-label, older dicamba formulations, resulting in drift damage. Other lawsuits involve claims that the new herbicide products are unreasonably dangerous and have caused harm even when applicators followed all instructions provided by law. In December of 2017, the Arkansas Plant Board voted to not recommend imposing a cut-off date of April 15 for dicamba applications. Further consideration of the issue will occur in early 2018.

January 1, 2018 in Business Planning, Civil Liabilities, Environmental Law, Estate Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Tuesday, November 28, 2017

Partnerships and Tax Law – Details Matter

Overview

Sometimes farmers and ranchers operate in the partnership form without any formal documentation of their business association.  Other times, there is a formalized agreement that really isn’t paid much attention to.  But, the details of partnership law and the associated tax rules can produce some surprises if those details are not properly understood.

Today’s post takes a look at some key tax features, and surprises, surrounding the partnership form of doing business.

Self-Employment Tax

A major tax consideration for farmers and ranchers (and others) when deciding the appropriate form of business structure is self-employment tax.  This year, the tax rate is 15.3 percent on the first $127,200 of an individual’s self-employment income.  The rate then goes to 2.9 percent up to self-employment income of $250,000 (for a married person that files jointly).  Then, thanks to the health care law, the rate jumps another 31 percent to 3.8 percent on any additional amount of self-employment income. For the 3.8 percent amount, the combined earned income of spouses is measured against the $250,000 threshold.

But, self-employment tax is treated differently in a partnership – at least for limited partners.  A limited partner, under the tax law, is treated like an owner of an S corporation.  A limited partner’s compensation income is subject to self-employment tax, but the limited partner’s share of partnership income is not net earnings from self-employment.  Accordingly, it is not subject to self-employment tax.  For a limited liability company (LLC) that is treated as a partnership for tax purposes, the self-employment tax burden depends on the structure of the LLC and whether it is member-managed or manager-managed.  In other posts, I have written on that structure and the associated self-employment tax issues.  Basically, however, if a member does not have management authority under the agreement, the member is viewed under the tax law as a limited partner. 

Recent cases.  A couple of recent cases illustrate the self-employment tax treatment of members of partnerships.  In Hardy v. Comr., T.C. Memo. 2017-17, the petitioner was a plastic surgeon who purchased a 12 percent manager interest in an LLC that operated a facility in which the plaintiff could conduct surgeries when necessary. The petitioner also conducted surgeries in his own office separate from the LLC facility, and owned a separate company run by his wife for his surgical practice. The court did not allow the IRS to group the two activities together based on the weight of the evidence that supported treating the two activities as separate economic units. The petitioner did not have any management responsibilities in the LLC, did not share building space, employees, billing functions or accounting services with the LLC. In addition, the petitioner’s income from the LLC was not linked to his medical practice.  Thus, by looking to the petitioner’s actual conduct, the Tax Court determined that the petitioner was a limited partner in the LLC for self-employment tax purposes even though the petitioner held a manager interest in the LLC.  Hardy v. Comr., T.C. Memo. 2017-17. For reasons further explained below, one should not rely on the Hardy case to avoid self-employment tax if the person may exercise management authority.

By comparison, consider Methvin v Comr., 653 Fed. Appx. 616 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81.  In this case, the petitioner was a CEO of a computer company, and didn’t have any specialized knowledge or expertise in oil and gas ventures. In the 1970s, he acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. §761(a).

For the year at issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income.  He also believed that he was not a partner because of the election under I.R.C. §761(a), so his distributive share was not subject to self-employment tax.

The IRS agreed with the petitioner’s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. §7701(a)(2).  Importantly, the trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of Subchapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar the IRS from changing its mind and prevailing on the issue for the year at issue.

On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. §1402(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year.

The outcome of the case is not surprising.  In the oil and gas realm, operating agreements often create a joint venture between the owners of the working interests (who are otherwise passive) and the operator.  That will make the income for the working interest owners self-employment taxable, and an election out of Subchapter K won’t change that result.  That’s particularly the case if the court finds an agency relationship to be present, as it did in the present case.  And, IRS gets a pass for inconsistency.  At least the investor’s income would not be subject to the 3.8 percent Net Investment Income Tax imposed by the health care law (I.R.C. §1411).

As for the IRS, its position on the matter was most recently announced in a Chief Counsel Advice in 2014.  C.C.A. 201436049 (May 20, 2014).  Citing I.R.C. §1402(a)(13), the IRS noted that a limited partner is not subject to self-employment tax on the limited partner’s share of partnership income, but an active owner is.

Key Points

The cases point out several things of importance.  First, even though a taxpayer may not be personally active in the management of a partnership that is carrying on a trade or business that generates self-employment income, the taxpayer can still be subject to self-employment tax on the taxpayer’s share of partnership income if the partnership business is carried out on the partner’s behalf by an agent (or employee).  In addition to Methvin, the Tax Court decided similarly in a 1988 case.  Cokes v. Comr., 91 T.C. 222 (1998).  It doesn’t matter how large or small the taxpayer’s interest in the partnership is. 

The second point is that an election out of Subchapter K (the partnership tax section of the Code) has no impact on the nature of the entity for self-employment tax purposes.  That’s fundamental partnership tax law dating at least back to the Tax Court’s 1998 decision.  The real question is whether the entity satisfies the definitional test set forth in I.R.C. §7701(a)(2).  Likewise, a partnership’s existence turns on the parties’ intent.  That’s a factual determination and numerous considerations are important to answering that question.  See Luna v. Comr., 42 T.C. 1067 (1964).  So, even if a taxpayer doesn’t participate in the partnership’s business activities, it may not matter from a self-employment tax standpoint.  That’s why the Congress included a special “carve-out” for limited partners in I.R.C. §1402(a)(13).  A taxpayer classified as a general partner (or one with a manager interest) can’t use the special provision.  Viewed in this light, the Tax Court’s Hardy decision would appear incorrect.  But, there were other unique issues in Hardy that may have influenced the court’s conclusion on the self-employment tax issue. 

The third point is that the IRS can change its administrative position on an issue.  It need not be “fair” as it applies the tax rules to a taxpayer’s situation.  The simple fact is that an IRS concession of an issue for a taxpayer in one tax year does not mean it must concede the issue in other years.  See, e.g., Burlington Northern Railroad Co. v. Comr., 82 T.C. 143 (1984).  The same can be said for taxpayers.  The American Institute of Certified Public Accountants has Statements on Standards for Tax Services.  One of those Standards, No. 5, allows a CPA to argue a position that is contrary to one that the client has conceded in prior tax years.

Conclusion

Clarity on the type of partnership and the type of interest is important.  A well-drafter partnership agreement can go a long way to ensuring that the desired tax result is achieved.  Operating under an informal arrangement and/or not fully understanding the meaning of the type of ownership interest held from a tax standpoint can result in an unexpected tax result. 

November 28, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, November 8, 2017

Summer 2018 - Farm Tax and Farm Business Education

Overview

Next June, Washburn University School of Law will be sponsoring a two-day seminar in Pennsylvania on farm income tax and farm estate and business planning.  I will be one of speakers at the event as will Paul Neiffer, the author of the Farm CPA Today blog.  Paul and I have done numerous events together over the past few years and I thoroughly enjoy working with Paul.  The K-State Department of Agricultural Economics will be co-sponsoring the event, and we are looking forward to working with the Pennsylvania Society of CPAs and Farm Credit East.  The seminar dates will be June 7-8 and the location, while not set at the present time, will be within a couple of hours of Harrisburg, PA.  

Partnerships

Our two-day event will precede the 2018 conference in Harrisburg of the National Association of Farm Business Analysis Specialists (NAFBAS) and the National Farm and Ranch Business Management Education Association, Inc. (NFRBMEA) which begins on June 10.  We are looking forward to partnering with the two groups to provide technical and practical tax information in an applied manner that the attendees to the NAFBAS/NFRBMEA conference will find to be a beneficial supplement to their conference.  Accordingly, we are planning the agenda to supplement the information that will be provided at the NAFBAS/NFRBMEA conference.

Agenda

We will follow our traditional two-day seminar approach with farm income tax information on Day 1 and farm estate and business planning topics on Day 2.  On Day 1, we will provide an update on recent cases and rulings.  Of course, if there is new tax legislation, we will cover its application to various client situations.  We will also provide farm income averaging planning strategies, farm financial distress tax planning issues, self-employment tax and how to structure leases and entities.  Also on Day 1, we will explain how to handle indirect production costs and the application of the repair/capitalization regulations.  In addition, we will explain the proper handling of farm losses and planning opportunities with farming C corporations. 

On Friday, Day 2, we will cover the most recent developments in farm estate and business planning.  Of course, if there is legislation enacted that impacts the transfer tax system, we will cover it in detail.  We will also have a session on applicable tax planning strategies for the retiring farmer, and ownership transition strategies.  Also discussed on Day 2 will be the procedures and tax planning associated with incorporating the farm business tax-free.  We will also get into long-term health care planning, how best to structure the farming business to take maximum advantage of farm program payments, special use valuation as well as installment payment of federal estate tax.  Those handling fiduciary returns will also find our session on trust and estate taxation and associated planning opportunities to be of great benefit.

Other Seminars

Mark your calendars now for the June7-8 seminar in PA.  If flying, depending on the location we settle on, flights into either Pittsburgh, Philadelphia or Baltimore will be relatively close.  Be watching www.washburnlaw.edu/waltr for further details as the weeks go by.  Until then, upcoming tax seminars will find me next week in North Dakota, and then Kansas in the following two weeks.  In early December, I will be leading-off the Iowa Bar’s Bloethe Tax School in Des Moines with a federal tax update.  I have also heard from numerous Iowans that will be attending tax school in Overland Park in late November, and I am looking forward to seeing you there along with the other attendees.  Next week’s seminar from Fargo will be simulcast over the web in case you can’t attend in-person.  Also, the seminar from Pittsburg, KS will be simulcast over the web.  In addition, there will be a 2-hour ethics seminar/webinar on Dec. 15.  Be watching my CPE calendar on www.washburnlaw.edu/waltr for more details. 

New Book

I have a new book out, published by West Academic – “Agricultural Law in a Nutshell.”  Here’s the link to more information about the book and how to order.  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/agriculturallawnutshell/index.html  If you are involved in agriculture or just like to read up on legal issues involving those involved in agricultural production or agribusiness, the book would make a great stocking-stuffer.  If you are teaching or taking an agricultural law class in the spring semester of 2018, this is a “must have” book.

Conclusion

There are always plenty of legal issues to write about and current developments to keep up on.  Readers of this blog are well aware of that fact.   

November 8, 2017 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, November 6, 2017

H.R. 1 - Farmers, Self-Employment Tax and Business Arrangement Structures

Overview

H.R. 1, the House tax bill, was publicly released last week.  Of course, it’s getting a lot of attention for the rate changes for individuals and corporations and flow-through entities.  However, there is an aspect that is getting relatively little focus – how the self-employment tax rules would change and impact leasing and entity structuring. 

Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end.  Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few.  However, an examination of the text of the recently released tax bill, H.R. 1, reveals that self-employment tax planning strategy for farmers will change substantially if the bill becomes law.  If enacted, many farmers would see an increase in their overall tax bill while others would get a tax break.  In addition, existing business structures put in place to minimize the overall tax burden would likely need to be modified to achieve that same result.

Today’s post examines the common strategies employed to minimize self-employment tax, and the impact of H.R. 1 on existing business structures and rental arrangements.

The Basics – Current Law

The statute.  In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual.  Self-employment income is defined as “net earnings from self-employment.”  The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402.  For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200.  It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent.  That’s because the self-employment tax is also a deductible expense.  In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level. 

In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax (see I.R.C. §1402(a)(1)) unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates.  I.R.C. §1402(a)(1)(A).  For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax only if the activity constitutes a trade or business “carried on by such individual.”  See, e.g., Rudman v. Comr., 118 T.C. 354 (2002).  Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.

This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate.  But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax.  See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357. 

Trade or business.  Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property.  The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer is engaged in the activity regularly and continuously with the intent to profit from the activity.  Comr. v. Groetzinger, 480 U.S. 23 (1987).  But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court.  Batok v. Comr., T.C. Memo. 1992-727. 

As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21).  Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040.  A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.    

Planning strategy.  The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business.  But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax.  Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership.  If that is done, the income from the rental activity would flow through to the owner without self-employment tax.  However, with an S corporation, reasonable compensation would need to be paid.  For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income. 

Passive loss rules.  In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469.  But, there are a couple of major exceptions to this general rule.  Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable.  Treas. Reg. §1.469-2T(f)(3).  The effect of this exception is to convert rental income (and any gain on disposition of the activity) from passive to portfolio income.  But, that is only the result if there is net income from the activity.  If the activity loses money, the loss is still passive. 

Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates.  Treas. Reg. §1.469-2(f)(6). 

LLC members.  Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization.  Are they general partners or limited partners?  Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC.  So what is a limited partner?  Under existing proposed regulations, an LLC member has self-employment tax liability if:  (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year.  Prop. Treas. Reg. §1.1402(a)-2(h)(2).  If none of those tests are satisfied, then the member is treated as a limited partner. 

Structuring to minimize self-employment tax.  There is an entity structure that can minimize self-employment tax.  An LLC can be structured as a manager-managed LLC with two membership classes.  With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4).  They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses.  Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership.  Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter).  Thus, for a professional services partnership structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.     

However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated.  The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.

Here's what it might look like for a farming operation:

A married couple operates a farming business as an LLC.  The wife works full-time off the farm and does not participate in the farming operation.  But, she holds a 49 percent non-manager ownership interest in the LLC.  The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest.  The husband, as the farmer, also holds a 2 percent manager interest.  The husband receives a guaranteed payment with respect to his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC.  The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.  The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives.  This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC. 

Additional benefit.  There is another potential benefit of utilizing the manager-managed LLC structure.  Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return).  While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager.  I.R.C. §469(h)(5).  Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of both spouses from passive to active income that will not be subject to the 3.8 percent surtax. Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.

What about an S corporation?  The manager-managed LLC provides a better result than that produced by the member-managed LLC for LLCs that are not service partnerships.  For those that are service providers, the S corporation is the business form to use to achieve a better tax result.  For an S corporation, “reasonable” compensation will need to be paid subject to FICA and Medicare taxes, but the balance drawn from the entity can be received free of self-employment tax. The disadvantage of operating a business or holding property in the S corporation is inflexibility. Appreciated property cannot be removed from the S corporation without triggering gain. Upon the death of an S corporation shareholder, the tax bases of the underlying assets are not adjusted to fair market value. The partnership is the more tax-friendly and flexible structure.   

Impact of H.R. 1 on Business Structures 

In general.  The new proposals (contained in H.R. 1) add complexity in many situations involving partnerships and leasing arrangements.  Section 1004 of H.R. 1 eliminates the rental real estate exception from self-employment tax of existing I.R.C. §1402(a)(1) and proposes a new maximum tax of 25 percent to income received from a flow-through entity (such as a partnership, LLC or S corporation).  The 25 percent rate applies to all net passive income, plus all “qualified business income.”  Under Sec. 1004 of H.R. 1, “qualified business income” is the greater of 30 percent of active business income or a deemed return from the sum of the investment in depreciable property plus real property used in the business.  Depreciable property is determined without regard to bonus depreciation and Section 179.  Also in Sec. 1004, the deemed return is set at seven percent plus the short-term Applicable Federal Rate (AFR) as of the end of the year.  The short-term AFR is slightly over 1 percent at the present time. 

How does the formula for the application of the 25 percent tax flow-through rate work?  Consider the following:

Robert has capital invested in his farming S corporation of $4 million (based on depreciated values not including Section 179 and bonus depreciation).  His allowed deemed return is 7 percent plus the short-term AFR rate as of the end of the year (assume, for purposes of the example, one percent).  Thus, if Robert’s farming activity generates $320,000 or less, the farm income will be subject to the 25 percent rate, but not self-employment tax.  If Robert’s S corporation generates more than $320,000, the excess amount will also be subject to self-employment tax. 

In essence, H.R. 1 replaces the self-employment tax on business income with a computation that deems 70 percent of the business income to be attributable to labor and subject to self-employment tax, in accordance with the formula above.  This applies to businesses of all types – sole proprietorships, partnerships and S corporations.  That has some very important implications. 

S corporations.  S corporations have never been subject to self-employment tax.  They will be under H.R. 1 in what appears to be an attempt to conform the business tax rate with the self-employment tax.  For instance, if 70 percent of the income of the S corporation is subject to the labor rate, then 70 percent of the overall income of the S corporation (considering the amount of shareholders wages) should also be subject to self-employment tax. 

Partnerships.  The distributive share of a general partner in a general partnership has always been subject to self-employment tax.  The distributive share of a limited partner has not.  That changes under H.R. 1 via the repeal of I.R.C. §1402(a)(13) contained in Sec. 1004.  Thus, a portion of a limited partner’s distributive share of partnership income will become subject to self-employment tax. 

Sole proprietorships.  The self-employment tax changes of H.R. 1 will also impact sole proprietorships.  But, in this instance, the impact of the self-employment tax changes of H.R. 1 could work in the opposite direction.  While sole proprietorship farming operations will also be subject to the 70 percent provision, it would actually result in a decrease in self-employment. tax.  Under present law, 100 percent of the income of an active farmer that is reported on Schedule F is subject to self-employment. tax.  Under H.R. 1, only 70 percent of Schedule F income would be subject to self-employment tax, but 70 percent of passive rental income would also be subject to S.E. tax.  The bottom line – the ultimate tax outcome depends upon the mix that any particular farmer has of Schedule F (farm) income relative to Schedule E (passive rental income).  

Multiple entities.  Farmers who have arranged their farming business such that the land is in a separate entity (such as a limited liability company or other flow-through entity) and is leased to their operating farming business, would see an increase in self-employment tax.  In addition, if the taxable income of these farmers has been taxed at a 25 percent rate or less, they won’t have the income tax benefits from the maximum 25 percent rate applied to flow-through entities. They will see a tax increase, because more of the income will be subject to S.E. tax.

This impact of this change in self-employment tax in the context of multiple entity farming arrangements is important to understand.  The recent taxpayer victory in Martin v. Comr., 149 T.C. No. 12 (2017) which expanded the exception of McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000) for fair market leases to leases beyond the jurisdiction of the U.S. Court of Appeals for the Eighth Circuit, could be short-lived.  Under the language of H.R. 1, the IRS will most assuredly argue that such rental income is part of an active trade or business such that 70 percent of it would be subject to self-employment tax.

What About Conservation Reserve Program (CRP) Income?

The IRS has long argued that CRP income is not rental income that could be excluded from self-employment tax under I.R.C. §1402(a).  With that Code section removed, CRP income becomes business income under H.R. 1.  As business income, the land owner is certainly passive in the CRP activity, which makes it business income subject to the maximum tax rate of 25 percent and not subject to self-employment tax.  Even If CRP income were materially participating business income, however, only 70 percent of it would be subject to the self-employment tax at the labor rate of 25 percent.  In any event, this change to the self-employment tax rules would likely stop IRS audits of CRP income.

Conclusion.  So, what’s the bottom-line?  The typical farmer that owns land and farms it either as a sole proprietor or as a general partner in a general partnership will see an overall tax decrease.  That will be particularly true for these farmers in the high tax brackets.  That’s because only 70 percent of the farm income will be subject to self-employment tax.  However, a farmer that owns the land and rents it to a separate farming entity will incur more S.E. tax than under present law. If that farmer would be in a tax bracket higher than 25 percent, the benefit of the maximum business rate may fully offset the additional S.E. tax.  That’s probably an oversimplification of the impact of H.R. 1.  Obviously, each situation is unique and will require its own analysis.  And, remember, H.R. 1 is only a proposal.  It may never actually become law.

November 6, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Friday, October 27, 2017

IRS To Finalize Regulations On Tax Status of LLC and LLP Members?

Overview

In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules.  That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  Those regulations were initially issued in temporary form and became proposed regulations in 2011.

Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction?  Only time will tell, but the issue is important for LLC and LLP members.

Passive Loss Rules

The passive loss rules (I.R.C. §469) can have a substantial impact on farmers and ranchers as well as investors in farm and ranch land.  The effect of the rules is that deductions from passive trade or business activities, to the extent the deductions exceed income from all passive activities may not be deducted against other income.

The proper characterization of the loss depends on whether the taxpayer is materially participating in the business.  I.R.C. §469(h).  But, I.R.C. §469(h)(2) creates a per-se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  The statute was written before practically all state LLC statutes were enacted and before the advent of LLPs, and the Treasury has never issued regulations to detail how the statue is to apply to these new types of business forms.

A few years ago, the issue of how losses incurred by taxpayers that are members of LLCs (and LLPs) are to be treated under the passive loss rules surfaced in four court opinions - three by the U.S. Tax Court and one by the U.S. Court of Federal Claims.  In the cases, IRS stood by its long-held position that the per-se rule of non-material participation applies to ownership interests in LLCs because of the limited liability feature of the entity.

Material Participation Tests - Passive Losses

The key question presented in the cases was whether the taxpayer satisfied the material participation test.  As mentioned above, a passive activity is a trade or business in which the taxpayer does not materially participate.  Material participation is defined as “regular, continuous, and substantial involvement in the business operation.”  I.R.C. §469(h)(1).  The regulations provide seven tests for material participation in an activity.  Temp. Treas. Reg. §1.469-5T(a)(1)-(7). The tests are exclusive and provide that an individual generally will be treated as materially participating in an activity during a year if:

  • The individual participates more than 500 hours during the tax year;
  • The individual’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the tax year;
  • The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of anyone else (including non-owners) for the tax year;
  • The activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities during the tax year exceeds 500 hours;
  • The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the tax year at issue;
  • The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years preceding the tax year at issue; or
  • Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year

As noted, if the taxpayer is a limited partner of a limited partnership, the taxpayer is presumed to not materially participate in the partnership’s activity, “except as provided in the regulations.”  I.R.C. §469(h)(2).  The regulations provide an exception to the general presumption of non-material participation of limited partners in a limited partnership if the taxpayer meets any of one of three specific material participation tests that are included in the seven-part test for material participation under Treas. Reg. 1.469-5T(a)(1)-(7).  Those three tests are:

  • The 500 hour test;
  • The five out of 10 year test; and
  • The test involving material participation in a personal service activity for any three years preceeding the tax year at issue.

Thus, the standard of “material participation” for a limited partner is higher than that for a general partner, and the question presented in the cases was whether the more rigorous standard for material participation for limited partners in a limited partnership under I.R.C. §469(h)(2) applied to the taxpayers (who held membership interests in LLCs and LLPs) with the result that their interests were per-se presumptively passive.

Garnett v. Com’r, 132 T.C. No. 19 (2009)

Facts.  The taxpayers, a married couple residing in Nebraska, owned interests in various LLCs and partnerships that were organized under Iowa law as well as certain tenancy-in-common interests that were all engaged in agricultural production activities.  They held direct ownership interests in one LLP and and LLC and indirect interests in several other LLPs and LLCs.  Their ownership interests were denoted as “limited partners” in the LLP and “limited liability company members” in the LLC – which did have a designated manager.  The interests that they held in the two tenancies-in-common were also treated similarly.  For tax years 2000-2002, the taxpayers ran up large losses and treated them as ordinary losses.

The IRS claimed that an LLC member is always treated as a limited partner because of limited liability under state law and because the Code specifies that a limited partnership interest never counts as an interest with respect to which the taxpayer materially participates.  I.R.C. §469(h)(2).  Thus, the IRS characterized the losses as passive, basing their position on the regulation which, for purposes of I.R.C. §469, treats a partnership interest as a limited partnership interest if “the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount.” Temp. Treas. Reg. §1.469-5T(e)(3)(i)(B).  On the other hand, the taxpayers argued that the Code and regulations did not apply to them because none of the entities that they had interests in were limited partnerships and because, in any event, they were general partners rather than limited partners.  The taxpayers also pointed out that the Federal District Court for Oregon had previously ruled that, under the Oregon LLC Act, I.R.C. §469(h)(2) did not apply to LLC members.  Gregg v. United States, 186 F. Supp. 2d 1123 (D. Ore. 2000).

Analysis.  The Tax Court first noted that I.R.C. §469(h)(2) was enacted at a time when LLCs and LLPs were either new or nonexistent business entities and, as such, did not make reference to those entities.  The court also pointed out that the regulations did not refer explicitly to LLPs or LLCs.  Accordingly, the court rejected the IRS argument that a limitation on liability automatically qualifies an interest as a limited partnership interest under I.R.C. §469(h)(2).  On the contrary, the court held that the correct analysis involved a determination of whether an interest in a limited partnership (or LLC) is, based on the particular facts, actually a limited partnership interest.  That makes a state’s LLC statute particularly important.  Does it grant LLC and LLP members power and authority beyond those that limited partners have traditionally been allowed.?  The IRS conceded that the statute at issue in the case did just that.  Other distinguishing features were also present.  The court noted that limited partnerships have two classes of partners, one of which runs the business (general partners) and the other one which typically involves passive investors (limited partners).  The limited partners enjoy limited liability, but that protection can be lost by participating in the business.  By comparison, an LLP is essentially a general partnership in which the general partners have limited liability even if they participate in management.  Likewise, the court noted that LLC members can participate in management and retain limited liability.

The court made a key point that it was not invalidating the temporary regulations, but was simply declining to write a regulation for the Treasury that applied to interests in LLCs and LLPs.  Importantly, the court refused to give deference to the Treasury’s litigating position in absence of such a regulation.

Thompson v. United States, 87 Fed. Cl. 728 (2009)

Facts.  The taxpayer held a 99 percent interest in an LLC that was formed under the Texas LLC statute.  He held the other one percent interest indirectly through an S corporation.  The LLC’s articles of organization designated the taxpayer as the manager.  The LLC did not make an election to be taxed as a corporation and, thus, defaulted to partnership tax status.  The LLC, which provided charter air services, incurred losses in 2002 and 2003 of $1,225,869 and $939,878 respectively which flowed through to the taxpayer.  The IRS disallowed most of the losses on the basis that the taxpayer did not meet the more rigorous test for material participation that applied to limited partners in limited partnerships.  The taxpayer paid the additional tax of $863,124 and filed a refund claim for the same amount.  The IRS denied the refund claim and the taxpayer sued for the refund, plus interest.  Both the taxpayer and the IRS moved for summary judgment.

The IRS stood by its position that the more rigorous material participation test applied because the taxpayer enjoyed limited liability by owning the interests in the LLC just like he would if he held limited partnership interests.  Thus, according to the IRS, the taxpayer’s interest was identical to a limited partnership interest and the regulation applied triggering the passive loss rules.

The court disagreed with the IRS.  While both parties agreed that the statute and regulations trigger application of the passive loss rules to limited partnership interests, the taxpayer pointed out that he didn’t hold an interest in a limited partnership.  The court noted that the language of the regulation (Treas. Reg. § 1.469-5T(e)(3)) explicitly required that the taxpayer hold an interest in an entity that is a partnership under state law, and that the Treasury had never developed a regulation to apply to LLCs.  It was clear that the taxpayer’s entity was organized under Texas law as an LLC.  In addition, the court pointed out that the taxpayer was a manager of the LLC, and IRS had even conceded at trial that the taxpayer would be deemed to be a general partner if the LLC were a general partnership.  The court noted that the position of the IRS that an LLC taxed as a partnership triggers application of the Treas. Reg. §1.469-5T(e)(3)(ii) was “entirely self-serving and inconsistent.”  The court also stated that it was irrelevant whether the taxpayer was a manager of the LLC or not – by virtue of the LLC statute, the taxpayer could participate in the business and not lose the feature of limited liability.

Hegarty v. Comr., T.C. Sum. Op. 2009-153

In this summary opinion, the Tax Court reiterated its position that the reliance by IRS on I.R.C. § 469(h)(2) to treat members of LLCs as automatically limited partners for passive loss purposes is misplaced.  Instead, the general tests for material participation apply and the petitioners in the case (a married couple) were determined to have materially participated in their charter fishing activity for the tax year at issue.  They participated more than 100 hours and their participation was not less than the participation of any other individual during the tax year.

Newell v. Comr., T.C. Memo. 2010-23

In this case, the taxpayer’s primary business activity was managing various real estate investments.  He spent more than one-half of his time and more than 750 hours annually in real property trade or business activities.  During the years at issue, the taxpayer was the sole owner of an S corporation that manufactured and installed carpentry items, and his participation is that business qualified as a significant participation activity for purposes of the passive loss rules.  He also owned 33 percent of the member interests in a California-law LLC engaged in the business of owning and operating a golf course, restaurant and country club.  The LLC was treated taxwise as a partnership.  It was undisputed that the taxpayer was the managing member of the LLC.  For tax years 2001-2003, IRS claimed that the losses the taxpayer incurred from both the S corporation and the LLC were passive losses that were not currently deductible.  While the parties agreed that the taxpayer’s participation in both the S corporation and the LLC satisfied the significant participation activity test under the passive loss rules, IRS again asserted its position that I.R.C. §469(h)(2) required that the taxpayer’s interest in the LLC be treated as a passive limited partnership interest, even though IRS conceded that the taxpayer held the managing member interest in the LLC.

The Tax Court rejected the IRS’ argument, noting again that the general partner exception of Treas. Reg. §1.469-5T(e)(3)(ii) was not confined to the situation where a limited partner also holds a general partnership interest.  Under the exception, an individual who is a general partner is not restricted from claiming that the individual materially participated in the partnership.  Here, it was compelling that the taxpayer held the managing member interest in the LLC.  As such, the taxpayer’s losses were properly deducted.

Chambers v. Comr., T.C. Sum. Op. 2012-91

Here, the taxpayer owned rental property with his spouse that produced a loss. The taxpayer was also a managing member of an LLC that owned rental properties.  The LLC also owned rental property, and produced losses with one-third of the losses allocated to the taxpayer.  The taxpayer was also employed by the U.S. Navy.  He deducted his rental losses in full on the basis that he was a real estate professional.  In order to satisfy the “more than 50 percent test,” he combined his hours spent on his personally-owned rental activity with his management activity for the LLC.  The IRS invoked I.R.C. §469(h) to disallow the taxpayer’s LLC managerial hours, but the court disagreed.  The court held that the taxpayer’s LLC interest was not defacto passive.  Thus, his hours spent in LLC managerial activities counted toward his total “real estate” hours.  However, he still failed to meet more than 50 percent test.  In addition, the court noted that the fallback test of active participation allowing $25,000 of rental real estate losses was not available because the taxpayer’s AGI exceeded $150,000 for the year in issue.

Conclusion

The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.  That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities.

As noted above, in late 2011, the Treasury Department proposed regulations defining “limited partner” for purposes of the passive loss rules. Notice of Proposed Rulemaking REG-109369-10 (Nov. 28, 2011). The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue.  Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement.  Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.

But, with the recent statement in the 2017-2018 Priority Guidance Plan, is the IRS going to finalize the proposed regulations as written or will there be modifications?  What will the standard be for material participation? It’s an important issue for farmers, ranchers and others that utilize the LLC or LLP form of structure, of which there are many.

October 27, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Friday, September 29, 2017

Self-Employment Tax on Farm Rental Income – Is the Mizell Veneer Cracking?

Overview

Self-employment tax applies to income that is derived from a “trade or business.”  That’s a fact-based determination.  In addition, by statute, “rentals from real estate and from personal property leased with the real estate” are excluded from the definition of net earnings from self-employment. I.R.C. §1402(a)(1).  Likewise, income from crop share and/or livestock share rental arrangements for landlords who are not materially participating in the farming or ranching operation will not be classified as self-employment income.  Only if the rents are produced under a crop or livestock share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income.  Income received under a cash rental arrangement is not subject to self-employment tax.

But, what is “material participation”?  A lease is a material participation lease if (1) it provides for material participation in the production or in the management of the production of agricultural or horticultural products, and (2) there is material participation by the landlord.  Both requirements must be satisfied. While a written lease is not required, a written lease certainly makes a material participation arrangement easier to establish (or not established, if that is desired).

But, what about leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity?  Does the real estate exemption from the definition of net earnings from self-employment apply in that situation?  Does the type of lease or the rate of rent charged under the lease matter?  In 1995, the Tax Court rendered an important decision on the first question that, apparently, also answered the second question.  Mizell v. Comr., T.C. Memo. 1995-571.  Later, the U.S. Court of Appeals for the Eighth Circuit carved out an exception from the 1995 Tax Court decision for fair market leases.  McNamara, et al. v. Comr., 263 F.3d 410 (8th Cir. 2000), rev’g., T.C. Memo 1999-333.  Now, the Tax Court, in a full Tax Court opinion, has applied the Eighth Circuit’s analysis and holding to a case with similar facts coming from Texas – a jurisdiction outside the Eighth Circuit.  Martin v. Comr., 149 T.C. No. 12 (2017). 

The Mizell Case

In Mizell, the petitioner was a farmer who, in 1986, structured his farming operation to become a 25 percent co-equal partner in an active farming partnership with his three sons. In addition, in 1988, leased about 730 acres of farmland to the farm partnership.  The lease called for the petitioner to receive a one-quarter share of the crop, and the partnership was responsible for all expenses.  The petitioner reported his 25 percent share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rents from real estate that was exempt from self-employment tax.

The IRS disagreed with that tax treatment of the land rent, assessing self-employment tax on the crop share lease income for the years 1988, 1989 and 1990.  The parties agreed that he materially participated in the agricultural production of his farming operation.  The IRS took the position that the crop share rental and the farming partnership constituted an “arrangement” that needed to be considered in light of the entire farming enterprise in measuring self-employed earned income.  Thus, the IRS position was that the landlord role could not be separated from the employee or partner role.  That meant that any employee or partner-level participation by the landowner triggered self-employment tax on the rental income. On the other hand, the petitioner, argued that the crop share lease did not involve material participation and that the crop share rental income should be exempt from self-employment tax.  In other words, the IRS looked to the overall farming arrangement to find a sufficient level of material participation on the petitioner’s part, but the petitioner confined the analysis to the terms of the lease which wasn’t a material participation lease.

While, rents from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income, there is an exception, however, if three criteria are met:

  • The rental income is derived under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land;
  • The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities; and
  • There is actual material participation by the owner.. R.C. §1402(a)(1)(A); Treas. Reg. §1.1402(a)-4(b)(1).

The Tax Court, agreeing with the IRS, focused on the word "arrangement" in both the statute and the regulations, noting that this implied a broader view than simply the single contract or lease for the use of the land between the petitioner and the farming partnership.  By measuring material participation with consideration to both the crop share lease and the petitioner’s obligations as a partner in the partnership, the court found that the rental income must be included in the petitioner’s net earnings for self-employment purposes.

Following its win in Mizell, the IRS privately ruled in 1996 that a married couple who cash-rented land to their agricultural corporation were subject to self-employment tax on the cash rental income, because both the husband and wife were employees of the corporation. T.A.M. 9637004 (May 6, 1996).

Implications of Mizell.  The Mizell decision was a landmine that posed a clear threat to the common set-up in agriculture where an individual leases farmland to an operating entity in which the individual is also a material participant.  Importantly, the type of lease was apparently immaterial to the court.  On that point, the wording of Treas. Reg. § 1.1402(a)-4(b)(2) appears to be broad enough to include income in any form, crop share or cash, if received in an arrangement that contemplates the material participation of the landowner.

Exception to the Mizell “Arrangement” Theory 

The Tax Court, in 1998, decided three more Mizell-type cases.   In Bot v. Comr., T.C. Memo. 1999-256, the court determined that rental income (at the rate of $90 per acre) received by a wife for 240 acres of land, paid to her by her husband’s farm proprietorship, was subject to self-employment tax. The wife also received an annual salary from the proprietorship of approximately $15,000, and the court said that the rental amount and the salary amounted to a single arrangement.   In Hennen v. Comr., T.C. Memo1999-306, the court again held that self-employment tax applied to rental income that a wife received on land leased to her husband’s farming business.  Like Mrs. Bot, Mrs. Hennen worked for the farming business and was paid a salary ($3,500/year).  McNamara v. Comr., T.C. Memo. 1999-333, also involved a husband and wife who owned land that they leased to their farming C corporation under a written, cash rent lease. The rent payment averaged about $50,000 per year.  The husband was employed full time by the corporation, and the wife was employed doing part-time bookkeeping and farm errand duties.  She was paid a nominal amount – about $2,500 annually.  The court again determined that the rental arrangement and the wife’s employment were to be combined, which meant that the rental income was subject to self-employment tax.

All three cases were consolidated on appeal to the U.S. Court of Appeals for the Eighth Circuit.  The Eighth Circuit, reversing the Tax Court, determined that the lessor/lessee relationship was to be analyzed separate and distinct from the employer-employee relationship. The Eighth Circuit interpreted I.R.C. §1402(a)(1) as requiring material participation by the landlord in the rental arrangement itself in order to subject the arrangement to self-employment tax. The court stated that, “The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement.”

The Eighth Circuit remanded the case to the Tax Court for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. The IRS could not establish a connection.  The rents were cash rents that were at or slightly below fair market value.  However, the IRS later issued a non-acquiescence to the Eighth Circuit’s decision.  A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003).   That meant that the IRS would continue to litigate the issue outside of the Eighth Circuit.

More Litigation

As the non-acquiescence indicated, the IRS continued to litigate the matter and two more cases found their way to the Tax Court.  In Johnson v. Comr., T.C. Memo. 2004-56, the petitioners verbally cash leased 617 acres of land to their farm corporation.  They also had a verbal employment agreement with the corporation and received a nominal salary.   The farming operation was located within the Eighth Circuit, which meant that the if the land rental and the employment agreement were two separate arrangements the land rental income would not be subject to self-employment tax.  Ultimately, the Tax Court determined that the rental amount under the lease was representative of a fair market rate of rent, and the rental payments were not tied to any services the petitioners provided to the farming corporation.  The compensation paid to the petitioners was also not understated.

However, in Solvie v. Comr., T.C. Memo. 2004-55, the Tax Court reached a different conclusion on a set of facts similar to those involved in Johnson.   In Solvie, the petitioners leased real estate to their controlled corporation and also received compensation as corporate employees.  Later, an additional hog barn was constructed which increased the total rent paid to the petitioners which the IRS claimed was subject to self-employment tax.  The Tax Court agreed because the additional rent was much greater than the rental amounts the received from the corporation for the other hog buildings even though the new building had a smaller capacity.  In addition, the court noted that the petitioners’ wages did not increase even they overall hog production increased, and the additional rent was computed on a per-head basis which meant that no building rent would be paid if there was no hog production. 

The Downfall of Mizell?

In Martin v. Comr., 149 T.C. No. 12 (2017), the Tax Court (in an opinion authored by Judge Paris) delivered its most recent opinion concerning the self-employment tax treatment of leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity.  Under the facts of the case, the petitioners, a married couple, operated a farm in Texas – a state not located within the Eighth Circuit’s jurisdiction.  In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator.  The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services.  They also pegged their salaries at levels consistent with other growers.  The wife provided bookkeeping services and the husband provided labor and management.  In 2005, they assigned the balance of their contract to the S corporation.  Thus, the corporation became the “grower” under the contract.  In 2005, the petitioners entered into a lease agreement with the S corporation.  Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period.  The court noted that the rent amount was consistent with other growers under contract with the integrator.  The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.

The Tax Court noted that the IRS agreed that the facts of the case were on all fours with McNamara.  In addition, the court determined that the Eighth Circuit’s rationale in McNamara was persuasive and that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation.  In other words, there must be a tie between the real property lease agreement and the employment agreement.  The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners’ investment in their facilities.  Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business.  Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara and relying on the court to broadly interpret “arrangement” to include all contracts related to the S corporation.  Accordingly, the court held that the petitioner’s rental income was not subject to self-employment tax.

A dissenting judge complained that the IRS should not have the burden of producing evidence of establishing a nexus between the land lease and the employment agreement once the petitioner establishes that the land lease is a fair market lease.  Another dissenter would have continued to apply the Mizell arrangement theory outside of the Eighth Circuit.

Implications

The cases point out that leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement.  Services and labor participation should remain solely within the domain of the employment agreement.  In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases.  If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services.  If lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services. 

Conclusion

The Martin decision, a full Tax Court opinion, is a breath of fresh air for agricultural operations that are structured with leases of farmland to an operating entity in which the lessor is also a material participant.  Proper structuring of the land lease and a separate employment agreement can provide protection from an IRS claim that self-employment tax applies to the land rental income.  Now there is substantial authority for that proposition outside the Eighth Circuit.  

September 29, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, September 13, 2017

New Partnership Audit Rules

Overview

Under the Balanced Budget Act of 2015 (BBA), P.L. 114-74, section 1101(a), 129 Stat. 584 (2015), as amended by P.L. 114-113, new partnership audit rules take effect for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment, November 2, 2015).

The new rules, make it easier for the IRS to audit large partnerships by making a determination of taxes at the partnership level, ensuring that a partner's return is consistent with the partnership return.  They also allow for the designation of a partnership representative.  In essence, the rules allow the IRS to audit partnerships, make a tax adjustment in the year in which the audit is done, and have the general partner have the income flow through to the partners.

The IRS had been pushing for the change to a centralized partnership audit regime for some time.  In general, the new process will result in the assessment and collection of tax at the partnership level and could result in more partnership audits.

One reason the new rules matter and should be paid attention to is that they could require the modification/amendment of partnership operating agreements. 

Today’s post takes a brief look at the new partnership audit rules and their impact. 

What is Changing?

1982 rules.  The current partnership audit rules date back to 1982 and the Tax Equity and Fiscal Responsibility Act (TEFRA).  Under those rules, for partnerships with 10 or fewer partners, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately.  For partnerships with 11 to 100 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Once the audit is completed and the resulting adjustments are determined, the IRS recalculates the tax liability of each partner in the partnership for the particular audit year. 

For partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (ELPs) for reporting and audit purposes, partnership adjustments generally flow through to the partners for the year in which the adjustment takes effect, rather than the year under audit.  As a result, the current-year partners’ share of current-year partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior-year audit that take effect in the current year.  The adjustments generally do not affect prior-year returns of any partners (except in the case of changes to any partner’s distributive share).

BBA provision.  Under the BBA provision, the current TEFRA and ELP rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.  Similar to the current TEFRA rule excluding small partnerships, the BBA provision allows partnerships with 100 or fewer qualifying partners to opt out of the new rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers.

The new rules allow a partnership to pay a computed tax at the end of any partnership examination rather than a tax being assessed at the partnership level.  This tax will be assessed to the partnership in the year that the audit is completed (the adjustment year), rather than the year of the examination (the reviewed year).  The tax will be computed at the highest income tax rate applicable to corporations and individuals (currently the individual rate, at 39.6%). I.R.C. §6221(a).

The partnership is permitted to issue adjusted Schedules K-1 to the partners of the reviewed year.  The recomputed tax for the reviewed year is paid in the adjustment year.  The partners take the adjustment into account on their individual returns in the adjustment year (not the reviewed year).  I.R.C. §6226(b)(1).

In addition, rather than amending the partnership tax return, partnerships will have the option of initiating an adjustment for a reviewed year.  The adjustment could be taken into account at the partnership level or the partnership could issue adjusted information return to each partner of the reviewed year.

A “partnership representative” replaces the former “tax matters partner.”  The representative has more authority to act on the partnership’s behalf without involving the partners.  The “partnership representative,” a person (or entity) must have a “substantial presence” in the United States.  If it is an entity, the partnership must identify and appoint an individual to act on the entity’s behalf.  While the representative doesn’t have to be a partner of the partnership, they do have the sole authority to settle any disputes with the IRS and agree to a final adjustment.  The representative also can make the election to shift the tax liability to the partners, and extend the statute of limitations on assessment.   But, under the proposed regulations, the representative doesn’t have to communicate with the partners or get consent from the partners before the representative acts on behalf of the partnership.  Also, if the partnership does not have a representative designation in effect, the IRS can pick who the representative will be.

A “small partnership” can elect out of the new rules.  A “small partnership” is one that is required to furnish 100 or fewer Schedules K-1 for the year.  In addition, the partnership must have partners that are individuals, corporations or estates.  If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers.   There are more specifics on the election in the regulations, but a drawback of the election might be that a small partnership electing out of the BBA audit provisions could be at a higher audit risk. IRS has seemingly indicated that this could be the case.

Proposed regulations.   Proposed regulations were issued in January to replace the 1982 unified audit rules and implement the new rules, but never were published in the Federal Register because of the regulatory freeze that the White House imposed.  They were reissued in June.  REG-136118-15. 

Needed Action?

So, what do partnerships need to do in light of the new audit rules?  One consideration might be to amend an existing partnership agreement to establish a procedure to be used when the IRS determines that the partnership has a deficiency and partners might be able to do something to reduce the tax burden.  I am thinking here of situations where individual partners might have information or could take steps might be helpful to the partnership in dealing with the IRS audit of the partnership and reducing the ultimate tax burden of an additional assessment.  Related to that, partnership agreements commonly include notice and consent procedures for various aspect of partnership business, so it may be beneficial to add in notice and consent language that specifically pertains to IRS audit matters under the new rules.  As a caveat, however, it’s not likely that a court would determine that the IRS is bound by such language.  But, the language might provide more clarity and guidance for the partnership and its partners.

Conclusion

The new audit rules that take effect on January 1, 2018, change the landscape for partnership audits.  In some respects, the audit process will be simpler and more streamlined.  In addition, the vast majority of farming and ranching partnerships will be able to elect out of the new rules.  But, the election must be affirmatively made, and the proposed regulations provide detail on making the election.  In any event, now is the time for partnership agreements to be amended where necessary to take into account the coming new rules. 

September 13, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, August 30, 2017

Farmers Renting Equipment – Does It Trigger A Self-Employment Tax Liability?

Overview

Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end.  Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few. 

But, what about those equipment rentals?  This can be a big issue for many farmers, including those that have recently retired.  Must self-employment tax be paid on the income from equipment rents?  The answer, as it is with many tax questions, depends on the facts of each situation.

That’s the focus of today’s post – self-employment tax on the rental of farm equipment.

The Basics

The statute.  In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual.  Self-employment income is defined as “net earnings from self-employment.”  The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402.  For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200.  It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent.  That’s because the self-employment tax is also a deductible expense.  In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level. 

In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates.  I.R.C. §§1402(a)(1) and 1402(a)(1)(A).  For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax only if the activity constitutes a trade or business “carried on by such individual.”  See, e.g., Rudman v. Comr., 118 T.C. 354 (2002).  Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.

This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate.  But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax.  See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357. 

The reporting.  Income from a rental activity is normally passive and is reported on Schedule E (Form 1040).  From there it flows to page one of Form 1040 and is reported on the line for “Other Income.”  Self-employment tax would not apply (but the additional 3.8 percent “passive tax” of I.R.C. §1411 could apply if the taxpayer has income over the applicable threshold).  However, as noted at the top of Schedule E, Part 1, taxpayer are directed to report the income and expense from a personal property rental activity on Schedule C (or Schedule C-EZ).  Schedule C is for reporting of business income, and the IRS instructions for completing Schedule E (at page E-4) say that Schedule C (or Schedule C-EZ) is to be used to report the income and expense associated with the rental of personal property if the taxpayer is in the business of renting personal property. 

Trade or Business

Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property.  The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer’s activity is engaged in regularly and continuously with the intent to profit from the activity.  Comr. v. Groetzinger, 480 U.S. 23 (1987).  But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court.  Batok v. Comr., T.C. Memo. 1992-727. 

As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21).  Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040.  A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.     

Planning Strategy

The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business.  But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax.  Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership.  If that is done, the income from the rental activity would flow through to the owner without self-employment tax.  However, with an S corporation, reasonable compensation would need to be paid.  For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income. 

Conclusion

Many farmers lease farm equipment, particularly if they have retired from farming and still own the equipment.  In that situation, it is often desirable not to incur self-employment tax on the equipment rental.  To achieve that result, the rental activity should not rise to the level of a trade or business, or the equipment should be leased with real estate.  Alternatively, the leasing should be done through an S corporation or a partnership. 

August 30, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Monday, August 28, 2017

Forming a Farming/Ranching Corporation Tax-Free

Overview

Incorporation of an existing farming or ranching operation can be accomplished tax-free.  A tax-free incorporation is usually desirable because farm and ranch property typically has a fair market value substantially in excess of basis.  But, how is it done?  What are the basics?  What if liabilities are transferred to a corporation when it is formed?  Are there special rules concerning debt assumption?  What’s the IRS assignment of income theory all about? 

Tax-free incorporation – that’s our topic today.

Basic Principles

Three conditions – no election needed.  For property conveyed to the corporation, neither gain nor loss is recognized to the transferor(s) on the exchange (I.R.C. §357(a)) 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.”

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. Also, care should be taken to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation.  See, e.g., Priv. Ltr. Rul. 9405007 (Oct. 19, 1993).

Income tax basis and holding period.  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.  I.R.C. §362.  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.  I.R.C. §358.  The basis reduction can’t go below zero in the event the corporation assumes liabilities that exceed the basis of the assets transferred to the corporation.  See, e.g., Wiebusch v. Comr., 59 T.C. 777 (1973), aff’d., 487 F.2d 515 (1973). 

But, there is no basis reduction for a liability that generates a deduction when it is paid.  Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash.  The holding period of the transferor’s stock is pegged to the holding period of the assets that were transferred to the corporation.  I.R.C. §1223(1).  However, inventory and other non-capital assets do not qualify for “tacking-on” of the holding period.  Thus, to get long-term gain treatment when the stock that is received on incorporation is sold, the stock seller will have to have held the stock for at least 12 months.  See Rev. Rul. 62-140, 1962-2 C.B. 181.

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.  Also, the holding period of the transferred property carries over from the transferor to the corporation.  I.R.C. §1223(2).  Depreciable property received by the corporation at the time of incorporation is not eligible for “fast” methods of depreciation (for non-recovery property), expense method depreciation or a shift in ACRS or MACRS status.  In other words, ACRS or MACRS property continues to be ACRS or MACRS property.

Transferring liabilities.  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). The test is applied to each transferor individually, with the computation accomplished by aggregating the adjusted tax basis of all assets and measuring that result against all of the liabilities of that particular transferor.  The gain is capital gain if the asset is a capital asset or ordinary gain if the asset is not a capital asset.  I.R.C. §357(c)(1). 

But, some liabilities don’t count for purposes of the computation – specifically, those that give rise to a deduction when they are paid.  So, for example, accrued expenses of a transferor that is on the cash method of accounting would not be considered to be “liabilities” for purposes of the computation.  I.R.C. §357(c)(3).

Can taxable gain that would otherwise be incurred upon incorporating (when liabilities exceed basis) be avoided by 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 said “no,” determining that this technique will not work because the note has a zero basis.  Rev. Rul. 68-629, 1968-2 C.B. 154.   The Tax Court agrees.  Alderman v. Comr., 55 T.C. 662 (1971); Christopher v. Comr., T.C. Memo. 1984-394.

However, an appellate court, in reversing the Tax Court in a different case eighteen years later, 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).  The Tax Court was reversed again in a 1998 case. Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191. In this case, 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 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 also acknowledged 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. 

The 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.  Likewise, a partner in a partnership cannot create basis in a partnership interest by contributing a note.  Rev. Rul. 80-235, 1980-2 C.B. 229. 

            What if the transferor remains personally liable?  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.  But, nonrecourse debts of a transferor, under I.R.C. §357(d), are presumed to be transferred to the corporation unless the transferor holds other assets subject to the debt that are not transferred to the corporation and the transferor remains subject to the debt.  The same rule applies to recourse liabilities. 

            What if gain is triggered?  If liabilities exceed basis, the gain is “phantom” income.  That’s because the taxpayer hasn’t generated any cash to pay the tax on the gain that is triggered by transferring assets to the corporation with less basis than debt.  In addition, for farm/ranch incorporations, the gain is likely to be ordinary in nature (determined as if the transferred assets were sold – I.R.C. §357(c)(1)).  The one favorable factor if gain is recognized upon incorporation is that the basis of the transferred assets is increased by the amount of the gain.  I.R.C. §358(a)(1(B)(ii)).  

Business purpose.  As noted above, one of the three requirements that must be satisfied to accomplish a tax-free incorporation is that the transfer must be for a business purpose.  If the corporate assumption of liabilities has as a purpose the avoidance of federal income tax or lacks a bona fide business purpose, the assumed liabilities are treated as boot paid to the transferor.  I.R.C. §357(b); 351(b).  If the liabilities are created shortly before incorporation and are then transferred to the corporation, the IRS will raise questions.  See, e.g., Weaver v. Comr., 32 T.C. 411 (1959); Thompson v. Campbell, 353 F.2d 787 (5th Cir. 1965); Harrison v. Comr., T.C. Memo. 1981-211.

Assignment of Income

In general, formation of a farm or ranch corporation in the regular course of business not involving substantial tax avoidance motives or a manifest desire to artificially shift income tax liability should not result in income recognition.  However, the IRS has several theories available to challenge transfers carried out in the presence of obvious tax avoidance motives or a manifest desire to shift income tax liability artificially.  See, e.g., I.R.C. §482.  For instance, the “assignment of income” doctrine may override an otherwise tax-free exchange and cause the proceeds from the sale of transferred assets to be taxed to the transferor.  See, e.g., Weinberg v. Comr., 44 T.C. 233 (1965); Slota v. Comr., T.C. Sum. Op. 2010-152.  The IRS utilization of this theory should be watched in situations where the transferor has, via incorporation, shifted income to the corporation but claimed associated deductions on the transferor’s personal return.  However, the theory does not apply to the transfer of cash method accounts receivable.  See, e.g., Hempt Bros., Inc. v. United States, 354 F. Supp. 1172 (M.D. Pa. 1973), aff’d, 490 F.2d 1172 (3d Cir. 1974); Rev. Rul. 80-198, 1980-2 C.B. 113. 

Distortion of Income

The IRS also has, under I.R.C. §482, broad powers to reallocate income, deductions, credits or allowances as necessary “in order to prevent the evasion of taxes or clearly to reflect...income.”  See, e.g., Rooney v. United States, 305 F.2d 681 (9th Cir. 1962).  However, if all of the farm income and expense that is incurred before incorporation stays with the transferor and is reported on the transferor’s return accordingly, an IRS challenge to a tax-free incorporation is not likely.  See, e.g., Heaton v. United States, 573 F. Supp. 12 (E.D. Wash. 1983).  One thing to avoid is the incurring of a substantial net operating loss shortly before incorporation.

Conclusion

A corporation can be formed tax-free.  But, certain requirements must be satisfied and the transferred assets must have more basis than liabilities.  In addition, stock should not be issued for basis, unless there is only one transferor or, for all transferors, the income tax basis of transferred assets bears a uniform relationship to the fair market value of the transferred property. 

Carefully following the rules can lead to a happy tax result.  Unfortunately, the opposite is also true. 

August 28, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Tuesday, August 22, 2017

The Business of Agriculture – Upcoming CLE Symposium

Overview

On September 18, Washburn School of Law will be having its second annual CLE conference in conjunction with the Agricultural Economics Department at Kansas St. University.  The conference, hosted by the Kansas Farm Bureau (KFB) in Manhattan, KS, will explore the legal, economic, tax and regulatory issue confronting agriculture.  This year, the conference will also be simulcast over the web.

That’s my focus today – the September 18 conference in Manhattan, for practitioners, agribusiness professionals, agricultural producers, students and others. 

Symposium Topics

Financial situation.  Midwest agriculture has faced another difficult year financially.  After greetings by Kansas Farm Bureau General Counsel Terry Holdren, Dr. Allen Featherstone, the chair of the ag econ department at KSU will lead off the day with a thorough discussion on the farm financial situation.  While his focus will largely be on Kansas, he will also take a look at nationwide trends.  What are the numbers for 2017?  Where is the sector headed for 2018? 

Regulation and the environment.  Ryan Flickner, Senior Director, Advocacy Division, at the KFB will then follow up with a discussion on Kansas regulations and environmental laws of key importance to Kansas producers and agribusinesses. 

Tax – part one.  I will have a session on the tax and legal issues associated with the wildfire in southwest Kansas earlier this year – handling and reporting losses, government payments, gifts and related issues.  I will also delve into the big problem in certain parts of Kansas this year with wheat streak mosaic and dicamba spray drift.

Weather.  Mary Knapp, the state climatologist for Kansas, will provide her insights on how weather can be understood as an aid to manage on-farm risks.  Mary’s discussions are always informative and interesting. 

Crop Insurance.  Dr. Art Barnaby, with KSU’s ag econ department, certainly one of the nation’s leading experts on crop insurance, will address the specific situations where crop insurance does not cover crop loss.  Does that include losses caused by wheat streak mosaic?  What about losses from dicamba drift?

Washburn’s Rural Law Program.  Prof. Shawn Leisinger, the Executive Director of the Centers for Excellence at the law school (among his other titles) will tell attendees and viewers what the law school is doing (and planning to do) with respect to repopulating rural Kansas with well-trained lawyers to represent the families and businesses of agriculture.  He will also explain the law school’s vision concerning agricultural law and the keen focus that the law school has on agricultural legal issues.

Succession Planning.  Dr. Gregg Hadley with the KSU ag econ department will discuss the interpersonal issues associated with transitioning the farm business from one generation to the next.  While the technical tax and legal issues are important, so are the personal family relationships and how the members of the family interact with each other.

Tax – part two.  I will return with a second session on tax issues.  This time my focus will be on hot-button issues at both the state and national level.  What are the big tax issues for agriculture at the present time?  There’s always a lot to talk about for this session.

Water.  Prof. Burke Griggs, another member of our “ag law team” at the law school, will share his expertise on water law with a discussion on interstate water disputes, the role of government in managing scarce water supplies, and what the relationship is between the two.   What are the implications for Kansas and beyond?

Producer panel.  We will close out the day with a panel consisting of ag producers from across the state.  They will discuss how they use tax and legal professionals as well as agribusiness professionals in the conduct of their day-to-day business transactions.

Conclusion

The Symposium is a collaborative effort of Washburn law, the ag econ department at KSU and the KFB.  For lawyers, CPAs and other tax professionals, application has been sought for continuing education credit.  The symposium promises to be a great day to interact with others involved in agriculture, build relationships and connections and learn a bit in the process.

We hope to see you either in-person or online.  For more information on the symposium and how to register, check out the following link:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html

August 22, 2017 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)