Tuesday, April 17, 2018
Trusts are a popular part of an estate plan for many people. Trusts also come in different forms. Some take effect during life and can be changed whenever the trust grantor (creator or settlor) desires. These are revocable trusts. Other trusts, known as irrevocable trusts, also take effect during life but can’t be changed when desired. Or, at least not as easily. That’s an issue that comes up often. People often change their minds and circumstances also can change. In addition, the tax laws surrounding estates and trust are frequently modified by the Congress as well as the courts. Also, sometimes drafting errors occur and aren’t caught until after the irrevocable trust has been executed.
So how can a grantor of an irrevocable accomplish a “do over” when circumstances change? It involves the concept of “decanting” and it’s the topic of today’s post.
Trying to change the terms of an irrevocable trust is not a new concept. “Decanting” involves pouring one trust into another trust with more favorable terms. To state it a different way, decanting involves distributing the assets of one trust to another trust that has the terms that the grantor desires with the terms that the grantor no longer wants remaining in the old trust.
The ability to “decant” comes from either an express provision in the trust, or a state statute or judicial opinions (common law). Presently, approximately 20 states have adopted “decanting” statutes, and a handful of others (such as Iowa and Kansas) allow trust modification under common law. In some of the common law jurisdictions, courts have determined that decanting is allowed based upon the notion that the trustee’s authority to distribute trust corpus means that the trustee has a special power of appointment which allows the trustee to transfer all (or part) of the trust assets to another irrevocable trust for the same beneficiaries.
In terms of a step-by-step approach to decanting, the first step is to determine whether an applicable state statute applies. If there is a statute, a key question is whether it allows for decanting. Some statutes don’t so provide. If it does, the statutory process must be followed. Does the statute allow the trustee to make the changes that the grantor desires? That is a necessary requirement to being able to decant the trust. If there is no governing statute, or there is a statute but it doesn’t allow the changes that the grantor desires, a determination must be made as to what the state courts have said on the matter, if anything. But, that could mean that litigation involving the changes is a more likely possibility with a less than certain outcome.
If conditions are not favorable for decanting in a particular jurisdiction, it may be possible under the trust’s terms (or something known as a “trust protector”) to shift the trust to a different jurisdiction where the desired changes will be allowed. Absent favorable trust terms, it might be possible to petition a local court for authority to modify the trust to allow the governing jurisdiction of the trust to be changed.
If decanting can be done, the process of changing the trust terms means that documents are prepared that will result in the pouring of the assets of the trust into another trust with different terms. Throughout the process, it is important to follow all applicable statutory rules. Care must be taken when preparing deeds, beneficiary forms, establishing new accounts and conducting any other related business to complete the change.
IRS Private Ruling
In the fall of 2015, the IRS released a Private Letter Ruling that dealt with the need to change an error in the drafting of an irrevocable trust in order to repair tax issues with the trust. Priv. Ltr. Rul. 201544005 (Jun. 19, 2015). The private ruling involved an irrevocable trust that had a couple of flaws. The settlors (a married couple) created the trust for their children, naming themselves as trustees. One problem was that the trust terms gave the settlors a retained power to change the beneficial interests of the trust. That resulted in an incomplete gift of the transfer of the property to the trust. In addition, the retained power meant that I.R.C. §2036 came into play and would cause inclusion of the property subject to the power in the settlors’ estates. The couple intended that their transfers to the trust be completed gifts that would not be included in their gross estates, so they filed a state court petition for reformation of the trust to correct the drafting errors. The drafting attorney submitted an affidavit that the couple’s intent was that their transfers of property to the trust be treated as completed gifts and that the trust was intended to optimize their applicable exclusion amount. The couple also sought to resign as trustees. The court allowed reformation of the trust. That fixed the tax problems. The IRS determined that the court reformation would be respected because the reformation carried out the settlors’ intent.
When to Decant
So, it is possible that an irrevocable trust can be changed to fix a drafting error and for other reasons if the law and facts allow.
What are common reasons decant an irrevocable trust? Some of the most common ones include the following:
- To achieve greater creditor protection by changing, for example, a support trust to a discretionary trust (this can be a big issue, for example, with respect to long-term health care planning);
- To change the situs (jurisdiction where the trust is administered) to a location with greater pro-trust laws;
- To adjust the terms of the trust to take into account the relatively larger federal estate exemption applicable exclusion and include power of appointment language that causes inclusion of the trust property in the settlor’s estate to achieve an income tax basis “step-up” at death (this has become a bigger issue as the federal estate tax exemption has risen substantially in recent years);
- To provide for a successor trustee and modify the trustee powers;
- To either combine multiple trusts or separate one trust into a trust for each beneficiary;
- To create a special needs trust for a beneficiary with a disability;
- To permit the trust to be qualified to hold stock in an S corporation and, of course;
- To correct drafting errors that create tax problems and, perhaps, in the process of doing so create a fundamentally different trust.
The ability to modify an irrevocable trust is critical. This is particularly true with the dramatic change in the federal estate and gift tax systems in recent years. Modification may also be necessary when desires and goals change or to correct an error in drafting. Fortunately, in many instances, it is possible to make changes even though the trust is “irrevocable.” If you need to “decant” a trust, see an estate planning professional for help.
Friday, April 13, 2018
Many readers of this blog are tax preparers. Many focus specifically on returns for clients engaged in agricultural production activities. As tax season winds down, at least for the time being, another season is about to begin. For me, that means that tax seminar season is just around the corner. Whether it’s at a national conference, state conference, in-house training for CPAs or more informal meetings, I am about to begin the journey which will take me until just about Christmas of providing CPE training for CPAs and lawyers across the country.
CPAs and lawyers are always looking for high-quality and relevant tax and legal education events. In today’s post I highlight some upcoming events that you might want to attend.
Calendar of Events
Shortly after tax preparers come back from a well-deserved break from the long hours and weekends of preparing returns and dealing with tax client issues, many will be ready to continue accumulating the necessary CPE credits for the year. This is an important year for CPE tax training with many provisions of the Tax Cuts and Jobs Act taking effect for tax years beginning after 2017.
If you are looking for CPE training the is related to agricultural taxation and agricultural estate and business planning below is a run-down of the major events I will be speaking at in the coming months. Washburn Law School is a major player in agricultural law and taxation, and more details on many of these events can be found from the homepage of WALTR, my law school website – www.washburnlaw.edu/waltr.
May 9 – CoBank, Wichita KS
May 10 – Kansas Society of CPAs, Salina, KS
May 14 - Lorman, Co. Webinar
May 16 – Quincy Estate Planning Council, Quincy, IL
May 18 – Iowa Bar, Spring Tax Institute, Des Moines, IA
May 22 – In-House CPA Firm CPE training, Indianapolis, IN
June 7-8 – Summer Tax/Estate & Business Planning Conference, Shippensburg, PA
June 14-15 – In-House CPA Firm CPE training, Cedar Rapids, IA
June 22 - Washburn University School of Law CLE Event, Topeka, KS
June 26 - Washburn University School of Law/Southwest KS Bar Assoc, Dodge City, KS
June 27 – Kansas Society of CPAs, Topeka, KS
July 10 – Univ. of Missouri Summer Tax School, Columbia, MO
July 16-17 – AICPA Farm Tax Conference, Las Vegas, NV
July 19 – Western Kansas Estate Planning Council, Hays, KS
July 26 – Mississippi Farm Bureau Commodity Conference, Natchez, MS
August 14 – In-House training, Kansas Farm Bureau, Manhattan, KS
August 15 - Washburn University School of Law/KSU Ag Law Symposium, Manhattan, Kansas
August 16-17 – Kansas St. Univ. Dept. of Ag Econ. Risk and Profit Conference, Manhattan, KS
September 17-18 – North Dakota Society of CPAs, Grand Forks, ND
September 19 – North Dakota Society of CPAs, Bismarck, ND
September 21 – University of Illinois, Moline, IL
September 24 – University of Illinois, Champaign-Urbana, IL
September 26-27 – Montana Society of CPAs, Great Falls, MT
October 3 – CoBank, Wichita, KS
October 11-12 – Notre Dame Estate Planning Institute, South Bend, IN
The events listed above are the major events geared for practitioners as of this moment. I am continuing to add others, so keep watching WALTR for an event near you. Of course, I am doing numerous other events geared for other audiences that can also be found on WALTR’s homepage. Once I get into mid-late October, then the annual run of tax schools begins with venues set for Kansas, North Dakota, Iowa and South Dakota. Added in there will also be the Iowa Bar Tax School in early December.
Special Attention – Summer Seminar
I would encourage you to pay particular attention to the upcoming summer seminar in Shippensburg, PA. This two-day conference is sponsored by Washburn University School of Law and is co-sponsored by the Pennsylvania Institute of CPAs and the Kansas State University Department of Agricultural Economics. I will be joined for those two days by Paul Neiffer, Principal with CliftonLarsonAllen, LLP. On-site seating for that event is limited to 100 and the seminar is filling up fast. After those seats are taken, the only way to attend will be via the simultaneous webcast. More information concerning the topics we will cover and how to register can be found at: 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.
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.
Thursday, February 22, 2018
Leasing is of primary importance to agriculture. Leasing permits farmers and ranchers to operate larger farm businesses with the same amount of capital, and it can assist beginning farmers and ranchers in establishing a farming or ranching business.
Today’s post takes a brief look at some of the issues surrounding farmland leases – economic; estate planning; and federal farm program payment limitation planning.
Common Types of Leases
Different types of agricultural land leasing arrangements exist. The differences are generally best understood from a risk/return standpoint. Cash leases involve the periodic payment of a rental amount that is either a fixed number of dollars per acre, or a fixed amount for the entire farm. Typically, such amounts are payable in installments or in a lump sum. A flexible cash lease specifies that the amount of cash rent fluctuates with production conditions and/or crop or livestock prices. A hybrid cash lease contains elements similar to those found in crop-share leases. For example, a hybrid cash lease usually specifies that the rental amount is to be determined by multiplying a set number of bushels by a price determined according to terms of the lease, but at a later date. The tenant will market the entire crop. The landlord benefits from price increases, while requiring no management or selling decisions or capital outlay. However, the rental amount is adversely affected by a decline in price. The tenant, conversely, will not bear the entire risk of low commodity prices, as would be the case if a straight-cash lease were used, but does bear all of the production risk and must pay all of the production costs.
Under a hybrid-cash lease, known as the guaranteed bushel lease, the tenant delivers a set amount of a certain type of grain to a buyer by a specified date. The landlord determines when to sell the grain, and is given an opportunity to take advantage of price rises and to make his or her own marketing decisions. However, the landlord must make marketing decisions, and also is subject to price decreases and the risk of crop failure. For tenants, the required capital outlay will likely be less, and the tenant should have greater flexibility as to cropping patterns. While the rental amount may be less than under a straight-cash lease, the tenant will continue to bear the risk of crop failure.
Another form of the hybrid-cash lease, referred to as the minimum cash or crop share lease, involves a guaranteed cash minimum. However, the landlord has the opportunity to share in crop production from a good year (high price or high yield) without incurring out-of-pocket costs. For a tenant, the minimum cash payment likely will be less than under a straight-cash lease because the landlord will receive a share of production in good years. The tenant, however, still retains much of the production risk. In addition, the tenant typically does not know until harvest whether the tenant will receive all or only part of the crop. This may make forward cash contracting more difficult.
Under a crop-share leasing arrangement, the rent is paid on the basis of a specified proportion of the crops. The landlord may or may not agree to pay part of certain expenses. There are several variations to the traditional crop-share arrangement. For example, with a crop share/cash lease, rent is paid with a certain proportion of the crops, but a fixed sum is charged for selected acreage such as pasture or buildings, or both. Under a livestock-share leasing arrangement, specified shares of livestock, livestock products and crops are paid as rent, with the landlord normally sharing in the expenses. For irrigation crop-share leases, rent is a certain proportion of the crops produced, but the landlord shares part of the irrigation expenses. Under labor-share leases, family members are typically involved and the family member owning the assets has most of the managerial responsibility and bears most of the expenses and receives most of the crops. The other family members receive a share of yield proportionate to their respective labor and management inputs.
Estate Planning Implications
Leasing is also important in terms of its relation to a particular farm or ranch family's estate plan. For example, with respect to Social Security benefits for retired farm-landlords, pre-death material participation under a lease can cause problems. A retired farm-landlord who has not reached full retirement age (66 in 2018) may be unable to receive full Social Security benefits if the landlord and tenant have an agreement that the landlord shall have “material participation” in the production of, or the managing of, agricultural products.
While material participation can cause problems with respect to Social Security benefits, material participation is required for five of the last eight years before the earlier of retirement, disability or death if a special use valuation election is going to be made for the agricultural real estate included in the decedent-to-be's estate. I.R.C. §2032A. A special use valuation election permits the agricultural real estate contained in a decedent's estate to be valued for federal estate tax purposes at its value for agricultural purposes rather than at fair market value. The solution, if a family member is present, may be to have a nonretired landlord not materially participate, but rent the elected land to a materially participating family member or to hire a family member as a farm manager. Cash leasing of elected land to family members is permitted before death, but generally not after death. The solution, if a family member is not present, is to have the landlord retire at age 65 or older, materially participate during five of the eight years immediately preceding retirement, and then during retirement rent out the farm on a nonmaterial participation crop-share or livestock-share lease.
Farm Program Payments
Leases can also have an impact on a producer's eligibility for farm program payments. In general, to qualify for farm program payments, an individual must be “actively engaged in farming.” For example, each “person” who is actively engaged in farming is eligible for up to $125,000 in federal farm program payments each crop year. A tenant qualifies as actively engaged in farming through the contribution of capital, equipment, active personal labor, or active personal management. Likewise, a landlord qualifies as actively engaged in farming by the contribution of the owned land if the rent or income for the operation's use of the land is based on the land's production or the operation's operating results (not cash rent or rent based on a guaranteed share of the crop). In addition, the landlord's contribution must be “significant,” must be “at risk,” and must be commensurate with the landlord's share of the profits and losses from the farming operation.
A landowner who cash leases land is considered a landlord under the payment limitation rules and may not be considered actively engaged in farming. In this situation, only the tenant is considered eligible. Under the payment limitation rules, there are technical requirements that restrict the cash-rent tenant's eligibility to receive payments to situations in which the tenant makes a “significant contribution” of (1) active personal labor and capital, land or equipment; or (2) active personal management and equipment. Leases in which the rental amount fluctuates with price and/or production (so-called “flex” leases) can raise a question as to whether or not the lease is really a crop-share lease which thereby entitles the landlord to a proportionate share of the government payments attributable to the leased land.
Under Farm Service Agency (FSA) regulations (7 C.F.R. §1412.504(a)(2)), a lease is a “cash lease” if it provides for only a guaranteed sum certain cash payment, or a fixed quantity of the crop (for example, cash, pounds, or bushels per acre).” All other types of leases are share leases. In April 2007, FSA issued a Notice stating that if any portion of the rental payment is based on gross revenue, the lease is a share lease. Notice DCP-172 (April 2, 2007). However, according to FSA, if a flex or variable lease pegs rental payments to a set amount of production based on future market value that is not associated with the farm’s specific production, it’s a cash lease. Id. That was the FSA’s position through the 2008 crop year. Beginning, with the 2009 crop year, FSA has taken the position that a tenant and landlord may reach any agreement they wish concerning “flexing” the cash rent payment and the agreement will not convert the cash lease into a share-rent arrangement.
There are many issues that surround farmland leasing. Today’s post just scratches the surface with a few. Of course, many detailed tax rules also come into play when farmland is leased. The bottom line is that the type of lease matters, for many reasons. Give your leasing arrangement careful consideration and get it in writing.
Tuesday, February 20, 2018
For over the past decade I have conducted at least one summer tax conference addressing farm income tax and farm estate and business planning. The seminars have been held from coast-to-coast in choice locations – from North Carolina and New York in the East to California and Alaska in the West, and also from Michigan and Minnesota in the North to New Mexico in the South. This summer’s conference will be in Shippensburg, Pennsylvania on June 7-8 and is sponsored by the Washburn University School of Law. Our co-sponsors are the Kansas State University Department of Agricultural Economics and the Pennsylvania Institute of CPAs. My teaching partner again this year will be Paul Neiffer, the author of the Farm CPA Today blog. If you represent farm clients or are engaged in agricultural production and are interested in ag tax and estate/succession planning topics, this is a must-attend conference.
Today’s post details the seminar agenda and other key details of the conference.
The first day of the seminar will focus on ag income tax topics. Obviously, a major focus will be centered on the new tax law and how that law, the “Tax Cuts and Jobs Act” (TCJA), impacts agricultural producers, agribusinesses and lenders. One of points of emphasis will be on providing practical examples of the application of the TCJA to common client situations. Of course, a large part of that discussion will be on the qualified business income (QBI) deduction. Perhaps by the time of the seminar we will know for sure how that QBI deduction applies to sales of ag products to cooperatives and non-cooperatives.
Of course, we will go through all of the relevant court cases and IRS developments in addition to the TCJA. There have been many important court ag tax court decisions over the past year, as those of your who follow my annotations page on the “Washburn Agricultural Law and Tax Report” know first-hand.
Many agricultural producers are presently having a tough time economically. As a result, we will devote time to financial distress and associated tax issues – discharged debt; insolvency; bankruptcy tax; assets sales, etc.
We will also get into other issues such as tax deferral issues; a detailed discussion of self-employment tax planning strategies; and provide an update on the repair/capitalization regulations.
On Day 2, the focus shifts to estate and business planning issues for the farm client. Of course, we will go through how the TCJA impacts estate planning and will cover the key court and IRS developments that bear on estate and business planning. We will also get into tax planning strategies for the “retiring” farmer and farm program payment eligibility planning.
The TCJA also impacts estate and business succession planning, particularly when it comes to entity choice. Should a C corporation be formed? What are the pros and cons of entity selection under the TCJA? What are the options for structuring a farm client’s business? We will get into all of these issues.
On the second day we will also get into long-term care planning options and strategies, special use valuation, payment federal estate tax in installments, and the income taxation of trusts and estates.
The seminar will be held at the Shippensburg University Conference Center. There is an adjacent hotel that has established a room block for conference attendees at a special rate. Shippensburg is close to the historic Gettysburg Battlefield and is not too far from Lancaster County and other prime ag production areas. Early June will be a great time of the year to be in Pennsylvania.
Attend In-Person or Via the Web
The conference will be simulcast over the web via Adobe Connect. If you attend over the web, the presentation will be both video and audio. You will be able to interact with Paul and I as well as the in-person attendees. On site seating is limited to the first 100 registrants, so if you are planning on attending in-person, make sure to get your spot reserved.
You can find additional information about the seminar and register here: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
If you have ag clients, you will find this conference well worth your time. We look forward to seeing you at the seminar either in-person or via the web.
Friday, February 16, 2018
I am often asked the questions at lay-level seminars whether a person can write their own will. While the answer is “yes,” it probably isn’t the best idea. Why? One of the primary reasons is because unclear language might be inadvertently used. Some words have multiple meanings in different contexts. Other words may simply be imprecise and not really require the executor or trustee to take any particular action concerning the decedent’s assets. The result could be that the decedent’s property ends up being disposed of in a way that the decedent hadn’t really intended.
Sometimes these problems can still occur when a will or trust is professionally prepared. A recent Texas case involving the disposition of ranch land illustrates the problem. Because of the imprecise language in a will and trust, a ranch ended up being sold without the decedent’s heirs having an option to purchase the property so that the land would stay in the family.
Imprecise language in wills and trusts and the problems that can be created - that’s the topic of today’s post.
The Peril of Precatory Language
In the law of wills and trusts, precatory words are words of wish, hope or desire or similar language that implores an executor or trustee of the decedent’s estate to dispose of property in some particular way. These types of words are not legally binding on the executor or trustee. They are merely “advisory.” However, words such as “shall” or “must” or some similar mandatory-type words are legally binding. Other words such as “money,” “funds,” or “personal property” are broad terms that can mean various things unless they are specifically defined elsewhere in the will or trust. Litigation involving wills and trusts most often involves ambiguous terms.
In Estate of Rodriguez, No. 04-17-00005-CV, 2018 Tex. App. LEXIS 254 (Tex. Ct. App. Jan. 10, 2018), a beneficiary of a trust sued the trustee to prevent the sale of ranchland that was owned by the decedent’s testamentary trust. The decedent died in early 2015 leaving a will benefitting his four children and a daughter-in-law. A son was named as executor and the trustee of a testamentary trust created by the decedent’s will. The primary property of the decedent’s residuary estate (after specific bequests had been satisfied) was the decedent’s ranchland. The residuary estate passed to the testamentary trust. Three of the children and the daughter-in-law were named as beneficiaries of the trust.
The trustee decided to sell the ranchland, and the daughter-in-law attempted to buy the ranch to no avail. She sued, seeking a temporary restraining order and an injunction that would prevent the trustee from selling the ranch to a third party that the trustee had accepted an offer to purchase from. The third party also got involved in the lawsuit, seeking specific performance of the purchase contract. The daughter-in-law claimed that the contract between the trustee and the third party violated a right-of-first-refusal that the trust language created in favor of the trust beneficiaries. The trial court disagreed and ordered the trustee to perform the contract. The daughter-in-law appealed.
The appellate court noted the following will language: “I hereby grant unto my…Executor…full power and authority over any and al of my estate and they are hereby authorized to sell…any part thereof…”. The trust created by the will also gave the trustee the specific power to sell the corpus of the trust, but the language was imprecise. The pertinent trust language stated, “My Trustee can sell the corpus of this Trust, but it [is] my desire my ranch stay intact as long as it is reasonable.” Another portion of the trust stated, “If any of the four beneficiaries of his estate wants to sell their portion of the properties they can only sell it to the remaining beneficiaries.” The daughter-in-law claimed the trust language was mandatory rather than precatory, and the mandatory language granted the trust beneficiaries the right-of-first-refusal to buy the ranchland. She claimed that the decedent desired that the ranchland stay intact, and had mentioned that intent to others during his life.
The appellate court disagreed with the daughter-in-law. Neither of the trust clauses, the court noted, required the trustee to offer to anyone, much less the beneficiaries, the chance to buy the ranchland on the same terms offered to another potential buyer. While the language limited a beneficiary’s power to sell to anyone other than another beneficiary, it didn’t restrict the trustee’s power to sell. There was simply nothing in the will or trust that limited the trustee’s power to sell by creating a right-of-first-refusal in favor of the trust beneficiaries. The decedent’s “desire” to keep the ranchland intact was precatory language that didn’t bar the trustee from selling it to a third party. In addition, there was no right-of-first-refusal created for the beneficiaries. The contract to sell the ranchland to the third party was upheld.
For many farm or ranch families, a major objective is to keep the farmland/ranchland in the family. That might be the case regardless of whether the family members will be the actual operators down through subsequent generations. However, the recent Texas case points out how important precise language in wills and trusts is in preserving that intent.
Tuesday, February 6, 2018
Some spousal business ventures can elect out of the partnership rules for federal tax purposes as a qualified joint venture (QJV). I.R.C. §761(f). While the election will ease the tax reporting requirements for husband-wife joint ventures that can take advantage of the election, the Act also makes an important change to I.R.C. §1402 as applied to rental real estate activities that can lay a trap for the unwary.
When is making a QJV election a good planning move? When should it be avoided? Are their implications for spousal farming operations with respect to farm program payment limitation planning? Is there any impact on self-employment tax? This week I am taking a look at the QJV. Today’s post looks at the basics of the election. On Thursday, I will look at its implications for farm program payment limitation planning as well as its impact on self-employment tax.
The QJV election is the topic of today’s post.
Joint Ventures and Partnership Returns
A joint venture is simply an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. That is similar to the Uniform Partnership Act’s definition of a partnership. UPA §101(6). The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership (I.R.C. §§761(a) and 7701(a)(2)), and the IRS follows the UPA definition of a partnership by specifying that a business activity conducted in a form jointly owned by spouses (including a husband-wife limited liability company (LLC)) creates a partnership that requires the filing of an IRS Form 1065 and the issuance to each spouse of separate Schedules K-1 and SE, followed by the aggregation of the K-1s on the 1040 Schedule E, page 2. The Act does not change the historic IRS position.
Note: Thus, for a spousal general partnership, each spouse’s share of partnership income is subject to self-employment tax. See, e.g., Norwood v. Comr., T.C. Memo. 2000-84.
While the IRS position creates a tax compliance hardship, in reality, a partnership return does not have to be filed for every husband-wife operation. For example, if the enterprise does not meet the basic requirements to be a partnership under the Code (such as not carrying on a business, financial operation or venture, as required by I.R.C. §7701(a)(2)), no partnership return is required. Also, a spousal joint venture can elect out of partnership treatment if it is formed for “investment purposes only” and not for the active conduct of business if the income of the couple can be determined without the need for a partnership calculation. I.R.C. §761(a).
A spousal business activity (in which both spouses are materially participating in accordance with I.R.C. §469(f)) can elect to be treated as a QJV which will not be treated for tax purposes as a partnership. In essence, the provision equates the treatment of spousal LLCs in common-law property states with that of community property states. In Rev. Proc. 2002-69, 2002-2 C.B. 831, IRS specified that husband-wife LLCs in community property states can disregard the entity.
Note: The IRS claims on its website that a qualified joint venture, includes only those businesses that are owned and operated by spouses as co-owners, and not those that are in the name of a state law entity (including a general or limited partnership or limited liability company). So, according to the IRS website, spousal LLCs, for example, would not be eligible for the election. However, this assertion is not made in Rev. Proc. 2002-69. There doesn’t appear to be any authority that bars a spousal LLC from making the QJV election.
With a QJV election in place, each spouse is to file as a sole proprietor to report that spouse’s proportionate share of the income and deduction items of the business activity. To elect QJV status, five criteria must be satisfied: (1) the activity must involve the conduct of a trade or business; (2) the only members of the joint venture are spouses; (3) both spouses elect the application of the QJV rule; (4) both spouses materially participate in the business; and (5) the spouses file a joint tax return for the year I.R.C. §761(f)(1).
Note: “Material participation” is defined in accordance with the passive activity loss rules of I.R.C. §469(h), except I.R.C. §469(h)(5). Thus, whether a spouse is materially participating in the business is to be determined independently of the other spouse.
The IRS instructions to Form 1065 (the form, of course, is not filed by reason of the election) provide guidance on the election. Those instructions specify that the election is made simply by not filing a Form 1065 and dividing all income, gain, loss, deduction and credit between the spouses in accordance with each spouse’s interest in the venture. Each spouse must file a separate Schedule C, C-EZ or F reporting that spouse’s share of income, deduction or loss. Each spouse also must file a separate Schedule SE to report their respective shares of self-employment income from the activity with each spouse then receiving credit for their share of the net self-employment income for Social Security benefit eligibility purposes. For spousal rental activities where income is reported on Schedule E, a QJV election may not be possible. That’s because the reporting of the income on Schedule E constitutes an election out of Subchapter K, and a taxpayer can only come back within Subchapter K (and, therefore, I.R.C. §761(f)) with IRS permission that is requested within the first 30 days of the tax year.
In general, electing QJV status won’t change a married couple’s total federal income tax liability or total self-employment tax liability, but it will eliminate the need to file Form 1065 and the related Schedules K-1. In that regard, the QJV election can provide a simplified filing method for spousal businesses. It can also remove a potential penalty for failure to file a partnership return from applying. That penalty is presently $200 per partner for each month (or fraction thereof) the partnership return is late, capped at 12 months.
Friday, January 19, 2018
Normally, the computation of a tax deduction for a gift to charity is simple – it’s the fair market value of the donated property limited by basis. That’s why, for example raised grain gifted to charity by a farmer doesn’t generate an income tax deduction. The farmer that gifts the grain doesn’t have a basis in the grain. But, special rules apply to a trust from which property is gifted to charity.
Today’s post looks at the issue of the tax deduction for property gifted to charity from a trust. Those special rules came up in a recent case involving a multi-million-dollar gift.
Rule Applicable to Trusts
I.R.C. §642(c)(1) says that a trust can claim a deduction in computing its taxable income for any amount of gross income, without limitation, that under the terms of the governing instrument is, during the tax year, paid for a charitable purpose. Note the requirement of “gross income.” A trust only gets a charitable deduction if the source of the contribution is gross income. That means that tracing the contribution is required to determine its source. See, e.g., Van Buren v. Comr., 89 T.C. 1101 (1987); Rev. Rul. 2003-123, 2003-150 I.R.B. 1200. Does the tracing have to be to the trust’s gross income earned in years before the year of the contribution? Or, does the trust just have to show that the charitable contribution was made out of gross income received by the trust in the year the contribution was made? According to the U.S. Supreme Court, the trustee does not have to prove that the charitable gift was made from the current year’s income, just that the gift was made out of trust income. Old Colony Trust Company v. Comr., 301 U.S. 379 (1937).
But, does trust income include unrealized gains on appreciated property donated to charity? That’s an interesting question that was answered by a recent federal appellate court.
A recent case involving a charitable donation by a trust raised the issue of the amount of the claimed deduction. Is it the fair market value of the property or is it the basis of the donated property if that amount is less than the fair market value? Under the facts of Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), the settlors created a dynasty trust in 1993 with terms authorizing the trustee to make charitable distributions out of the trust's gross income at the trustee's discretion. The trust wholly owned a single-member LLC and in 2004, the LLC donated properties that it had purchased to three charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the United States.
The IRS initially claimed that the trust could not take a charitable deduction, but then decided that a deduction could be claimed if it were limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund.
On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. § 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. §170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor.
The trial court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust.
On appeal, the U.S. Court of Appeals for the Tenth Circuit reversed. Green v. United States, No. 16-6371, 2018 U.S. App. LEXIS 885 (10th Cir. Jan. 12, 2018). The appellate court noted that the parties agreed that the trust had acquired the donated properties with gross income and that the charitable donation was made out of gross income. However, the IRS claimed that only the basis of the properties was traceable to an amount paid out of gross income. It was that amount of gross income, according to the IRS, that was utilized to acquire each property. The appellate court agreed. There was no realization of gross income on the appreciation of the properties because the underlying properties had not been sold. So, because the trust had not sold or exchanged the properties, the gains tied to the increases in market value were not subject to tax. The appellate court reasoned that if the deduction of I.R.C. §642(c)(1) extended to unrealized gains, that would not be consistent with how the tax Code treats gross income. The appellate court tossed the “ball” back to the Congress to make it clear that the deduction under I.R.C. §642(c)(1) extends to unrealized gains associated with real property originally purchased with gross income
The charitable donation rules associated with trusts are complicated. The income tax deduction is tied to the trust’s gross income. Now we have greater certainty that the deduction is limited to realized gains, not unrealized gains. Maybe the Congress will clarify that unrealized gains should count in the computation. But, then again, maybe not.
Wednesday, January 17, 2018
Much of the focus on the new tax law (TCJA) has been on its impact on the rate changes for individuals along with the increase in the standard deduction, and the lower tax rate for C corporations. Also receiving a great deal of attention has been the qualified business income (QBI) deduction of new I.R.C. §199A.
But, what about the impact of the changes set forth in the TCJA on estate planning? That’s the focus of today’s post.
Estate Planning Implications
Existing planning concepts reinforced. The TCJA reinforces what the last major tax act (the American Taxpayer Relief Act (ATRA) of 2012) put in motion – an emphasis on income tax basis planning, and the elimination of any concern about the federal estate tax for the vast majority of estates. Indeed, the Joint Committee on Taxation (JCT) estimates that in 2018 the federal estate tax will impact only 1,800 estates. Given an approximate 2.6 million deaths in the U.S. every year, the federal estate tax will now impact about one in every 1,400 estates. Because of this minimal impact, estate planning will rarely involve estate tax planning, but it will involve income tax basis planning. In other words, the basic idea is to ensure that property is included in a decedent’s estate at death for tax purposes so that a “stepped-up” basis at death is achieved (via I.R.C. §1014).
Increase in the exemption. Why did the JCT estimate that so few estates will be impacted by the federal estate tax in 2018? It’s because the TCJA substantially increases the value of assets that can be included in a decedent’s estate without any federal estate tax applying – doubling the exempt amount from what it would have been in 2018 without the change in the law ($5.6 million) to $11.2 million per decedent. That amount can be transferred tax-free during life via gift or at death through an estate. In addition, for gifts, the present interest annual exclusion is set at $15,000 per donee. That means that a person can make cumulative gifts of up to $15,000 per donee in 2018 without any gift tax consequences (and no gift tax return filing requirement) and without using up any of the $11.2 million applicable exclusion that offsets taxable gifts – it will be fully retained to offset taxable estate value at death. In addition, the $15,000 amount can be doubled by spouses via a special election. But, if the $15,000 (or $30,000) amount is exceeded, Form 709 must be filed by April 15 of the year following the year of the gift.
Marital deduction and portability. For large estates that exceed the applicable exclusion amount of $11.2 million, the tax rate is 40 percent. The TCJA didn’t change the estate tax rate. Another aspect of estate tax/planning that didn’t change involves the marital deduction. For spouses that are U.S. citizens, the TCJA retains the unlimited deduction from federal estate and gift tax that delays the imposition of estate tax on assets one spouse inherits from a prior deceased spouse until the death of the surviving spouse. Thus, assets can be gifted to a spouse with no tax complications at the death of the first spouse, and the first spouse can simply leave everything to a surviving spouse without any tax effect until the surviving spouse dies. This, of course, may not be a very good overall estate plan depending on the value of the assets transferred to the surviving spouse.
The “portability” concept of prior law was retained. That means that a surviving spouse can carry over any unused exemption of the surviving spouse’s “last deceased spouse” (a phrase that has meaning if the surviving spouse remarries). Portability allows married couples to transfer up to $22.4 million without any federal transfer tax consequences, and without any need to have complicated estate planning documents drafted to achieve the no-tax result. But, portability is not “automatic.” The estate executor must “elect” portability by filing a federal estate tax return (Form 706) within nine months of death (unless a six-month extension is granted). That requirement applies even if the estate is beneath the applicable exclusion amount such that no tax is due.
Remember the “Alamo” – state transfer taxes. A minority of states (presently 17 of them) tax transfers at death, either via an estate tax or an inheritance tax. The number of states that do is dwindling - two more states repealed their estate tax as of the beginning of 2018. A key point to remember is that in the states where an estate tax is retained, the exemption is often much less than the federal exemption. Only three states that retain an estate tax tie the state exemption to the federal amount. This all means that for persons in these states, taxes at death are a real possibility. This point must be remembered by persons in these states – CT, HI, IL, IA, KY, ME, MD, MA, MN, NE, NJ, NY, OR, PA, RI, VT, WA and the District of Columbia.
Generation-skipping transfer tax. The TCJA does retain the generation-skipping transfer (GSTT) tax. Thus, for assets transferred to certain individuals more than a generation younger than the decedent (that’s an oversimplification of the rule), the “generation-skipping” transfer tax (GSTT) applies. The GSTT is an addition to the federal estate or gift tax, but it does come with an exemption of $11.2 million (for 2018) for GSTT transfers made either during life (via gift) or at death. Above that exemption, a 40 percent tax rate applies. Portability does not apply to the GSTT.
Income tax basis. As noted above, the TCJA retains the rule that for income tax purposes, the cost basis of inherited assets gets adjusted to the fair market value on the date of the owner’s death. This is commonly referred to as “stepped-up” basis, but that may not always be the case. Sometimes, basis can go down. When “stepped-up” basis applies, the rule works to significantly limit (or eliminate) capital gains tax upon subsequent sale of the asset by the heir(s). This can be a very important rule for ag estates where the heirs desire to sell the inherited assets. Ag estates are commonly comprised of low-basis assets. So, while the federal estate tax won’t impact very many ag estates, the basis issue is important to just about all of them. That’s why, as mentioned above, the basic estate plan for most estates is to cause inclusion of the property in the estate at death. Achieving that basis increase is essential.
Estate planning still remains important. While the federal estate tax is not a concern for most people, there are still other aspects of estate planning that must be addressed. This includes having a basic will prepared and a financial power of attorney as well as a health care power of attorney. In certain situations, it may also include a pre-marital/post-marital agreement. If a family business is involved, then succession planning must be incorporated into the overall estate plan. That could mean, in many situations, a well-drafted buy-sell agreement. In addition, a major concern for some people involves planning for long-term health care.
Also, it’s a good idea to always revisit your estate plan whenever there is a change in the law to make sure that the drafting language used in key documents (e.g., a will or a trust) doesn’t result in any unintended consequences.
Oh…remember that the changes in the federal estate tax contained in the TCJA mentioned above are only temporary. If nothing changes as we go forward, the law reverts to what the law was in 2017 starting in 2026. That means the exemption goes back down to the 2017 level, adjusted for inflation. That also means estate planning is still on the table. The federal estate tax hasn’t been killed, just temporarily buried a bit deeper.
Monday, January 1, 2018
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 126.96.36.199.3.1 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).
- 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).
- 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.
Wednesday, November 8, 2017
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.
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.
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.
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.
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.
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.
Monday, October 23, 2017
The death of a family member or other loved-one is often difficult circumstance for the family and other close ones that are left behind. From a financial and tax standpoint, however, proper and thorough estate planning is the key to minimizing and potentially eliminating more distress associated with the decedent’s passing.
One aspect of estate planning that does not involve technical tax planning or entity structuring or other crucial legal aspects involves cataloguing where the decedent’s important documents are located and who has access to them. In the past, that has often involved counseling clients to make sure that they have a filing system for key items such as insurance policies, contact information for utility companies, and contracts and warranty information for equipment and appliances, etc. In addition, a safety deposit box and/or safe has commonly been suggested for the storage of critical documents such as a will, power of attorney, or trust as well as real estate deeds and similar items.
But, in recent years a new issue has arisen in the estate planning realm. This issue involves the decedent’s digital assets such as electronic mail (email) accounts, bank accounts, credit cards, mortgages, and any other type of digital record as well as electronically stored information and social media accounts. Even business assets have become digitized. Depending on the decedent’s type of business, the extent of digitization of business records and information can be quite large.
So, what is the big estate planning issue with digital assets? It involves who has access to those assets upon death and whether appropriate language is included in estate planning documents to provide that access. A recent court decision in Massachusetts brings the issue front and center.
That’s the topic of today post – digital assets and estate planning.
Interestingly, federal law governing privacy rights to electronic communications goes back over 30 years. The Stored Communications Act (SCA) was included as part of the Electronic Communications Privacy Act of 1986. 18 U.S.C. §§2701-2712. That SCA created privacy rights to particular electronic communications and associated files from disclosure by online service providers. However, with the development of the internet and email communication that started in the mid-1990s, the SCA created a significant problem for fiduciaries and family members that needed access to the decedent’s online records and accounts. The SCA bars an online service provider from disclosing the decedent’s files and/or accounts to the estate fiduciaries or others unless the requirements for an exception contained in 18 U.S.C. §2702(b) are satisfied. But, even if an exception is satisfied, the service provider is not required to provide access to or otherwise disclose the contents of the decedent’s digital files or online accounts. Voluntary disclosure is the rule upon “lawful consent” of the “originator” or “subscriber.” 18 U.S.C. §2702(b)(3). In addition, the statute does not clearly state whether an estate fiduciary (e.g., executor or personal representative) can give the required “lawful consent.”
Facts. In a recent decision, the highest court in Massachusetts held that “…the personal representatives may provide lawful consent on the decedent’s behalf to the release of the contents of the Yahoo email account.” Ajemian v. Yahoo!, Inc., 478 Mass. 169 (2017). The facts of the case indicate that the decedent died intestate in 2006 as the result of a bicycle accident. The decedent had, at the time of death, an email account. However, he didn’t leave any instructions regarding how to handle the account after his death. Two of his siblings were appointed the personal representatives of his estate, and sought access to the contents of the email account. But, the service provider refused to provide access on the basis that it was barred from doing so by the SCA. The service provider also claimed that the terms of service that governed the email account gave the service provider the discretion to reject the personal representatives’ request.
Court determinations. The personal representatives sued, and the probate court granted the service provider’s motion to dismiss the case. On appeal, the appellate court vacated that judgment and remanded the case for a determination of whether the SCA barred the service provider from releasing the contents of the decedent’s email account to the personal representatives. On remand, the service provider claimed that the SCA prevented disclosure and, even if it did not, the terms-of-service agreement gave the service provider the right to deny access to (and even delete the contents of) the account. The appellate court granted summary judgment for the service provider on the basis that the SCA prohibited disclosure (but not on the basis of the terms of service contract).
On further review at the Massachusetts Supreme Judicial Court, the personal representatives claimed that they were the decedent’s agents for purposes of the exception of 18 U.S.C. §2702(b)(1) which gave the service provider the ability to disclose the contents of the decedent’s email account to them. However, the Supreme Judicial Court did not buy that argument, determining instead that a person appointed by a court does not fall within the common law meaning of “agent” citing Restatement (Third) of Agency §1.01 comment f. As to whether the personal representatives “stepped into the shoes” of the decedent as the originator of the account and, thus, could lawfully consent to the release of the contents of the email account under 18 U.S.C. §2702(b)(3), the Supreme Judicial Court held that they could, reasoning that there was nothing in the statutory definition or legislative history that indicated an intent to preempt state probate and/or common law allowing personal representatives to provide consent on a decedent’s behalf. The Supreme Judicial Court vacated the appellate court’s judgment and remanded the case to the probate court.
Revised Uniform Fiduciary Access To Digital Assets Act
While the Ajemian decision holds that a personal representative can meet the “lawful consent” exception of the SCA, a service provider is still not required to provide the desired access to digital records. However, under the Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA), a state law procedure is provided that fiduciaries can use to get access to online accounts (or other digital assets) of a decedent. The RUFADAA defines a “fiduciary” as a person appointed to manage the property of another person in that other’s person’s best interest. In essence, the RUFADAA empowers a fiduciary to manage another person’s “digital assets.” However, under the RUFADAA, the fiduciary must still get consent from the “owner” to be able to manage certain digital assets such as electronic communications and social media accounts unless the original user consented in a will, trust, power of attorney, or other record. Once that consent is obtained for digital assets that require it, if the service provider doesn’t comply with a disclosure request, §16(a) of the RUFADAA allows the personal representative to file a legal action seeking a court order requiring the service provider to comply with the personal representative’s request.
The majority of states have enacted the RUFADAA (or a substantially similar version thereof). Those that haven’t are: CA, DE, GA, KY, LA, MA, ME, MO, NH, OK, PA, RI, WV and the District of Columbia. Some of these states may enact the law in the near future. 2017 saw action in numerous state legislatures. As noted, MA has not enacted the RUFADAA, so a question is raised as to whether the court’s analysis in Ajemian would have differed, as well as how the RUFADAA would have impacted the SCA.
Digital Asset Planning Suggestions
What needs to be considered with respect to digital assets and an estate plan? The access question looms large. Who is to have access to digital assets and information post-death? From a will drafting standpoint, if a specific gift of digital assets is not made, the digital assets will be disposed of under the will’s residuary clause (“all the rest, residue and remainder of my estate”). Also, what type of access is the estate fiduciary to have? The type of access (such as the ability to read the substance of electronic communications) should be clearly specified in the owner’s will or trust. If access to digital assets and information is to be granted to a third party before death, the type and extent of access should be set forth in a power of attorney. On this point, the type of power of attorney matters.
Even with the authority to act as provided in a will, trust or power of attorney, it is likely that a service provider (or similar “custodian”) will require that the fiduciary obtain a court order before the release of any digital information or the granting of access.
While many people do not have estate planning documents in place at death, a very high percentage of decedents have at least some digital assets and/or accounts at the time of death. Some may have significant value. Others may have significant sentimental worth (such as photos). Thus, the ability to deal with and manage those assets post-death is very important. Technology has created additional legal and planning issues that should be accounted for.
The RUFADAA contains many associated comments that answer a lot of questions. To learn more, click on http://www.uniformlaws.org. Under the “Acts” tab, click on “Fiduciary Access To Digital Assets Act.”
Tuesday, October 3, 2017
Estate tax portability allows a surviving spouse to carry over any unused portion of the deceased spouse’s estate tax exclusion (DSUE) to be used to offset estate tax in the surviving spouse’s estate, if necessary. It gets added to the surviving spouse’s own exemption. The DSUE has become a key aspect of post-2012 estate planning, and makes it quite simple for married couple to utilize the full estate tax exclusion over both of their estates. The full estate and gift tax coupled exclusion is $5.49 million per individual for deaths in 2017 and gifts made in 2017.
One of the concerns about portability is the ability of the IRS to audit the estate of the deceased spouse where portability was elected. Does the IRS have an open-ended statute of limitations to go back and examine that estate to determine if the “ported” amount of the unused exclusion was computed properly? A recent Tax Court decision confirms that the IRS does.
The election. To “port” the unused exclusion at the death of the first spouse to the surviving spouse, an election must be made. As noted, the amount available to be “ported” to the estate of the surviving spouse is the deceased spouse’s unused exclusion (DSUE). IRC §2010(c)(4); Treas. Reg. §20.2010-2. The portability election must be made on a timely filed Form 706 for the first spouse to die. I.R.C. §2010(c)(5)(A); Treas. Reg. §20.2010-2(a)(1). This also applies for nontaxable estates, and the return is due by the same deadline (including extensions) as taxable estates. The deadline for filing is nine months after the decedent’s date of death (with a six-month extension possible). The election is revocable until the deadline for filing the return expires.
While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that "a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the Form 706. No further action is required to elect portability…". This election, therefore, is made by default if there is a DSUE amount and an estate tax return is filed (as long as the box in section A of part 6 is not checked, which affirmatively elects out of portability).
Late election relief. In Rev. Proc. 2014-18, 2014-7 IRB 513, the IRS provided a simplified method for certain estates to obtain an extended time to make the portability election. That relief has now expired and has been extended by Rev. Proc. 2017-34, 2017-26 IRB 1282. The portability election must be submitted with a complete and properly filed Form 706 by the later of January 2, 2018, or the second anniversary of the decedent's death. After January 2, 2018, the extension is, effectively, for two years. The extension is only available to estates that are not otherwise required to file an estate tax return. Other estates can only obtain an extension under Treas. Reg. §301.9100-3. Form 706 must state at the top that the return is "FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A)."
An estate that files late, but within the extended deadlines of Rev. Proc. 2017-34, cannot rely on the revenue procedure if it later learns that it should have filed a Form 706. If a valid late election is made and results in a refund of estate or gift taxes for the surviving spouse, the time period for filing for a refund is not extended from the normal statutory periods. In addition, a claim for a tax refund or credit is treated as a protective claim for a tax credit or refund if it is filed within the time period of §6511(a) by the surviving spouse or the surviving spouse's estate in anticipation of Form 706 being filed to elect portability under Rev. Proc. 2017-34.
Election requirements. Treas. Reg. §20.2010-2 requires that the DSUE election be made by filing a complete and properly prepared Form 706. Treas. Reg. §20.2010-2(a)(7)(ii)(A) permits the “appointed” executor who is not otherwise required to file an estate tax return to use the executor's "best estimate" of the value of certain property and then report on Form 706 the gross amount in aggregate, rounded up to the nearest $250,000.
Treas. Reg. §20.2010-2(a)(7)(ii) sets forth simplified reporting for particular assets on Form 706, which allows for good faith estimates. The simplified reporting rules apply to estates that do not otherwise have a filing requirement under IRC §6018(a). This means that if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017), simplified reporting is not applicable.
Simplified reporting is only available for marital and charitable deduction property (under IRC §§2056, 2056A, and 2055) but not to such property if certain conditions apply. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without any value entered in the column for "Value at date of death." The sum of the asset values included in the return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10 and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2(a)(7)(ii)).
In addition to listing the assets on the appropriate schedules, the regulations require that certain additional information must be provided for each asset. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Availability. The inherited DSUE amount is available to the surviving spouse as of the date of the deceased spouse's death. It is applied to gifts and the estate of the surviving spouse before their own exemption is used. Accordingly, the surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the surviving spouse's estate at death. Treas. Reg. §20.2010-3(b)(ii).
The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed (and before the amount of the DSUE is established). Treas. Reg. §20.2010-3(ii). However, the DSUE amount is subject to audit until the statute of limitations expires on the surviving spouse’s estate tax return. Temp. Treas. Regs. §§20.2010-3T(c)(1) and 25.2505-2T(d)(1). However, the regulations do not address whether a presumption of survivorship can be established. Thus, there is no guidance on what happens if both spouses die at the same time and the order of death cannot be determined and it is not known whether the IRS would respect estate planning documents that include a provision for simultaneous deaths.
Statute of Limitations – IRS Audits
The statute of limitations for assessing additional tax on the estate tax return is the later of three years from the date of filing or two years from the date the tax was paid. However, the IRS can examine the DSUE amount at any time during the period of the limitations for the second spouse as it applies to the estate of the first spouse. Treas. Reg. §20.2010-2(d) allows the IRS to examine the estate and gift tax returns of each of the decedent's predeceased spouses. Any materials relevant to the calculation of the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Thus, a surviving spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all intervening estate and gift tax returns to substantiate the DSUE amount.
New Case On The Audit Issue
Facts. In Estate of Sower v. Comr., 149 T.C. No. 11 (2017), the decedent died in August of 2013 as the surviving spouse. Her predeceased spouse died in early 2012. His estate reported no federal estate tax liability on its timely filed Form 706. His estate also reported no taxable gifts although he had made $997,920 in taxable gifts during his life. However, his estate did include $845,420 in taxable gifts on the worksheet provided to calculate taxable gifts to be reported on the return. His estate reported a deceased spouse unused exclusion (DSUE) amount of $1,256,033 and a portability election of the DSUE was made on his estate’s Form 706 to port the DSUE to the surviving spouse.
The decedent’s estate filed a timely Form 706 claiming the ported DSUE of $1,256,033 and paid an estate tax liability of $369,036, and then an additional $386,424 of tax and interest to correct a math error on the original return. The decedent’s estate also did not include lifetime taxable gifts (of which there were $997,921) on the return, simply leaving the entry for them blank. About two months later, the IRS issued an estate tax closing letter to the husband’s estate showing no estate tax liability and noting that that the return had been accepted as filed.
IRS audit. In early 2015, the IRS began its examination of the decedent’s return. In connection with that exam, the IRS opened an exam of the husband’s estate to determine the proper DSUE to be ported to the decedent’s estate. As a result of this exam, the IRS made an adjustment for the amount of the pre-deceased spouse’s lifetime taxable gifts and issued a second closing letter and also reducing the DSUE available to port to the decedent’s estate of $282,690. The IRS also adjusted the decedent’s taxable estate by the amount of her lifetime taxable gifts and reduced it for funeral costs. The end result was an increase in federal estate tax liability for the decedent’s estate of $788,165, and the IRS sent the decedent’s estate a notice of deficiency for that amount and the estate disputed the full amount by filing a petition in Tax Court.
Estate’s arguments. The estate claimed that the IRS was estopped from reopening the estate of the predeceased spouse after the closing letter had been initially issued to that estate. The estate also claimed that the IRS was precluded from adjusting the DSUE for gifts made before 2010. The estate additionally claimed that I.R.C. §2010(c)(5)(B) (allowing IRS to examine an estate tax return to determine the correct DSUE notwithstanding the normal applicable statute of limitations) was unconstitutional for lacking due process because it overrode the statute of limitations on assessment contained in I.R.C. §6501.
Tax Court opinion. The Tax Court disagreed with the estate on all points. The court noted that I.R.C. §2010(c)(5)(B) gave the IRS the power to examine the estate tax return of the predeceased spouse to determine the correct DSUE amount. That power, the court noted, applied regardless of whether the period of limitations on assessment had expired for the predeceased spouse’s estate. This, the Tax Court noted, was bolstered by temporary regulations in place at the time of the predeceased spouse’s (and the decedent’s) death. I.R.C. §7602, the Tax Court noted, also gave the IRS broad discretion to examine a range of materials to determine whether a return was correct, including estate tax returns.
The Tax Court also determined that the closing letter did not amount to a closing document under I.R.C. §7121, which required a Form 866 and Form 906, and there had been no negotiation between the IRS and the estate. The Tax Court also held that the decedent’s estate had not satisfied the elements necessary to establish equitable estoppel against the IRS. The IRS had not made a false statement or had been misleadingly silent that lead to an adverse impact on the estate.
Also, the Tax Court noted that there had not been any second examination. No additional information had been requested from the pre-deceased spouse’s estate and no additional tax was asserted. The effective date of the proposed regulation was for estates of decedent’s dying after 2010 and covered gifts made by such estates irrespective of when those gifts were made.
There was also no due process violation because adjusting the DSUE did not amount to an assessment of tax against the estate of the pre-deceased spouse. Consequently, the Tax Court held that the IRS properly adjusted the DSUE and the decedent’s estate had to include the lifetime taxable gifts in the estate for estate tax liability computation purposes.
Because the election to utilize portability allows the IRS an extended timeframe to question valuations, the use of a bypass/credit shelter trust that accomplishes the same result for many clients may be a preferred approach. However, in those situations, it should be a routine practice for practitioners to obtain a signed acknowledgement and waiver from the executor of the first spouse’s estate that the potential benefit of portability in the surviving spouse’s death has been explained fully and has been waived.
As the Tax Court points out, the IRS has the power to audit the first spouse’s estate tax return and can add any increased tax to the surviving spouse’s estate tax return – no matter how many years have passed since the first spouse’s death. That means it should also be routine practice for practitioners to make sure that Form 706 for the first spouse’s estate is prepared with absolute perfection.
Tuesday, August 22, 2017
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.
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.
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)
Friday, August 18, 2017
Upon a decedent’s death, any liabilities for deficiencies on the decedent’s tax returns do not disappear. Someone must pay those taxes. In addition, creditors’ claims against the estate must be paid. If one of the creditors is the IRS, there is a federal tax lien that will come in to play. In that situation, the question becomes the priority of the lien. Does the IRS beat out other creditors? What if the estate administrator is entitled to get paid under state law?
Tax liability for deficiencies associated with a decedent’s estate and the IRS as an estate creditor – what are the related issues? That’s the topic of today’s post.
The decedent’s estate, in essence, is liable for the decedent’s tax deficiency at the time of death. Individuals receiving assets from a decedent take the assets subject to the claims of the decedent’s creditors — including the government. Asset transferees (the recipients of those assets) are liable for taxes due from the decedent to the extent of the assets that they receive. In addition, a trust can be liable as a transferee of a transfer under I.R.C. §6901 to the extent provided in state law. See, e.g., Frank Sawyer Trust of May 1992 v. Comr.,, T.C. Memo. 2014-59.
The courts have addressed transferee/executor liability issues in several recent cases. For instance, in United States v. Mangiardi, No. 9:13-cv-80256, 2013 U.S. Dist. LEXIS 102012 (S.D. Fla. Jul. 22, 2013), the court held that the IRS could collect estate tax more than 12 years after taxes were assessed. The decedent died in 2000. At the time of death, his revocable trust was worth approximately $4.58 million and an IRA worth $3.86 million. The estate tax was approximately $2.48 million. Four years of extensions were granted due to a market value decline of publicly traded securities. The estate paid estate taxes of $250,000, and the trust had insufficient assets to pay the balance. The IRS sought payment of tax from the transferee of an IRA under I.R.C. §6324. The court held that the IRS was not bound by the 4-year assessment period of I.R.C.§§6501 and 6901(c) and could proceed under I.R.C. §6324 (10-year provision). The court determined that the 10-year provision was extended by the 4-year extension period previously granted to the estate, and IRA transferee liability was derivative of the estate's liability. The court held that it was immaterial that the transferee may not have known of the unpaid estate tax. The amounts withdrawn from the IRA to pay the estate tax liability were also subject to income tax in the transferee's hands.
In another recent case, United States v. Tyler, No. 12-2034, 2013 U.S. App. LEXIS 11722 (3d Cir. Jun. 11, 2013), a married couple owned real estate as tenants by the entirety (a special form of marital ownership recognized in some states). The husband owed the IRS $436,849 in income taxes. He transferred his interest in the real estate to his wife for $1, and the IRS then placed a lien on the real estate. He died with no distributable assets and there were no other assets with which to pay the tax lien. His surviving wife died within a year of her his death and the property passed to their son, the defendant in the case. The son was named as a co-executor of his mother’s estate. The IRS claimed that the tax lien applied to the real estate before legal title passed to the surviving spouse. Thus, the IRS asserted, the executors had to satisfy the lien out of the assets of her estate. The executors conveyed the real estate to the co-executor son for $1 after receiving letters from the IRS asserting the lien. The son then later sold the real estate and invested the proceeds in the stock market, subsequently losing his investment. The IRS brought a collection action for 50 percent of the sale proceeds of the real estate from the executors. The trial court ruled for the IRS and the appellate court affirmed. Under the federal claims statute, the executor has personal liability for the decedent’s debts and obligations. The rule is that the fiduciary who disposes of the assets of an estate before paying a governmental claim is liable to the extent of payments for unpaid governmental claims if the fiduciary distributes the estate assets, the distribution renders the estate insolvent, and the distribution takes place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes.
United States. v. Whisenhunt, No. 3:12-CV-0614-B, 2014 U.S. Dist. LEXIS 38969 (N.D. Tex. Mar. 25, 2014), is another case that points out that an executor has personal liability for unpaid federal estate tax when the estate assets are distributed before the estate tax is paid in full. The court determined that the executor was personally liable for $526,507 in delinquent federal estate tax and penalties, which was the amount of the distribution at the time of the decedent's death.
Federal Estate Tax Lien
Another recent case illustrates additional peril for estate executors. In In re Estate of Simmons, No. 1:15-cv-01097-TWP-MPB, 2017 U.S. Dist. LEXIS 120487 (S.D. Ind. Jul. 31, 2017), the decedent died in 2014. He and his wife had one son in 1991 and then divorced in 1998. The decedent remarried, and the second wife was the surviving spouse at the time of the decedent’s death. The primary asset of the estate was the decedent’s home. The claims against the estate amounted to $1.8 million, including those of the decedent’s first wife, two of the decedent’s former employees for unpaid wages and benefits of approximately $800,000, and two noteholders for which the decedent had defaulted on the notes. Those amounted to about $250,000 in total. The state of Indiana also filed a tax lien, and the IRS lien was just shy of $600,000. However, the state court determined that the estate was insolvent. The estate only contained assets of $266,873. A state court order required that the estate assets be sold and be distributed in accordance with the priority stated in Indiana law. The state court order indicated that the IRS lien was in a seventh priority position.
On the motion of the IRS, the case was removed to federal district court. The federal district court determined that the IRS had a first priority lien and ordered that the net proceeds of from the sale of the residence ($245,766) go to the IRS. Neither the surviving spouse nor the executor were pleased with this conclusion. The surviving spouse expended substantial funds to get the home ready to be sold, and the executor (and the attorney for the estate) was entitled to be paid in accordance with state law. That’s the normal course of events – administrative expenses and fees generally have priority over other creditors, including the IRS.
However, there is another principal that can come into play. The Supremacy Clause of the Constitution (Article VI, Clause 2) says that state law is subject to federal preemption if there is a federal law on point that would override state law. That’s where the federal priority statute for governmental claims comes into play. 31 U.S.C. §3713. Under this provision, a federal governmental claim has first priority when a decedent’s estate has insufficient funds/assets to pay all of the decedent’s debts. However, courts have generally held that administrative expenses (e.g., fees of the executor and attorney for the estate) are not actually the decedent’s “expenses” with the result that they take priority over governmental claims. But, the In re Estate of Simmons court said that when the IRS files a federal tax lien I.R.C. §6321 comes into play. Under that statute, the federal government has a blanket priority lien on the assets of the estate. The limited exceptions of I.R.C. §6323 don’t apply to claims involving administrative expenses.
The federal court’s determination would seem to have a chilling effect on person’s assuming administrative tasks, including legal counsel for estate’s that have insufficient funds to pay all outstanding taxes, and it’s not the first time a court has reached the same conclusion. See, e.g., Estate of Friedman v. Cadle Co., 3:08CV488(RNC), 2009 U.S. Dist. LEXIS 130505 (D. Conn. Sept. 8, 2009). But, the In re Estate of Simmons court did note that the Internal Revenue Manual, at Section 188.8.131.52(3) says that the IRS has discretion to not assert its priority position so that reasonable administrative expenses can be paid to the persons entitled to them. In In re Estate of Simmons, the IRS stated that it intended to pay the executor’s unreimbursed expenses. That was enough for the court to go ahead and give the IRS priority on its lien.
The discretion of the IRS to allow the payment of reasonable administrative expenses is not terribly reassuring. It’s also troubling that it’s solely up to the IRS to determine what is “reasonable.” From a practitioner’s standpoint, when considering the representation of an estate with sizable outstanding unpaid federal taxes, it’s probably a good idea to first conduct a search for federal tax liens. Also, there probably is also a duty to advise the executor of the potential impact of a federal tax lien.
Executors (and their counsel) already have a mess on their hands in large estates where Form 706 must be filed and the new basis consistency reporting rules are triggered. Those rules already provide a disincentive to serve as an executor. The federal tax lien statute may create another reason not to handle certain estates.
Tuesday, July 25, 2017
For many people, the federal estate tax is not a concern. But, for a farming operation, other small business operation, and high-wealth individuals, it is. If a goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT). The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time period.
Today’s post looks at the use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner
What Is An IDGT?
An IDGT is a specially designed irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §671. That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. Thus, a sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
This is what makes the trust “defective.” The seller (grantor) and the trust are treated as the same taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected for federal estate and gift tax purposes. The result is that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments are paid to the grantor in-kind, and the trust is an eligible S corporation shareholder. See, e.g., Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A).
How Does An IDGT Transaction Work?
The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor. The IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.
The trust language should be carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate. It’s a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death. This is why an IDGT is generally viewed as an “estate freeze” technique.
What about the note? Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term. The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Given the current low interest rates, it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).
The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995). I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an “applicable retained interest” is not a creditor interest in bona fide debt. The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply. If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments. For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).
Pros and Cons of IDGTs
An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the low interest rate on the installment note payable. Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes.
On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death. Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.
Proper Structuring of the Sale to the IDGT
A key point is that the installment note must constitute bona fide debt. That is the crucial aspect of the IDGT transaction from an income tax and estate planning or business succession standpoint. If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate. In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701 and 2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt. The case was settled before trial on terms favorable to the taxpayer with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied. However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013). The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016 that resulted in no additional gift or estate tax. The total amount of the gift tax, estate tax, and penalties at issue was $152 million.
Another concern is that I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it. But, again, in the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.
So, as you can imagine, all of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note represents bona fide debt.
Administrative Issues with IDGT’s
An IDGT is treated as a separate legal entity. That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost. That’s especially true for highly appreciating assets and family business assets. But, again, it is critical to get good legal and tax counsel before trying the IDGT strategy.
Monday, July 17, 2017
One step in the estate planning process involves an examination of possible alternatives for disposing of property during life including a sale for cash, an installment sale, a private annuity or a part-gift, part-sale transaction. As for an installment sale, it can be used in an estate plan to “freeze” the value of an estate (typically that of a parent), and simultaneously shift future appreciation in asset value caused by inflation or improvements to the next generation successor-operator. Structured as an installment sale with an appropriate rate of interest, the transaction does not constitute a gift, and can provide a stream of income for the parents (as the sellers). In addition, if the value of the assets subject to the installment sale drop in value, the transaction can be renegotiated and the purchase price decreased while still maintaining installment sale tax treatment.
Transitioning the farm via an installment sale – that’s the topic of today’s post.
One way to facilitate the transfer of farm assets from one generation to the next is via the installment sale. Given that the current level of the present interest annual exclusion for gift tax purposes is $14,000, an installment sale transaction could be established whereby farm assets could be conveyed to a child, for example, for a $14,000 principal amount interest-bearing note, payable semi-annually. This provides an income stream to the parents and does not trigger any gift tax. That’s because installment sales are not within the scope of I.R.C. §2701. But, if the parents desire to make a gift to the child, they could forgive the payments as they become due. In that situation, it might be possible to discount the gift below the face value of the installment obligation. Also, if a gift is made within three years of death, any gift tax that the decedent (or the estate) pays on the gift is pulled back into the estate. I.R.C. §2035. In addition, in an estate, an installment obligation is income in respect of decedent (IRD). It is not an item of property. That means that there is no basis step-up in accordance with I.R.C. §1014 in the hands of the recipient of the obligation.
Of course, the IRS has its own view of the tax treatment of installment sales. It may assert that the entire value of the property involved in an installment sale is a gift. Indeed, in Rev. Rul. 77-299, 1977-2 C.B. 343, the IRS said that an installment sale of land to grandchildren where the annual payments were forgiven constituted a gift of the full amount of the land in the year the transaction was entered into. The IRS said that was the result because the grandparent had made been gifting property to his grandchildren in prior years and because they didn’t have any other source of income. The courts, however, don’t tend to agree with the IRS position. That’s especially true if the notes involved are legally enforceable, subject to sale to third parties or assignable, and the property involved is subject to foreclosure if the buyer defaults. See, e.g., Estate of Kelley v. Comr., 63 T.C. 321 (1974); Haygood v. Comr., 42 T.C. 936 (1964); Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975).
The IRS may also assert that a gift may occur on an installment sale of land if the interest rate is below a market rate of interest. The IRS, U.S. Tax Court, the Eighth and Tenth Circuit Courts of Appeals and the United States District Court for the Northern District of New York agree that the use of an interest rate in an installment sale other than the market rate of interest results in a gift of the present value of the difference in interest rates. See, e.g., Ltr. Rul. 8804002, Sept. 3, 1987; Frazee v. Comm’r, 98 T.C. 554 (1992); Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996); Lundquist v. United States, 99-1 U.S. Tax Cas. (CCH) ¶60,336 (N.D. N.Y. 1999). The 7th Circuit Court of Appeals disagrees, however. Ballard v. Comm’r, 854 F.2d 185 (7th Cir. 1988). The U.S. Supreme Court has twice declined to resolve the conflicting views of the Circuit Courts of Appeal. Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996).
The take home is that if the transaction is an arm’s length transaction where the parents are not legally obligated to forgive payments or make cash gifts to enable the buyer (child(ren)) to make the payments, then the installment sale should be respected and not gift in the year the transaction is entered into would result. This is particularly the case is the parents actually do receive payments in the early years of the installment sale and a market rate of interest is utilized.
Variation – The Sale-Leaseback
For parents that aren’t ready to retire from farming/ranching, a sale-leaseback transaction might be a consideration. Under this structure, the parents sell the property to the children and then lease it back. While this type of transaction would result in gain recognition to the parents, that gain could be at least partially offset by a deduction for rent. In addition, the rental payment that the parents make to the children will help the children make the payments. A bona fide sale-leaseback transaction will result in the children being able to deduct interest on the installment obligation to the extent the children use the rental payments they receive from the parents to repay the mortgage on the property purchased under the installment sale. There won’t be any interest deduction allowed for annual payments attributable to cash gifts. The sale-leaseback transaction works if ownership is completely transferred to the children and they have a non-contingent obligation to pay. See, e.g., Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975); Stiebling v. Comr., No. 95-70391, 1997 U.S. App. LEXIS 11447 (9th Cir. 1997).
Are There Any Related Party Concerns?
Of course, concerns about sales to related parties arise. That’s because when depreciable property is sold to a “related party” ordinary income is the result. I.R.C. §1239. In addition, the seller can’t use the installment method to report the income unless a principal purpose of the sale was something other than the avoidance of federal income tax. I.R.C. §453(g)(2); see, e.g., Priv. Ltr. Rul. 9926045 (Apr. 2, 1999). A “related party” is for this purpose is defined under I.R.C. §1239(b).
When a related party resells the property within two years of the original sale, gain is accelerated to the original seller. There are some exceptions to the two-year rule. See, e.g., I.R.C. §453(e)(6)). A primary one is that a disposition after the death of the seller or buyer to the original transaction is not treated as a second disposition. That’s probably also the case when there is a death of a joint tenant with respect to jointly owned property. But, any installment sale contract should contain language that bars any disposition by the buyer within two years of the original sale unless the original seller consents. The same can be said with respect to pledging the property. In that instance, the original buyer should continue to bear any risk of loss associated with the property.
There are various ways to transition the family farm/ranch. An outright gift or an outright sale are two options. Another one is the installment sale. An installment sale can provide a means to transfer the assets to the next generation in a tax efficient manner. But, as with any transaction, the details must be paid close attention to in order to achieve the desired tax (and legal) result. The drafting of the installment sale contract must be crafted with care. Of course, as with any complex legal transaction, competent legal (and tax) advice and counsel should be sought and obtained.
Monday, July 3, 2017
A taxpayer that manufactures, produces, grows or extracts property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business by or to an Interest Charge Domestic International Sale Corporation (IC-DISC) for direct use, consumption or disposition outside the U.S., and not more than 50 percent of the fair market value of the property is attributable to articles imported into the U.S. can get some favorable tax breaks.
The IC-DISC concept may not be that well known, but it can be utilized by agricultural businesses. It’s also a topic that Paul Neiffer and I will cover at our two-day summer ag tax/estate and business planning conference in Sheridan, Wyoming (and online) next week. http://washburnlaw.edu/employers/cle/farmandranchincometax.html
An IC-DISC has as its statutory basis I.R.C. §§991-997. It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter. To meet the statutory definition of an IC-DISC, it must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year equals or exceeds 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year. Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year. In addition, the corporation must make an election to be treated as an IC-DISC for the tax year. I.R.C. §992(a)(1).
As such, it is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at the more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1).
“Destination test.” As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S. This is known as the “destination test.” This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery. It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold. The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale. Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S.
The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing. This is particularly the case with fruits and vegetables. Growers can trace their products to grocery stores and other end-use foreign destinations. The same is true for grain producers that deliver crops to export elevators. They will likely be able to get the necessary documents showing the precise export location of their grain products.
Once an IC-DISC is set-up (by competent legal and tax counsel), the producer, manufacturer, reseller or exporter can pay the IC-DISC a commission that is tax deductible. This is the most common way that the IC-DISC earns income. The commission is tied to the producer’s (or manufacturer or reseller or exporter) foreign sales or foreign taxable income for the tax year. It is that commission that then can be distributed (after the tax year) to the IC-DISC shareholders as qualified dividends at qualified long-term capital gain rates.
There is a safe harbor for the commission which is the greater of four percent of the qualified export receipts on reselling the property, or 50 percent of the combined taxable income from the export sales. For instance, assume that a Kansas what farmer (sole proprietor) sells wheat to an export elevator for $2 million. The elevator is able to document that all of the wheat was exported. The farmer pays four percent of $2 million ($80,000) to the IC-DISC, and claims a deduction of that amount on Schedule F. The IC-DISC has income of $80,000 (less any expenses incurred). If that income is distributed to the farmer, it takes the form of a qualified dividend which will be taxed at long-term capital gain rates.
What’s the benefit to the farmer? It's in the form of a reduction in self-employment taxable income, and the replacement (to an extent) of ordinary income with qualified dividend income.
There’s also a benefit if the farmer operates in the C corporate form. In that case, the commission that is paid to the IC-DISC reduces C corporate taxable income. As a result, if the IC-DISC shareholders are individuals, there is only a single layer of tax. In addition, as noted, the IC-DISC ordinary income is converted to qualified dividends and taxed at long-term capital gain rates.
Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral. Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate. Each shareholder does their own computation. Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate.
The IC-DISC may be unheard of by many farmers and practitioners. However, it can play a role in the overall income tax and estate planning process. As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes. In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling. Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation. That will please the on-farm heirs (and, likely, the parents).
The IC-DISC can also reduce tax liability to an extent that exceeds its cost of formation, operation and administration. But, as is the case with any tax tool, all applicable Code requirements must be satisfied, and competent professional help should be utilized in setting up the IC-DISC structure.
Thursday, June 29, 2017
Farm and ranch clients face many income tax issues that require special attention and planning. Likewise, they also encounter many estate and business planning opportunities that they can either take advantage of miss out on. For those representing farm and ranch clients, professional training in these issues is an important part of proper client representation. Our upcoming summer conference in the Bighorn Mountains of Sheridan, Wyoming on July 13-14, will dig into these issues and provide an opportunity for professional development. My teaching partner for the two days is Paul Neiffer of CliftonLarsonAllen.
Day 1 – Farm Income Tax
On Day 1, Paul and I will dig into numerous farm income tax topics. I will begin the day with an update of key developments in farm taxation. Before lunch, we will address various depreciation issues, farm income averaging and financial distress tax issues along with tax-deferral opportunities. In the afternoon, cash accounting issues for farmers, an update on the repair/capitalization regulations and a number of other specific farm income tax issues are on the agenda.
Day 2 – Farm Estate and Business Planning
On Day 2, we get into key estate and business planning issues for farmers and ranchers including how to maintain a stepped-up basis, planning strategies, the use of charitable trusts and FSA planning issues and opportunities. We will also get into other topics related to farm/ranch estate and business planning.
In-Person or Webinar
If you can’t attend the event in-person, the conference will also be webcast live. For in-person attendees, you can enjoy the beautiful Bighorn Mountains nearby with numerous outdoor opportunities. Also, the Sheridan Rodeo will be going on while we are there.
Here’s the link to the conference brochure: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
We hope to see you in Sheridan in two weeks. There’s a week left for early registration. After that, the registration rates increase.
Wednesday, May 24, 2017
I.R.C. §1402(a) defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member.”
That seems fairly clear – the business activity must be carried on by and “individual.” If that’s the case, that provides some planning opportunities for farm and ranch businesses (and other businesses too). That’s what today’s post takes a look at, based on a piece that I wrote for the University of Illinois Tax Workbook in recent years. That’s a workbook that is used at tax seminars in many states each fall and is a great resource for your tax library.
Business of a Trust Not Subject to Self-Employment Tax
The regulations provide that a trade or business must be carried on by an individual, either personally or through agents or employees. The regulations further provide “accordingly, income derived from a trade or business carried on by an estate or trust is not included in determining the net earnings from self-employment of the individual beneficiaries of such estate or trust.” Treas. Reg. §1.1402(a)-2(b).
As a result of this statutory and regulatory language, income derived from a business maintained by a trust (or an estate) is not included in determining net earnings from self-employment of the individual beneficiaries. Thus, in situations where a trade or business is carried on by an estate or trust rather than an individual, the income derived from the entity is not includable in determining the self-employment earnings of an individual beneficiary (or executor) unless there is a basis for disregarding the entity for purposes of the Code.
What type of a situation would serve as a basis for disregarding the entity (estate or a trust)? One example would be where the grantor of the trust is also the trust beneficiary. For example, in Huval v. Comr., T.C. Memo. 1985-568, a surviving spouse operated an oil and gas lease in her capacity as executrix of her husband’s estate, rather than in her individual capacity. That meant that the leasing business was conducted by the estate, and the Tax Court held that the lease income was not net earnings from self-employment for the surviving spouse.
What is a Trust?
A “trust” is subject to trust taxation, which means that self-employment tax savings can be achieved. Treas. Reg. §301.7701-4(a) addresses the definition of trusts for purposes of the Code, noting that trusts generally refer to arrangements created by either will or inter vivos declaration for the purpose of either protecting or conserving property for beneficiaries. Where the beneficiaries of the trust are the persons who created the trust, the trust will be recognized under the Code if it was created for the purpose of protecting or conserving trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. But, a trust that is treated as a grantor trust under the provisions of I.R.C. §§671-679 is treated as owned directly by the grantor. That’s because the grantor retains the control to direct the trust income or assets. Consequently, trust taxation does not apply, and self-employment tax savings will not be achieved.
A “business trust” is not subject to trust taxation, and won’t result in saving self-employment tax. Treas. Reg. §301.7701-4(b) addresses business trusts, describing them as arrangements where legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Code because they are not arrangements to protect or conserve property for beneficiaries. These trusts are described as being created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships under the Code.
Let’s take a look at an example. Assume that Bob was a farmer at the time of his death. When he died, his farm assets were placed in a trust created under the terms of his will. Bob’s surviving widow, Brenda, was named as the sole trustee of the trust and the sole beneficiary of a QTIP trust and a credit-shelter bypass trust. Both of these trusts became irrevocable upon Bob’s death. Brenda participated in the operations and the management of the farming activity. Brenda reported the income and the distributions from the trusts on her Form 1040 Schedule E where it was not subject to self-employment tax.
This is the factual setting that the IRS was faced with in Tech. Adv. Memo. 200305001 (Jul. 24, 2002). The IRS determined that the QTIP trust and the credit shelter bypass trust were trusts with a separate existence. Thus, the pass-through income from the trusts was not deemed to be net earnings from self-employment to Brenda. The trusts were not found to be business trusts whose separate existence would be ignored under the Code. However, the IRS noted that there could be an issue of whether the wife, as trustee, received adequate payments for the services she performed for these two trusts, and suggested that a determination be made by the IRS Examination Division as to whether the payments that the wife received were reasonable and of sufficient amount for the services that she provided to these trusts.
Let’s change the facts slightly. Assume that Jack died, and an irrevocable, testamentary trust went into effect as a result. His surviving widow, Mary and their son, Doug, were the trustees and beneficiaries of the trust. The trust paid a fee to Doug for managing the farming operation, and paid a fee to Mary for maintaining the farming records. Doug and his mother reported the fees as self-employment income, but did not report the income received as beneficiaries of the trust as subject to self-employment tax.
These facts were involved in Tech Adv. Memo. 200305002 (Jul. 24, 2002). There, there IRS treated the trust as a separate entity with the result that the earnings were not subject to self-employment tax. The trust was to be separately respected under the Code. But, again, the IRS noted that there could be an issue of whether the wife received adequate payments for her services, and whether the son received reasonable and sufficient payments for his management activities.
These IRS Memos suggest that a trust can insulate the beneficiaries from SE income on an actively conducted farming operation, but only if two conditions are met:
- The trust is created to preserve the property for another party or in a testamentary manner that suggests it is not merely an attempt to move business operations into a trust entity (i.e., it is not a business trust);
- The trustees or other individuals rendering management or other services to the trust are reasonably compensated for their services in a manner that is subject to either FICA or self-employment With respect to the second issue, a testamentary trust can serve in much the same manner as an S corporation, where the issue at hand is the reasonableness of fees or compensation to those owners of the entity that also receive Schedule K-1 income exempt from self-employment tax.
As an additional thought, an individual receiving a distribution from a trust as a beneficiary who is also paid for trade or business services that the individual provides to the trust should be able to document that their compensation is reasonable based on what would have to be paid to a third party for the services.
An active business conducted through a trust can achieve self-employment tax savings. But, proper structuring is critical. As is the case with other estate or business planning techniques, whether to use a trust to achieve self-employment tax savings is to be considered in light of a host of planning considerations, both tax and non-tax.
Tuesday, May 16, 2017
This coming July 13-14 the Washburn University School of Law in conjunction with the Kansas State University, Department of Agricultural Economics and the Wyoming Society of CPAs are co-sponsoring a two-day CLE/CPE conference on agricultural tax and estate and business planning at Sheridan College in Sheridan, Wyoming. The event will also be streamed live over the internet. If you represent agricultural clients in the handling of tax work or the preparation of estate and business plans, this conference will be tailor-made for you. The presenters will be myself and Paul Neiffer of CliftonLarsonAllen. Paul and I have worked together for several years and it will be a joy to do join forces again in Sheridan.
Day 1 – Farm and Ranch Tax Day
Thursday, July 13, will be devoted to agricultural tax-related topics. We will start the day with an overview of recent developments in ag taxation. While it appears doubtful at this time that there will be any significant tax legislation to discuss in July, there have been many key court developments and IRS rulings impacting agriculture that will be covered. We will also have sessions on this day concerning farm income averaging, financial distress and income tax deferral opportunities for ag clients. During the afternoon session, we will take a deep look at the continued IRS attack on the cash method of accounting, including analysis of the recently decided Agro-Jal Farms case from California and the Estate of Backemeyer case from Nebraska. We will also provide an update on the capitalization/repair regulations, and go over in some detail various tax planning strategies for farmers and ranchers. To round out the day will be coverage of numerous miscellaneous ag tax topics.
Day 2 – Farm and Ranch Estate and Business Planning
On Friday, July 14, we will focus on estate and business planning issues for farm and ranch clients. Any legislative developments will be covered along with their impact on the planning process, as will recent case and rulings. We will also cover the use of charitable trusts, and the present planning landscape in light of higher exemptions and portability. Also addressed on Friday will be FSA planning and tax issues associated with the sale of a decedent’s residence. The afternoon session will focus on how the business structure can impact self-employment tax liability, long-term care planning strategies, profits interests and portability planning.
As noted above the two-day session will be webcast. Glen McBeth, Instructional Technology at Washburn Law School, will be handling the webcasting. You will be able to see and hear both myself and Paul and interact with us if you wish.
There are plenty of things to see and do in the Sheridan area if you are attending the conference in person. Sheridan is just east of the Bighorn Mountains and there are plenty of things to see and do. The 87th Annual PRCA Sheridan Rodeo will be on while we are there. It starts on July 12 and goes through the 15th. Paul and I are planning a fishing event for Saturday the 15th. If, you would like to join us, please let us know so that we can plan accordingly.
We certainly hope that you will join us in Sheridan. If you can’t join in person, you can join via the web. Either way, the conference will be a great opportunity for you to pick up concepts that you can use with your clients.
You can learn more about the conference and register here: http://washburnlaw.edu/employers/cle/farmandranchincometax.html