Wednesday, April 25, 2018
Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous. The commodity gifts can be used to shift income to minor children to take advantage of their lower tax rates. Likewise, they could be used to assist with a child’s college costs or made to a child in return for the child support the donor-parents.
How should commodity gift transactions be structured? What are the tax consequences? What is the impact of the Tax Cuts and Jobs Act (TCJA) on commodity gifts to children.
Ag commodity gifts to children. That’s the topic of today’s post.
Tax Consequences to the Donor.
Avoid income and self-employment tax. A donor does not recognize income upon a gift of unsold grain inventory. Rev. Rul. 55-138, 1955-1 C.B. 223; Rev. Rul. 55-531, 1955-2 C.B. 520. Instead, a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income. Estate of Farrier v. Comr., 15 T.C. 277 (1950); SoRelle v. Comr., 22 T.C. 459 (1954); Romine v. Comr., 25 T.C. 859 (1956). That means that the farmer, as the donor, sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, self-employment tax is also eliminated on the commodities. That’s because excludable gross income is not considered in determining self-employment income. Treas. Reg. 1.1402(a)-2(a). This is particularly beneficial for donor-parents that have income under the Social Security wage base threshold.
Prior year’s crop. The gifted commodities should have been raised or produced in a prior tax year. If this is not the case, the IRS takes the position that a farmer is not 100 percent in the business of raising agricultural commodities for profit and will require that a pro rata share of the expenses of raising the gifted commodity will not be deductible on the farmer’s tax return. According to the IRS, if a current year’s crop is gifted, the donor’s opening inventory must be reduced for any costs or undeducted expenses relating to the transferred property. Rev. Rul. 55-138, 1955-1, C.B. 223. That means that the donor cannot deduct current year costs applicable to the commodity. See also Rev. Rul. 55-531, 1955-2 C.B. 522. However, costs deducted on prior returns are allowed. Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year).
Tax consequences to the Donee.
The donor's tax basis in the commodity carries over to the donee. I.R.C. §1015(a). Thus, in the case of raised commodities given in the year after harvest by a cash method producer, the donee receives the donor’s zero basis. Conversely, an accrual method farmer will have an income tax basis in raised commodities. If this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift.
Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity by the donee is treated as unearned income that is not subject to self-employment tax. Even though the raised farm commodity was inventory in the hands of the farmer-donor, the asset will typically not have inventory status in the hands of the done. That means the sale transaction is treated as the sale of a capital asset that is reported on Schedule D.
The holding period of an asset in the hands of a donee refers back to the holding period of the donor. I.R.C. §1223(2). So, if the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss.
Gifts of Livestock?
A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to self-employment tax. To help avoid that result, physical segregation of the livestock at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees. See, e.g., Smith v. Comr., T.C. Memo. 1967-229; Alexander v. Comr., 194 F.2d 921 (5th Cir. 1952); Jones Livestock Feeding Co., T.C. Memo. 1967-57; Urbanovsky v. Comr., T.C. Memo. 1965-276.
Structuring the Transaction
Cash-method farm proprietors intending to gift raised commodities to a child or other non-charitable donee should structure the transaction in two distinct steps. First, the donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee. Second, the donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain. The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity. Make sure that the transaction is not a loan.
“Kiddie Tax” Complications
Unearned income of a dependent child includes items such as interest, dividends and rents, as well as income recognized from the sale of raised grain received as a gift and not as compensation for services. The “Kiddie Tax” has a small inflation-indexed exemption. I.R.C. §1(g). For dependent children who sell commodities received as a gift and are subject to the” Kiddie Tax,” a standard deduction offsets the first $1,000 of unearned income (2017 amount). Then the next $1,000 of unearned income is subject to tax at the child’s single tax rate of 10 percent. That means that the child’s unearned income in excess of $2,100 is taxed at the parents’ top tax rate.
The Kiddie Tax applies to a child who has not attained age 18 before the close of the year. It also applies to a child who has not attained the age of 19 as of the close of the year or is at least age 19 and under 24 at the close of the year and is a full-time student at an educational organization during at least five months of the year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships).
TCJA modification. As noted above, under pre-TCJA law, the child who receives a commodity gift and then sells the commodity usually pays income taxes based on the parent’s tax rates (there is a smaller amount taxed at lower rates) on unearned income. Earned income, such as wages, is always taxed at the child’s tax rates. But, under the TCJA for tax years beginning after 2017, the child’s tax rates on unearned income are the same as the tax rates (and brackets) for estates and trusts. That means that once the child’s unearned income reaches $12,500, the applicable tax rate is 37 percent on all unearned income above that amount. This will make it much costlier for farm families to gift grain to their children or grandchildren and receive any tax savings.
Gifting commodities to a family member can produce significant tax savings for the donor, and also provide assistance to the donee. That was much more likely to be the result pre-2018. The TCJA removes much of the tax benefit of commodity gifting to children. In any event, however, the commodity gifting transactions must be structured properly to achieve the intended tax benefits.
Monday, April 23, 2018
The Tax Cuts and Jobs Act (TCJA) constituted a major overhaul of the tax Code for both individuals and businesses. In previous posts, I have examined some of those provisions. In particular, I have taken a look at the new I.R.C. §199A and its impact on agricultural producers and cooperatives. Recently the IRS Commissioner told the Senate Finance Committee that it would take “years” to finish writing all of the rules needed to clarify the many TCJA provisions and provide the interpretation of the IRS. But, recently the IRS did clarify how “alimony trusts” are to work for divorces entered into before 2019.
The alimony tax rules and “alimony trusts”, that’s the focus of today’s blog post.
Tax treatment of alimony. For divorce agreements entered into before 2019, “alimony or separate maintenance payment” is taxable to the recipient and deductible to the payor. I.R.C. §71. What is an alimony or separate maintenance payment? It’s any payment received by or on behalf of a spouse (or former spouse) of the payor under a divorce or separate maintenance agreement that meets certain basic requirements: 1) the payment is made in cash (checks and money orders) pursuant to a decree, court order or written agreement; 2) the payment is not designated as a payment which is excludible from the gross income of the payee and non-deductible by the payor; 3) for spouses legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time payment is made; 4) the payor has no liability to continue to make any payment after the payee’s death and the divorce or separation instrument states that there is no such liability. I.R.C. §71(b)(1). It’s also possible that a settlement requiring or allowing the paying spouse to make payments directly to third parties for the benefit of the other spouse (such as for medical treatment, life insurance premiums or mortgage payments, for example) can result in the payments being treated as alimony as long as they do not benefit the paying spouse or property owned by the paying spouse.
It is possible, however, to specify in a separation agreement or divorce decree that such payments escape taxation in the hands of the recipient (and not give rise to a deduction in the hands of the payor-spouse). Conversely, child support and property settlements are tax neutral – neither party pays tax nor gets a deduction. I.R.C. §71(c).
Another rule specifies that if the payor owes both alimony and child support, but pays less than the total amount owed, the payments apply first to child support and then to alimony. If the separation agreement does not specify separate alimony and child support payments, general “family support” payments are treated as child support for tax purposes, unless the alimony qualifications are met.
Planning point. This tax treatment raises an interesting planning point. In general, when the higher income spouse makes payments to the lower-income spouse, the payments should be structured as alimony because the deduction can be available to the spouse in the higher tax bracket and, concomitantly, the income will be taxable to the spouse in the lower tax bracket. If the spouse making payments is not in the higher income tax bracket (perhaps because of high levels of tax-exempt income such as disability payments), it makes more sense to structure the payments as child support or as a property settlement, or simply specify in the agreement that the alimony is not taxable to the recipient.
What about trusts? During marriage, one spouse may have created an irrevocable trust for the benefit of the other spouse. In that situation, I.R.C. §672(e)(1)(A) makes the trust a “grantor” trust with the result that the income of the trust is taxed to the spouse that created the trust. If the couple later divorces, the trust remains. It’s an irrevocable trust. The divorce doesn’t change the nature or tax status of the trust – the spouse (now ex-spouse) that created the trust must continue to pay tax on trust income. That’s probably both an unexpected and unhappy result for the spouse that created the trust. That’s why (at least through 2018) I.R.C. §682(a) provides that the spouse that didn’t create the trust is taxed on the trust income, except for capital gain. Capital gain income remains taxable to the spouse that created the trust. In essence, then, the “payee” spouse is considered to be the trust beneficiary. I.R.C. §682(b).
Reversing tax treatment of alimony. Under the TCJA, for agreements entered into after 2018, alimony and separate maintenance payments are not deductible by the payor- spouse, and they are not included in the recipient-spouse’s income. Title I, Subtitle A, Part V, Sec. 11051. This modification conforms alimony tax provisions to the U.S. Supreme Court’s opinion in Gould v. Gould, 245 U.S. 151 (1917). In that case, the Court held that alimony payments are not income to the recipient.
Under the TCJA, income that is used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse. The treatment of child support remains unchanged.
Impact on “alimony trusts.” However, the TCJA also struck I.R.C. §682 from the Code as applied to any divorce or separation instrument executed after 2018, and any divorce or separation agreement executed before the end of 2018 that is modified after 2018 if the modification provides that the TCJA amendments are to apply to the modification.
With the coming repeal of I.R.C. §682, what will happen to “alimony trusts” that were created before the repeal? IRS has now answered that question. According to IRS Notice 2018-37, IRB 2018-18, regulations will be issued stating that I.R.C. §682 will continue to apply to these trusts. That means that the “beneficiary” spouse will continue to be taxed on the trust income. But, the IRS points out that this tax treatment only applies to couples divorced (or legally separated) under a divorce or separation agreement executed on or before December 31, 2018. The only exception is if such an agreement is modified after that date and the modification says that the TCJA provisions are to apply to the modification.
What happens to “alimony trusts” executed after 2018? The spouse that creates the trust will be taxed on the trust income under the “grantor trust” rules. That’s because I.R.C. §672(e)(1) will continue to apply. Some taxpayers finding themselves in this position may want to terminate grantor trust treatment in the event of divorce. A qualified terminable interest property (QTIP) trust may be desired. Another approach may be to have a provision drafted into the language of the trust that says that the spouse creating the trust will be reimbursed for any tax obligation post-divorce attributable to the trust.
The IRS is requesting comments be submitted by July 11, 2018.
The TCJA changed many tax Code provisions. The alimony rules are only a small sample of what was changed. If you haven’t done so already, find a good tax practitioner and get to know them well. Tax planning for 2018 and beyond has already begun.
Thursday, April 19, 2018
It is not uncommon for a farmer or a higher-income taxpayer to invest in various activities in which they do not materially participate (as determined by a seven-factor test under Treas. Reg. §1.469-5T(a). Examples of passive investments for farmers include rental activities, “condominium” grain storage LLCs and interests in ethanol and bio-diesel plants. These investments generate either passive income or passive losses. Passive income is subject to ordinary income tax and may also be subject to an additional 3.8 percent passive tax. I.R.C. §1411. When a passive activity generates losses, however, the passive activity rules limit the ability to deduct the losses to the extent the taxpayer has passive income in the current year. Otherwise, they are deducted in the taxpayer’s final year of the investment.
When a farmer (or other taxpayer) has investments in which they don’t materially participate and, hence, potentially face the impact of the passive activity rules can those investment activities be combined with an activity in which the taxpayer materially participates so that the limitation on deducting losses can be avoided? There might be. It might be possible to group activities. A recent case shows how the grouping rules work.
That’s the topic of today’s post – grouping activities under the passive loss rules.
An election can be made on the tax return to group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. Treas. Reg. §1.469-4. Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.” But, how is an appropriate economic unit determined? The Treasury Regulations state that a taxpayer may use any reasonable method to make the grouping determination, although the following factors set forth in Treas. Reg. 1.469‑4(c)(2) are given the greatest weight:
- Similarities and differences in types of business;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependence between the activities
Grouping disclosure. The IRS has issued final guidance on the disclosure reporting requirements of groupings (and regroupings). Rev. Proc. 2010-13, 2010-1 C.B. 329. A grouping statement is to be filed with the tax return stating that the taxpayer is electing to group the listed activities together so that they are treated as a single activity for the tax year, and all years thereafter. The taxpayer should also represent in the grouping statement that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.
A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, since 2013, a 3.8 percent net investment income tax applies to net rental income and other passive business income of upper income taxpayers.
Under the guidance, a written tax return statement is required for:
- New groupings, such as in the first year of grouping two activities;
- The addition of a new activity to an existing grouping; and
- Regroupings, such as for an error or change in facts.
However, no written statement is required for:
- Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
- The disposition of an activity from a grouping; and
- Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.
If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity.
Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer. However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure.
Special Grouping Rules
A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity. Treas. Reg. §1.469-4(d)(1).
An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business. Treas. Reg. §1.469-4(d)(5)(ii).
An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. Treas. Reg. §1.469-4(d)(2).
A recent case illustrates the how the factors for grouping are applied. In Brumbaugh v. Comr. T.C. Memo. 2018-40, the petitioner owned 60 percent of a C corporation that was engaged in developing real estate. The balance of the stock was owned by two others. The business had its headquarters in southern California and the plaintiff participated in the business for more than 500 hours in 2007, the year in issue. The business had a development project in 2007 in northern California several hundred miles away. The shareholders discussed buying an airplane for the trips to the project and back to southern California.
Ultimately, instead of the corporation buying the plane, the plaintiff bought it personally through his LLC. In 2006, the plaintiff had formed and LLC (taxed as a partnership) in which he owned 51 percent and his wife owned 49 percent. The LLC entered into a management agreement with an aviation company that provided that the aviation company was responsible for all managerial duties related to the plane and had the exclusive right to charter the plane for commercial flights by third parties whenever the petitioner did not need to use the plane. The plaintiff was also given access to other planes when his was being chartered. In 2007, the plaintiff used the plane on only one occasion. On four other occasions he used a different plane because his was being chartered. On petitioner’s 2007 return, he reported a $683,000 loss. Upon audit, the IRS recharacterized the loss as a passive loss on the basis that the plaintiff had not materially participated in the LLC’s activities.
The Tax Court agreed with the IRS and also concluded that the petitioner could not group the airplane activity with the real estate development activity because none of the Treas. Reg. §1.469-4(c)(2) factors favored grouping the two activities together. There was no functional similarity between the two activities and the plane was not integrated into the real estate activity in any way. While the factors for extent of common ownership and common control were neutral (the petitioner held controlling interests in both entities, but the interests were very different), there was no interdependence between the two businesses. In addition, the court noted that the petitioner did not materially participate in the aviation activity because there was no evidence to support the petitioner’s contention that he participated for at least 100 hours including no contemporaneous logs, appointment books, calendars or narrative summaries. In any event, the petitioner did not devote 500 or more hours in the aggregate to “significant participation activities.” In addition, the real estate development activity did not qualify as a significant participation activity (another issue not discussed in this post).
Farmers, ranchers and other taxpayers often engage (invest) in passive activities in addition to their business activity in which they materially participate. While it is possible to group the investment activities with a farming business, for example, the factors set forth in the regulations for grouping must be satisfied. The recent Tax Court case illustrates that it can be rather difficult to satisfying those factors.
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.
Wednesday, April 11, 2018
Economic conditions in much of agriculture have deteriorated in recent years. Prices for many crops have dropped, livestock prices have come down from recent highs, and cash rents and land values have leveled off or fallen. In some instances, agricultural producers leveraged to expand their operations during the good times, only to find that the tougher farm economy has made things financially difficult.
In the downturn, legal and tax issues become critically important for many farmers and ranchers. One of those involves the distinction between a capital lease and an operating lease. That distinction and why it matters is the topic of today’s post.
A capital lease is a lease in which the only thing that the lessor does is finance the “leased” asset, and all other rights of ownership transfer to the lessee. Conversely, with an operating lease the asset owner (lessor) transfers only the right to use the property to the lessee. Ownership is not transferred as it is with a capital lease, and possession of the property reverts to the lessor at the end of the lease term. As a result, if the transaction is a capital lease, the asset is the lessee’s property and, for accounting purposes, is recorded as such in the lessee’s general ledger as a fixed asset. For tax purposes, the lessee deducts the interest portion of the capital lease payment as an expense, rather than the amount of the entire lease payment (which can be done with an operating lease).
So, what distinguishes a capital lease from an operating lease and why is the distinction important? There are at least a couple of reasons for properly characterizing capital and operating leases. One reason involves the fact that leases can be kept off a lessee’s financial statements, which could provide a misleading picture of the lessee’s finances. Another reason involves the proper tax characterization of the transaction. With an operating lease, the lessee deducts the lease payment as an operating expense and there is no impact on the lessee’s balance sheet. With a capital lease, however, the lessee recognizes the lease as an asset and the lease payment as a liability on the balance sheet. Also, with a capital lease, the lessee claims an annual amount of depreciation and deducts the interest expense associated with the lease. Based on these distinctions, many businesses prefer to treat lease transactions as operating leases, sometimes when the structure of the transaction indicates that they should not.
For a capital lease, the present value of all lease payments is considered to be the asset’s cost which, as noted above, the lessee records as a fixed asset, with an offsetting credit to a capital lease liability account. For accounting purposes, as each lease payment is made, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lessor has revenue equal to the present value of the future cash flows from the lease, and records the expenses associated with the lease. For the lessor, a lease receivable is recorded on the lessor’s balance sheet and recognizes the interest income as it is paid.
A transaction that is a capital lease has any one of the following features (according to the Financial Accounting Standards Board (FASB)):
- Ownership of the asset shifted from the lessee by the end of the lease period; or
- The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
- The lease term is at least 75 percent of the estimated economic life of the asset (and the lease cannot be cancelled during that time); or
- The value of the minimum lease payments (discounted to present value) required under the lease equals or exceeds 90 percent of the fair value of the asset at the time the lease is entered into.
If none of the above factors can be satisfied, the transaction is an operating lease. In that event, the lessee is able to deduct the lease payment as a business expense and the leased asset is not treated as an asset of the lessee.
In the typical example, a farmer “trades in” equipment in return for not having to pay any of the operating lease payments or make a large down payment on the lease. If the trade is for a capital lease, with the IRS treating the transaction as a financing arrangement (i.e., a loan), then no gain is triggered on the trade if no cash is received. But there also is no deduction for the lease payments (although interest may be deductible). If the trade constitutes an operating lease, the farmer has gain equal to the amount of “trade-in” value that is credited to the operating lease minus the farmer’s tax cost in the equipment. The gain can be offset (partially or fully) with the lease expense (lease cost amortized for the year of sale).
On June 1, 2016, a farmer trades in a used, fully depreciated, tractor worth $120,000 for a new tractor under an operating lease over four years. The farmer will have ordinary income of $120,000 in 2016 and can deduct the lease payments made in 2016 and later years as a business expense. Had the trade occurred late in 2016, it is possible that no lease expense could be claimed in 2016, but that $30,000 could be claimed as a lease expense deduction in each year of 2017- 2020.
TCJA Modification to Like-Kind Exchanges
While the above discussion focuses on a trade-in of equipment in return for a lease, it is useful to remember that the recently enacted tax bill modifies the like-kind exchange rules. Under a provision include the “Tax Cut and Jobs Act,” for exchanges completed after December 31, 2017, I.R.C. §1031 is inapplicable to personal property exchanges. Thus, for example, on the trade of an item of farm equipment, the transaction will be treated as a sale with gain recognition on the sale of the item “traded.” The trade-in value is reported as the sales price (Form 4797), with no tax deferral for any I.R.C. §1231 gain or I.R.C. §1245 recapture. The typical result will be that gain will result because most farm equipment has been fully depreciated via expense method or bonus depreciation. The taxpayer’s income tax basis in the new item of farm equipment acquired in the “trade” will be the new item’s purchase price. That amount will then be eligible for a 100 percent deduction (“bonus” depreciation) through 2022. The “bonus” percentage is reduced 20 percentage points annually through 2026. In 2027, a taxpayer would have to report 100 percent of the gain realized on a “trade” of personal property, but could deduct the cost of the item acquired in the “trade” under the expense method depreciation provision of I.R.C. §179 (presently capped at $1 million). The gain on the “trade” is not subject to self-employment tax, and the depreciation deduction on the item acquired in the trade reduces self-employment tax. A further complication, beginning in 2018, is that net operating losses can only offset 80 percent of taxable income. Thus, a taxpayer may want to elect out of bonus depreciation on the newly acquired asset and use just enough expense method depreciation to get taxable income to the desired level.
Understanding the difference between a capital lease and an operating lease, is helpful to avoiding bad tax and legal results in agricultural transactions. The proper classification is very important. It’s a big deal particularly when the agricultural economy turns south.
Tuesday, April 3, 2018
The Congress, through numerous tax and other legislative bills that have been enacted since the 1970s, has provided numerous subsidies designed to stimulate the production, sale and use of alternative fuels. In addition to the production-related subsidies, alternative fuel infrastructure subsidies also exist. In addition to the tax subsidies, Title IX of the 2014 Farm Bill included $694 million of mandatory funding and $765 million of discretionary funding for biofuels. In addition to tax subsidies and other funding mechanisms, the Renewable Fuel Standard provides preferential treatment for corn and soybean production. Many farmers, particularly in the Midwest, view the credits as important to their businesses (by removing supply and creating demand) and as an investment opportunity (“fueled” as it is, by government mandates).
The Internal Revenue Code (Code) provisions concerning the tax credits for alternative fuels are complex and must be precisely followed. The fact that many of these credits are refundable (can reduce the tax liability below zero and allow a tax refund to be obtained) increases the likelihood of fraud with respect to their usage. As a consequence, the IRS can levy huge penalties for the misuse of the credits. A recent federal case from Iowa illustrates how the alternative fuel credit can be misused, and the penalties that can apply for such misuse.
The alternative fuel credit – that’s the topic of today’s post.
The Alternative Fuel Credit
Section 6426 of the Code provides for several alternative fuel credits. Subsection (d) specifies the details for the alternative fuel credit. The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004. That initial version provided credits for alcohol and biodiesel fuel mixtures. In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures. The credits proved popular with taxpayers. During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.” That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy). The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy. C.C.M. AM2010-001 (Mar. 12, 2010). However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit.
As modified, I.R.C. §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used. In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business.
For purposes of I.R.C. §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3). I.R.C. §6426(d)(2)(G). “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.” An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel. See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b). An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer. Id. In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS. I.R.C. 6426(a)(2).
In Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018), the plaintiff was a Pella, IA firm that produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business. Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the I.R.C. §6426 refundable credit for alternative fuel production.
To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries. In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day.
The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction. The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code. The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.” A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit. C.C.A. 201133010 (Jul. 12, 2011). The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”
The plaintiff claimed a refundable alternative fuel mixture credit in accordance with I.R.C. §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014. The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (I.R.C. §6675); civil fraud penalty (I.R.C. §6663) and failure-to-file and failure-to-pay penalties (I.R.C. 6651).
The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied.
In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits.
The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice. In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon. Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon.
The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786. A large part of the other penalties had already been abated. The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff.
Initially, the refundable credits were presented to Congress as incubators. As the business and demand grew, there would be less need for the subsidy. The initial tax subsidies are critical for these business models to succeed. Unknown is whether any of the business models wean themselves off of the credit to be successful without taxpayer subsidy.
Each year, the IRS releases a list of the “Dirty Dozen” tax scams. On the current list are “excessive claims for business credits.” That includes alternative fuel tax credits. The fact that the alternative fuel credit is refundable makes it even more enticing to those that are seeking to scam the system. While alternative fuel credits may have their place, extreme care must be taken to ensure that appropriate business models and transactions are utilized to properly claim them. In the recent case, a local municipality (the WRA) was brought in to help make the scam look legitimate.
Friday, March 30, 2018
The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies. It is important to understand the various types of payments that a landowner might receive and the tax consequences that may apply due to the nature of the income received.
Sorting through the various types of payments associated with an oil and gas lease and their tax implications is the topic of today’s post.
Relationship of the Parties
The income from the oil and gas property is commonly divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In the typical lease arrangement, the royalty owner retains one-eighth (12.5 percent) and the working interest owner holds the other 87.5 percent (the balance of the portion of production or income that remains after the royalty interest owner’s share is satisfied).
The working interest owner bears the entire cost of exploration for minerals, as well as the development and production costs. The royalty owner bears none of the exploration, development, or operational costs. The funding necessary for the working interest owner to develop the oil and gas property is provided by investors who receive an interest in the activity in exchange for their capital investment. The costs of the activity borne by the working interest owner are allocated to the investors. These include geological survey costs, tangible costs (the drilling equipment and well), and intangible drilling costs (IDC). These costs can be currently deducted rather than capitalized.
This relationship between the working interest owner and the investors is typically a joint venture that is classified as a partnership for tax purposes. Thus, the partnership passes through the costs separately to the investors on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. In the early years of the activity, the partnership typically passes through large losses to the partners. Because the partners are merely investors in the activity, the losses in their hands are passive losses. These losses are limited under the passive loss rules (I.R.C. §1411) such that they are only deductible to the extent the investor has passive income.
The working interest owner (who owns the interest either directly or through an entity that does not limit liability for the interest), however, is treated as being engaged in a non-passive activity regardless of the participation of the working interest owner. Temp. Treas. Reg. §1.469-1T(e)(4)(i). Likewise, for an investor who holds both a general and limited partnership interest, the investor’s entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity regardless of whether the investor is materially participating.
Note: Investors in the working interest activity, given the broad definition of “partnership” contained in the Code, will likely have income from the activity that is subject to self-employment tax even though they are not materially participating in the activity. See, e.g., Methvin v. Comm’r, T.C. Memo 2015-81, aff’d., 653 Fed. Appx. 616 (10th Cir. 2016).
Types of Payments
Bonus payment. The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411. A bonus payment is ordinary income and not capital gain because it is not tied to production. See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014).
For the lessee, a bonus payment is not deductible even if it is paid in installments. It must be capitalized as a leasehold acquisition cost. However, the bonus payment may be subject to cost depletion.
Installment bonus payments. A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.
A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable. Rev. Rul. 68-606, 1968-2 CB 42. However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received. See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5.
Delay rentals. A delay rental is paid for the privilege of deferring development of the property by extending the primary term to allow additional time for drilling operations to begin. It can be avoided either by abandonment of the lease or by starting development operations (i.e., drilling for oil or obtaining production). A delay rental payment is “pure rent.” It is simply a payment to defer development rather than a payment for oil.
Delay rentals are ordinary income regardless of whether they are based on production. However, if they are not based on production, they are not depletable gross income to the lessor. Treas. Reg. §1.612-3(c)(2). Depletable gross income for the lessor is the royalty income received. Royalty income is based on production. If the delay rentals paid are not based on production, they do not reduce the lessee’s depletable gross income. Treas. Reg. §1.613-2(c)(5).
Delay rental payments are reported in the same manner as bonus payments. They are reported to the lessor in box 1 of Form 1099-MISC and constitute NII potentially subject to the additional 3.8 percent NIIT. The lessor reports the payments on Schedule E, with the amount flowing to line 17 of Form 1040, and are potentially subject to the NIIT.
Under Treas. Reg. §1.612-3(c), delay rentals are in the nature of rent that the lessee can deduct as a current expense. However, the IRS maintains that I.R.C. §263A applies to delay rentals, which requires that the payments be capitalized. The only exception to capitalization applies if the taxpayer has credible evidence establishing that the leasehold was acquired for some reason other than development.
Royalty income. A landowner royalty is the right to the oil, gas, or minerals “in place” that entitles the owner to a specified percentage of gross production (if and when production occurs) free of the expenses of development and operations. A royalty interest is a continuing non-operating interest in oil and gas. Thus, a royalty payment is a payment for oil and gas.
Royalty payments are payments received for the extraction of minerals from the property that the landowner, as lessor, owns. Royalties are paid as an agreed-upon percentage of the resource extracted (i.e., based on production).
Royalty payments are ordinary income that is reported to the lessor in box 2 of Form 1099-MISC. Royalty payments may be reduced by percentage or cost depletion. The lessor reports the royalty income on Schedule E, are they are included in NII and are subject to the additional 3.8 percent NIIT if the taxpayer’s gross income is above the applicable threshold ($200,000 single; $250,000 MFJ).
The lessee can deduct royalty payments as a trade or business expense. In addition, if the lessee pays the ad valorem taxes (taxes based on the property’s value) on mineral property, the payment constitutes an additional royalty to the lessor to the extent that income from production covers the tax payment.
Advance royalties. Although it is not commonly included in oil and gas leases, the lease may contain a provision providing the mineral owner with an advance royalty of the operating interest. Thus, an advance royalty is paid before the production of minerals occurs, and can be paid to the lessor either in a lump sum or periodically until production begins. The lessee deducts the advance royalty payments in the year in which the mineral production (on account of which it was paid) is sold.
Advance royalties are ordinary income to the lessor, and the lessor is not entitled to percentage depletion on the payments. However, the lessor is entitled to cost depletion in the year the payments are made to the extent they exceed production.
Advance minimum royalties. Advance minimum royalties meet the same conditions as an advanced royalty, but there is also a minimum royalty provision in the contract. This provision requires that a substantially uniform amount of royalties be paid at least annually over the life of the lease or for a period of at least 20 years.
The tax treatment to the lessor for advance minimum royalties is the same as with advanced royalties. The lessee can deduct the advance royalties from gross income in the year the oil or gas is sold or recovered. The lessee also has the option to deduct the payments in the year they are paid or accrued.
Shut-in royalties. The lease may provide for payments to be made to the lessor when a well is shut- in (turned off because of lack of market or marketing facilities) but the well is still capable of producing in commercial quantities. The lessee is entitled to deduct the shut-in royalty payment and the lessor must report the payment as income.
Damage payments. When a well is drilled, the nearby surface area can suffer damages that may entitle the landowner to compensation. To determine the income tax consequences of any payment for surface damages, the governing instrument (lease, etc.) may provide guidance.
Compensatory damages associated with lost profit (e.g., crop damage payments) are taxable as ordinary income (treated as a sale of the crop). To the extent the damage payment represents damages for destruction of business goodwill, the payment is nontaxable up to the taxpayer’s basis in the affected property. The amount of the damage payment that exceeds the taxpayer’s basis is taxable as I.R.C. §1231 gain. Payments for anticipated damages (but when no actual damage occurs) are reported as ordinary income. See, e.g., Gilbertz v. U.S., 808 F.2d 1374 (10th Cir. 1987), rev’g 574 F. Supp. 177 (Wyo. 1983).
Production payments. Most landowners retain only a royalty interest in minerals. However, landowners who have a working (operating) interest in the production may also receive a “production payment.” A production payment arises from a transaction in which the owner of an oil and gas interest sells a specific volume of production from an identifiable property until a specified amount of money or minerals has been received. A production payment is payable only out of the working interests’ share of production.
There are two types of production payments. Retained production payments result when the mineral interest owner assigns the interest and retains a production payment. The payment is payable out of future production from the assigned property interest. A carved-out production payment is created when an owner of a mineral interest assigns a production payment to another person but retains the interest in the property from which the production payment is assigned.
Generally, a carved-out production payment is treated under I.R.C. §636 as a mortgage (nonrecourse) loan on the property. As such, it does not qualify as an economic interest in the property. The lessee treats the payments as principal repayment and interest expense, and the lessor treats the payments received as principal and interest income. Thus, the producer does not recognize taxable income at the time the transaction is entered into. The lessor continues to be treated as the owner of the burdened properties. As the production occurs and is delivered to the holder of the production payment, the lessor is treated as having sold the production for its FMV and having applied the proceeds to repay the principal and interest due to the holder.
However, if the consideration given for the production payment is pledged for development of the property or if the production payment is retained when the property is leased, the payment qualifies as an economic interest. In this situation, the payments that the lessor receives via the production payment agreement are ordinary income that are subject to cost or percentage depletion. The lessee capitalizes the payments. The transaction may be treated as the sale of an overriding royalty interest in some instances, however.
Treas. Reg. §1.636-3 requires that the life of the production payment be shorter than the life of the property. Thus, for an unexplored property, if no minerals are discovered or the reserves are in such small quantities that they will never pay off the production payment, the production payment’s life will exist until the lease is abandoned. Once the lease is abandoned, the transaction is treated by the lessee as a purchase of an overriding royalty interest. It is capitalized by the lessee and treated as capital gain by the lessor.
Payments for “shooting rights.” In some situations, an operator may not want to incur the costs of entering into a lease on the property (to avoid lease bonuses, for example). Consequently, the operator may enter into a contract with the landowner to pay a smaller amount under a contract that gives the operator a right to enter onto the property to conduct exploration activities. The contract does not grant any drilling or production rights. The payments that the landowner receives under this type of arrangement are reportable as ordinary income.
Sorting out the proper tax treatment of various payments associated with an oil and gas lease is important and can be somewhat complex. For those receiving (or paying) such amounts, competent tax counsel should be consulted to ensure proper reporting. Today's post was just a quick summary of some of the tax issues associated with oil and gas production.
Wednesday, March 28, 2018
An issue that I sometimes get into when dealing with practitioner questions concerns the IRS collections process. What can the IRS reach? What’s the process for establishing an IRS lien? What’s the levy process? What planning steps should a taxpayer take to protect assets within the limits of applicable law? These, and similar questions are important when a taxpayer finds themselves on the wrong end of an IRS audit.
The basics of the IRS collection process and related issues – that’s the topic of today’s post. This is not intended as a comprehensive review of the IRS procedures. Instead, today’s post is merely a primer dealing with some of the more common questions. Also, not discussed is a taxpayer’s option of contesting an IRS determination in Tax Court.
IRS notices. When the IRS, upon audit, determines that a tax liability exists for any individual or taxpaying entity, the IRS collection process begins. The process is basically the same for an individual taxpayer as it is for any taxpaying entity. The IRS will send at least two notices requesting payment. The verbiage becomes increasingly urgent with each notice. The last notice sent before any action can be taken will be labeled “Final” and will sent via certified mail. It is important to note that the IRS cannot take any action or file a notice of federal tax lien until 30 days have expired from that final notice.
The IRS automated collection system. After the final notice goes out and the 30-day period elapses, regardless of whether a lien is filed, the initial IRS contact will be by IRS collection personnel in what is known as the Automated Collection System (ACS). The ACS will provide notice and make demand for payment and try to get as much financial information from the taxpayer as possible to document possible sources for future collection actions. Depending on personnel resources and workload priorities, if ACS cannot resolve the delinquency, it would be assigned to a “queue” of collection cases that would then be assigned to field collection personnel for face-to-face contact. Cases are assigned to the field based on workload priorities. There are maximum caseload inventories for collection personnel, so the case could conceivably sit dormant for a period of time before being assigned to the field. Of course, the collection statute of limitations (10 years from the date of assessment) continues to toll even though the case is not being actively pursued.
Tax lien. Subsequent to the final IRS notice and the expiration of the 30-day period, if the delinquent taxes remain unpaid, the IRS will provide notice of an intent to levy and notice of a Collection Due Process hearing. Typically, the IRS provides taxpayers with notice of each of these steps by sending multiple letters as part of the ACS. Once the last notice is received (it will signify that it is the last) and the unpaid tax balance isn’t paid (or other arrangements aren’t made to pay the balance), the IRS can levy the taxpayer’s income or other assets. This levy power also includes the ability to garnish wages as well as self-employment income and the seizure of bank accounts.
A federal tax lien can be filed with the appropriate office determined by the taxpayer’s residence. Where that lien is filed is determined by state law. In general, filing will be in the office of the County Recorder for the county of the taxpayer’s residence. Once the asserted tax liability reaches a certain point, the filing of the lien is a foregone conclusion and it will likely be an automated process. Where that point is at is discretionary with the IRS, but certainly if the asserted tax liability is $50,000 and greater, a federal tax lien will be filed.
The lien is a general lien and attaches to all property, both personal and real. The lien must be filed in the jurisdiction where the real property is located. Thee lien is good for 10 years from the date of assessment and will not be extended, although exceptions do exist in the event of bankruptcy or mutual agreement between the taxpayer and IRS.
What about a lien on the taxpayer’s personal residence? The likelihood of IRS seizing a personal residence and offering it for sale is extremely small unless, of course, the taxpayer is living an opulent lifestyle. But, unless there are exigent circumstances, there is a virtually no chance that the IRS would take enforcement action against the taxpayer’s personal residence. That’s because there are several layers of authorization that an IRS Revenue Officer must receive to get approval to proceed to enforce a tax lien on a taxpayer’s personal residence by virtue of a tax sale. The IRS simply doesn’t operate like a county does for nonpayment of real estate taxes. The IRS will collect on the lien, however, if the taxpayer sells the residence.
Offers in Compromise
Offer in Compromise (OIC) acceptances, contrary to all the media advertisements, are generally not accepted unless it works to the government’s best interests for collection. When determining whether to compromise a tax debt, the IRS takes into consideration numerous factors. The taxpayer’s age is one of those as it relates to the likelihood that the taxpayer will outlive the collection statute and make payment. In general, the IRS will always determine to what extent the taxpayer has equity in their assets. In general, if the taxpayer has equity in the property that gave rise to the tax liability, that property could be subject to enforcement actions. But, not only must the taxpayer have equity in the property, there must be a market for the property.
The IRS will also see whether the taxpayer has income in excess of necessary living expenses. Those are all factors that the IRS will use to determine an acceptable amount to compromise a tax debt. All of the factors are tied to the likelihood of the ability of the IRS to collect on the tax debt.
Note: The IRS Collection Financial Standards should can be reviewed to help determine what goes into the IRS calculation of the collectability of a tax debt: https://www.irs.gov/businesses/small-businesses-self-employed/collection-financial-standards.
Social Security benefits are subject to levy actions on a monthly basis, but are limited to 15 percent of the individual taxpayer’s Social Security benefit. Disability payments under Social Security are not subject to levy. If the taxpayer has only social security and pension benefits, then it is probably in the taxpayer’s best interest to complete a Collection Information Statement to determine if there is any monthly income after allowable living expenses. If there is, it may be possible for the taxpayer to enter into an installment agreement to pay-off the tax debt. If there is no excess income or assets, the IRS will report the account as “currently not collectible” and the taxpayer’s case would be designated as having a “dormant” status (with the collection statute still running). At the end of 10 years, the lien would be automatically released.
The IRS can also levy pension benefits, but they are limited to allow for necessary living expenses. The amounts of the limitation are generally revised annually to take into account cost of living variations.
Note: The IRS chart for the income exemption from levies can be found at the following link: https://www.irs.gov/pub/irs-pdf/p1494.pdf.
Tax overpayments will almost always be utilized to offset a tax delinquency.
A taxpayer, in general, doesn’t ever want communication from the IRS. That’s especially the case for communication asserting a tax deficiency. But, if it occurs, knowledge of the basics of the IRS collection process is important in order to determine the best course of action to take in getting the alleged tax debt eliminated.
Monday, March 26, 2018
Late last week, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625. This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017. I.R.C. §199A , known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses. However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives. Before the technical correction, those sales generated a tax deduction from gross sales for the seller. But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income. That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected.
The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaces it with the former (pre-2018) I.R.C. §199 for cooperatives. In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated. Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains. The Joint Committee on Taxation estimates that the provision modifying I.R.C. §199A will raise $108 million over the next decade.
Today’s blog post examines the modification to I.R.C. §199A.
The Domestic Production Activities Deduction
In general. I.R.C. §199, the Domestic Production Activities Deduction (DPAD) was enacted as part of the American Jobs Creation Act of 2004 effective for tax years beginning after 2004. While often referred to as a “manufacturing” deduction, the DPAD was available to many businesses including those engaged in agricultural activities. Except for domestic oil-related production activities (for which the deduction is limited to six percent), for tax years beginning after 2009 and before 2018, the DPAD is equal to the lesser of 9 percent of the taxpayer’s qualified production activities income for the year; 9 percent of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI); and 50 percent of the Form W-2 (FICA) wages of the taxpayer for the taxable year. Former I.R.C. §§199(a)(1) and (b)(1). The deduction was from taxable income, subject to an overall limit of 50 percent of current year Form W-2 wages that were associated with qualifying activity employment. The DPAD was allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, it was not allowed in computing SE income, and it could not create a loss.
Pass-Through Entities. In general, the DPAD was not claimed by pass-through entities (such as S corporations, partnerships, estates or trusts) when computing taxable income. Instead, the DPAD was applied at the shareholder, partner or beneficiary level. The pass-through entity would provide the necessary information required to compute the DPAD as a footnote on Schedule K-1. A taxable income limitation applied at the shareholder/partner level with each shareholder/partner separately computing the DPAD on its individual income tax return.
Note: While the DPAD was not claimed by a pass-through entity, estates and trusts were eligible for the DPAD if the income was not passed through to the beneficiaries.
Agricultural Cooperatives. Agricultural cooperatives could also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that were allocable to qualified production activities were deductible from the member’s gross income.
Members of agricultural cooperatives included the DPAD for their distributions from the cooperative. The rules for cooperatives provided in §199(d)(3) and Treas. Reg. §1.199-6 applied to any portion of the DPAD that is not passed through to the cooperative’s patrons. In addition, a cooperative’s qualified production activities income was computed without taking into account any deduction allowable under IRC §1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions.
The TCJA Provision As Applied to Agricultural Cooperatives
For tax years beginning after 2017, the DPAD is repealed. In it place, for taxable years beginning after December 31, 2017, and before January 1, 2026, the TCJA creates (as applied to an agricultural or horticultural cooperative) a deduction equal to the lesser of (a) 20 percent of the excess (if any) of the cooperative’s gross income over the qualified cooperative dividends paid during the taxable year for the taxable year, or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. I.R.C. §199A(g). The cooperative’s section 199A(g) deduction may not exceed its taxable income (computed without regard to the cooperative’s deduction under I.R.C. §199A(g)) for the taxable year.
As for the impact of I.R.C. §199A on patrons of ag cooperatives, effective for tax years beginning after 2017, there is no longer a DPAD that a cooperative can pass through to a patron. However, as noted above, the deduction is 20 percent of the total of payments received from the cooperative (including non-cash qualified patronage dividends). The only limit is 100 percent of net taxable income less capital gains. For sales to a non-cooperative, the deduction is 20 percent of net farm income.
Impact on cooperatives. The provision in the Omnibus bill removes the QBI deduction for agricultural or horticultural cooperatives. In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives. Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts. A cooperative’s DPAD is reduced by any amount passed through to patrons.
Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative.
Note: As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.
Impact on patrons. Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d).
Note: The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.
The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)). What is a qualified payment? It’s any amount that meets three tests: 1) the payment must be either a patronage dividend or a per-unit retain allocations; 2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and 3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative.
An eligible patron cannot be a corporation and cannot be another ag cooperative. In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g). Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons.
Transition rule. A transition rule applies such that the repeal of the DPAD does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018. That type of qualified payment is subject to the pre-2018 DPAD provision, and any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules. In that event, no post-2017 QBI deduction is allowed for those type of qualified payments.
With the technical correction to I.R.C. §199A, where do things now stand for farmers?
- The overall QBI deduction cannot exceed 20 percent of taxable income. That restriction applies to all taxpayers regardless of income. If business income exceeds $315,000 (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation test is phased-in.
- The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses. For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced.
- While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase only for those corporations that would have otherwise triggered a 15 percent rate under prior law.
- For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.
- For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source. Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation ($315,000 MFJ; $157,000 all others).
- For farmers selling to ag cooperatives that also pay W-2 wages, the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the $315,000 threshold (MFJ; $157,500 all others), the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent). If the farmer is above the $315,000 amount (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation. This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income. To this amount is added any pass-through DPAD from the cooperative to produce the total deductible amount.
- For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains. If net farm income exceeds $315,000 (MFJ; $157,500 single), the deduction may be reduced on a phased-in basis.
- The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.
Thursday, March 22, 2018
In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result. Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income. A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040.
Special rules apply to farm NOLs. Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA).
Farm NOLs – The Basics
Carryback rule. Until the changes contained in legislation enacted in late 2017, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years. Those were the rules in place through 2017. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. Whether a loss is carried back two years instead of five depends on the farmer’s level of income in those carryback years and the applicable tax bracket.
Another beneficial rule can apply when an NOL is carried back to a prior year. Because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow the taxpayer to claim future depreciation deductions. This is the case, at least, on the taxpayer’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Taxpayers may elect to forego an NOL carryback in favor of a carryforward (for 20 years). However, if a taxpayer elects not to carry a net operating loss back to offset income in prior years, the taxpayer will be limited to a carryforward of the NOL.
The TCJA and The Impact on Farm NOLs
For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.
An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The NOL carried over from other years may not be used in calculating the NOL for the year in question. In addition, capital losses may not exceed capital gains. Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses. In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.
The TCJA made changes to how farmers can treat NOLs. For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year. For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC. In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form).
Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset). In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). This effective date provision has an immediate impact on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years. Instead, the NOL can only be carried back two years. All other corporate taxpayers can only carry an NOL forward.
Instead, under the TCJA, farmer NOLs can only be carried back two years and all others must be carried forward. NOLs that are carried back can only offset 80 percent of taxable income. However, NOLs that are carried forward will not expire after 20 years (as they did under prior law). Similar to the carryback rule, NOLs that are carried forward can only offset
In the case of a partnership or S corporation, the TCJA applies the NOL rules at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.
Marital Status Changes
There are additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward. In that case, only the spouse who had the loss can claim the NOL deduction. On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss. Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return. The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.
Change in Filing Status
Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years.
NOLs and Death
A NOL that has been carried forward is deductible on a decedent’s final income tax return. It cannot be carried over to a decedent’s estate. Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.
Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow. That's where the NOL rules come into play.
Thursday, March 8, 2018
The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled. The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a). I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs. Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property.
The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with. A recent court decision involving a Colorado grape-growing operation illustrates the difficulty in determining the correct tax classification of expenses.
In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income. Depreciation is required if an asset has a useful life of more than one year. Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible. Instead, those items must be depreciated or amortized over the period of benefit or use. Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.
A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs. Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003). Under these court opinions, engines and transmissions are generally treated as part of the larger machine. This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine). Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction.
In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm. She had lived there off-and-on since 1965, but continuously from 1983 forward. Before the petitioner came into ownership of the property, her father owned it. She cultivated about 700 white French hybrid rind grapevines on a part of the property. In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton. The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers. She grazed animals on other parts of the farm. Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011. Many of those claimed deductible expenses were associated with her grape growing activity. Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized.
Underground water line. In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes. Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure. The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009. More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired. The court determined that the entire water line was replaced at least one time during 2009 and 2010.
The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased. Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010. She claimed to not have the funds in prior years to make repairs in those earlier years.
The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed. The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline. The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe). It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option. The court noted that an analogous situation was present in Hunter v. Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding.
The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses. However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible.
Storage yard. The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard. The storage yard did not previously exist. The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized. The court agreed. It was new construction on top of previously unimproved land and, as such, was an improvement. The associated costs were not currently deductible.
Burn area. In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals. After the fire, it was determined that the fire had made the burned area unable to absorb water. As a result, the petitioner, paid to have burned tree stumps removed along with boulders. The soil of the burned area was cultivated so that the tract could be used for forage. The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return. The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.”
The court agreed with the IRS. The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value. In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business. After the fire, the court noted that the petitioner testified that the entire area would be used as forage. Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized.
The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized. The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.
Monday, February 26, 2018
The “Tax Cuts and Jobs Act” (TCJA) enacted in late 2017, cuts the corporate tax rate to 21 percent. That’s 16 percentage points lower than the highest individual tax rate of 37 percent. On the surface, that would seem to be a rather significant incentive to form a C corporation for conducting a business rather than some form of pass-through entity where the business income flows through to the owners and is taxed at the individual income tax rates. In addition, a corporation can deduct state income taxes without the limitations that apply to owners of pass-through entities or sole proprietors.
Are these two features enough to clearly say that a C corporation is the entity of choice under the TCJA? That’s the focus of today’s post – is forming a C corporation the way to go?
The fact that corporations are now subject to a corporate tax at a flat rate of 21 percent is not the end of the story. There are other factors. For instance, the TCJA continues the multiple tax bracket system for individual income taxation, and also creates a new 20 percent deduction for pass-through income (the qualified business income (QBI) deduction). In addition, the TCJA doesn’t change or otherwise eliminate the taxation on income distributed (or funds withdrawn) from a C corporation – the double-tax effect of C-corporate distributions. These factors mute somewhat the apparent advantage of the lower corporate rate.
Under the new individual income tax rate structure, the top bracket is reached at $600,000 for a taxpayer filing as married filing joint (MFJ). For those filing as single taxpayers or as head-of household, the top bracket is reached at $500,000. Of course, not every business structured as a sole-proprietorship or a pass-through entity generates taxable income in an amount that would trigger the top rate. The lower individual rate brackets under the TCJA are 10, 12, 22, 24, 32 and 35 percent. Basically, up to about $75,000 of taxable income (depending on filing status), the individual rates are lower than the 21 percent corporate rate. So, just looking at tax rates, businesses with relatively lower levels of income will likely be taxed at a lower rate if they are not structured as a C corporation.
As noted, under the TCJA, for tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of business taxable income. However, the deduction comes with a limitation. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. I.R.C. §199A. Architects and engineers can claim the QBI deduction, but other services business are limited in their ability to claim it. For them, the QBI deduction starts to disappear once taxable income exceeds $315,000 (MFJ).
Clearly, the amount of income a business generates and the type of business impacts the choice of entity.
Another factor influencing the choice between a C corporation or a flow-through entity is whether the C corporation distributes income, either as a dividend or when share of stock are sold. The TCJA, generally speaking, doesn’t change the tax rules impacting qualified dividends and long-term capital gains. Preferential tax rates apply at either a 15 percent or 20 percent rate, with a possible “tack-on” of 3.8 percent (the net investment income tax) as added by Obamacare. I.R.C. §1411. So, if the corporate “double tax” applies, the pass-through effective rate will always be lower than the combined rates applied to the corporation and its shareholders. That’s true without even factoring in the QBI deduction for pass-through entities. But, for service businesses that have higher levels of income that are subject to the phase-out (and possible elimination) of the QBI deduction, the effective tax rate is almost the same as the rate applying to a corporation that distributes income to its shareholders, particularly given that a corporation can deduct state taxes in any of the 44 states that impose a corporate tax (Iowa’s stated corporate rate is the highest).
C corporations that have taxable income are also potentially subject to penalty taxes. The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531. The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments. I.R.C. §535. There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment. Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders. This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions. Consequently, this leads to a build-up of earnings and profits within the corporation.
The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year. Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business. So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax. I.R.C. §535(c)(2)(A). However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway. I.R.C. §535(c)(2)(B). But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. That’s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business.
The other penalty tax applicable to C corporations is the PHC tax. I.R.C. §§541-547. This tax is imposed when the corporation is used as a personal investor. The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).
To be a PHC, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources. See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991).
What if the Business Will Be Sold?
If the business will be sold, the tax impact of the sale should be considered. Again, the answer to whether a corporation or pass-through entity is better from a tax standpoint when the business is sold is that it “depends.” What it depends upon is whether the sale will consist of the business equity or the business assets. If the sale involves equity (corporate stock), then the sale of the C corporate stock will likely be taxed at a preferential capital gain rate. Also, for a qualified small business (a specially defined term), if the stock has been held for at least five years at the time it is sold, a portion of the gain (or in some cases, all of the gain) can be excluded from federal tax. Any gain that doesn’t qualify to be excluded from tax is taxed at a 28% rate (if the taxpayer is in the 15% or 20% bracket for regular long-term capital gains). Also, instead of a sale, a corporation can be reorganized tax-free if technical rules are followed.
If the sale of the business is of the corporate assets, then flow-through entities have an advantage. A C corporation would trigger a “double” tax. The corporation would recognize gain taxed at 21 percent, and then a second layer of tax would apply to the net funds distributed to the shareholders. Compare this result to the sale of assets of a pass-through entity which would generally be taxed at long-term capital gain rates.
Use of the C corporation may provide the owner with more funds to invest in the business. Also, a C corporation can be used to fund the owner’s retirement plan in an efficient manner. In addition, fringe benefits are generally more advantageous with a C corporation as compared to a pass-through entity (although the TCJA changes this a bit). A C corporation is also not subject to the alternative minimum tax (thanks to the TCJA). There are also other minor miscellaneous advantages.
So, what’s the best entity choice for you and your business? It depends! Of course, there are other factors in addition to tax that will shape the ultimate entity choice. See your tax/legal advisor for an evaluation of your specific facts.
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.
Monday, February 12, 2018
Although the loss of livestock due to disease does not occur that frequently, when it occurs the loss can be large. Fortunately, the tax Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold on account of weather-related conditions.
Today’s post takes a look at the tax rule for handling sale of livestock on account of disease.
Treatment as an Involuntary Conversion
Gain deferral. Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not lead to taxable gain if the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (in other words, dairy cows for dairy cows, for example) within two years of the close of the tax year in which the diseased animals were sold or exchanged. I.R.C. §1033(d). More specifically, the replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized. I.R.C. §1033(a)(2)(B)(i). In that event, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the new animals must be reduced by the unrecognized gain on the old animals that were either destroyed, sold or exchanged. Treas. Reg. §1.1033(b)-1.
Note: Involuntary conversion treatment is available for losses due to death of livestock from disease. It doesn’t matter whether death results from normal death loss or a disease causes massive death loss. Rev. Rul. 61-216, 1961-2 C.B. 134. In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they have been exposed to disease. Treas. Reg. §1.1033(d)-1.
When is gain recognized? Gain is realized to the extent money or dissimilar property is received in excess of the tax basis of the livestock. For farmers on the cash method of accounting, raised livestock has no tax basis. Therefore, gain is realized upon the receipt of any compensation for the animals. See, e.g., Decoite v. Comr., T.C. Memo. 1992-665. Thus, if there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property. I.R.C. §1033(a)(2)(A). The gain (or loss) is reported on Form 4797. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received). Treas. Reg. 1.1033(a)-2(c)(2). The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the two-year period.
Disease is not a casualty. Under the casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Rev. Rul. 72-592, 1972-2 C.B. 101. Livestock losses because of disease generally would not be eligible for casualty loss treatment because the loss is progressive rather than sudden. Thus, casualty loss treatment under I.R.C. §165(c)(3) does not apply. However, this provision doesn’t apply to losses due to livestock disease. I.R.C. §1033(d). Stated another way, the “suddenness” test doesn’t have to be satisfied to have involuntary conversion treatment apply. See Rev. Rul. 59-102, 1959-1 C.B. 200.
What is a “disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease. Rev. Rul. 59-174, 1959-1 C.B. 203. However, livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules. Rev. Rul. 54-395, 1954-2 C.B. 143.
What qualifies as “replacement animals”? I.R.C. §1033(d) says that if “livestock” are destroyed, sold or exchanged on account of disease then involuntary conversion treatment can apply. But, what is the definition of “livestock” for involuntary conversion purposes? The definition of “livestock” under I.R.C. §1231 applies for involuntary conversion treatment. Treas. Reg. §1.1231-2(a)(3). Under that regulation, “livestock” includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.” It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.” The IRS has ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment. Rev. Rul. 75-381, 1975-2 C.B. 25.
Environmental contamination. If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into non-like-kind farm property or real estate used for farming purposes. I.R.C. §1033(f). A communicable disease may not be considered to be an environmental contaminant. Miller v. United States, 615 F. Supp. 160 (E.D. Ky. 1985).
While the destruction, sale or exchange of livestock on account of disease is uncommon, it does occur. When it does, the financial impact on the farming or ranching business can be substantial. Fortunately, there is a tax rule that helps soften the blow.
Thursday, February 8, 2018
The Spousal Qualified Joint Venture – Implications for Self-Employment Tax and Federal Farm Program Payment Limitations
As noted in Part 1 of this two-part series on the spousal qualified joint venture (QJV), some spousal business ventures can elect out of the partnership rules for federal tax purposes as a QJV. I.R.C. §761(f). In Part 1, I looked at the basics of the QJV election and how it can ease the tax reporting requirements for spousal joint ventures that can take advantage of the election. Today, in Part 2, I look at how the election impacts self-employment tax and, for farmers, eligibility for federal farm program payments.
The QJV Election and Self-Employment Tax
Under I.R.C. §1402(a), net earnings from self- employment are subject to self-employment tax. Net earnings from self-employment are defined as income derived by an individual from any trade or business carried on by such individual. But, real estate rental income is excluded from the general definition of net earnings from self-employment. I.R.C. §1402(a)(1). Thus, for rental property in a partnership (or rental real estate income of an individual), self- employment tax is not triggered.
The QJV election and rental real estate. I.R.C. §1402(a)(17) specifies that when a QJV election has been made, each spouse’s share of income or loss is taken into account as provided for in I.R.C. §761(f) in determining self-employment tax. I.R.C. §761(f)(1)(C) specifies that, “each spouse shall take into account such spouse’s respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor.” That means that the QJV election does not avoid the imposition of self-employment tax.
However, the exception from self-employment tax for rental real estate income remains intact. The IRS instructions to Form 1065 state that if the QJV election is made for a spousal rental real estate business, "you each must report your share of income and deductions on Schedule E. Rental real estate income generally isn’t included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive loss limitation rules. Electing qualified joint venture status doesn’t alter the application of the self-employment tax or the passive loss limitation rules.” See also CCA Ltr. Rul. 200816030 (Mar. 18, 2008).
While the QJV election may not be a problem in a year when a loss results, the self-employment tax complication can be problematic when there is positive income for the year. That’s because it is not possible to simply elect out of QJV treatment in an attempt to avoid self-employment tax by filing a Form 1065. The QJV election cannot be revoked without IRS consent. Likewise, it’s probably not possible to intentionally fail to qualify for QJV status (by transferring an interest in the business to a non-spouse, for example) to avoid self-employment tax in an income year after a year (or years) of reducing self-employment by passed-through losses. Such a move would allow IRS to assert that the transfer of a minimal interest to a disqualified person or entity violates the intent of Subchapter K
Tax Reporting and Federal Farm Program Participation - The "Active Engagement" Test
For farm couples that participate in federal farm programs where both spouses satisfy the “active
engagement” test, each spouse may qualify for a payment limitation. 7 U.S.C. §§1308-1(b); 1308(e)(2)(C)(ii); 1400.105(a)(2). To be deemed to be actively engaged in farming as a separate person, a spouse must satisfy three tests: (1) the spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation; (2) the spouse’s contributions must be “at risk;” and (3) the spouse must make a significant contribution of capital, equipment or land (or a combination thereof) and active personal labor or active personal management (or a combination thereof). For the spouse’s contribution to be “at risk,” there must be a possibility that a non-recoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor or management must be material to the operation to be “significant contribution.” Thus, the spouse’s involvement, to warrant separate person status, must not be passive.
While the active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. That’s because, the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.
What this all means is that for spouses who sign up for two separate payment limitations under the farm programs, they are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear risk of loss.
From a tax standpoint, however, the couple may have a single enterprise the income from which is reported on Form 1040 as a sole proprietorship or on a single Schedule F with the income split into two equal shares for self- employment tax purposes. In these situations, IRS could assert that a partnership filing is required (in common-law property states). That’s where the QJV election could be utilized with the result that two proprietorship returns can be filed. As mentioned above that’s a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return. But, the filing of the QJV election will subject the income of both spouses (including each spouse’s share of government payments) to self-employment tax. That will eliminate any argument that at least one spouse’s income should not be subjected to self-employment tax on the basis that the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for self-employment tax purposes).
Separate “person” status and material participation. Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction is meaningless on the self-employment tax issue according to the U.S. Tax Court.
In Vianello v. Comr., T.C. Memo. 2010-17, the taxpayer was a CPA that, during the years in issue, operated an accounting firm in the Kansas City area. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant would deduct the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one- third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002. Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions with respect to raising and marketing the crop, and paid the petitioner one-third of the net proceeds. As for the pasture, the tenant mowed it and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. Also, the petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003, and bought another 50 acres from in late 2003.
The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year - as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on a reading of IRS Pub. 225 (Farmer’s Tax Guide) that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda grass planting with the tenant. The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules as having satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical cost.
The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active engagement test and was a co- producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…”. The Tax Court specifically noted that the Treasury Regulations under I.R.C. §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard” [emphasis added]. That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or self-employment tax purposes. As noted below, however, the USDA’s determination of participation is not controlling on the IRS.
Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented, and provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for self-employment tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for self-employment tax purposes. The case may also support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes. But that is probably a weaker argument – Vianello did not involve a spousal farming situation.
So, while Vianello may eliminate the need to make a QJV election in spousal farming situations, without the election it is possible that IRS could deem spouses to be in a partnership triggering the requirement to file a partnership return.
The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. That includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. But, the election does not eliminate self-employment tax on each spouse’s share of income.
Wednesday, January 31, 2018
Some taxpayers strive to convert a hobby or minor occupation into a more typical business operation. Doing so doesn’t present any problems with the IRS if the business makes money and, of course, all taxes are properly paid. But, what if the business activity loses money? If the losses stack-up over a length of time (deductions from the activity exceed income), the IRS may take the position that the activity is a hobby that is not engaged in with a profit intent as would be a legitimate business.
What is the consequence of being classified by the IRS as a hobby? Deductions that are attributable to an activity that is not engaged in for profit are significantly limited. I.R.C. §183(a). Certain deductions will remain available because they aren’t tied to whether the activity is a hobby or not. Those include state and local property taxes, home mortgage interest and casualty losses, for example. See Treas. Reg. §1.183-1(d)(2). But, deductions associated with conducting the activity will be limited to the excess of gross income from the activity over those expenses that are deductible regardless of whether the activity is entered into for profit. In addition, for hobby activities, allowed expenses are deducted on Schedule A (Form 1040) as a miscellaneous itemized deduction subject to the 2 percent-of-AGI (adjusted gross income) floor. This is the rule through 2017. For tax years beginning after 2017, there are no deductions against the hobby income due to the elimination of the 2 percent-of-AGI floor. If the activity isn’t a hobby, deductible expenses are business expenses that are deductible (even if they exceed income) on Schedule C. If the activity is a hobby, however, the income is reported as "other income" and is not subject to self-employment tax. But, the critical point is that if an activity is not engaged in for profit, then losses from the activity can’t be used to offset other income.
Note: Where property is used in several activities, and one or more of the activities is determined not to be engaged in for profit, deductions relating to the property must be allocated between the various activities on a reasonable and consistently applied basis. Treas. Reg. §1.183-1(d)(2).
In recent months, indications are that the IRS is pushing the hobby loss rules harder, particularly with respect to farming operations. In early 2017, I wrote about a pilot program that IRS was initiating involving Schedule F expenses for small business/self-employed taxpayer examinations. The program started on April 1, 2017 and will go through March of 2018. The focus will be on “hobby” farmers, and it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F.
The hobby loss rules and farming/ranching operations, that’s the topic of today’s post.
The Hobby Loss Rules
The key question is where the line is drawn between a hobby and a business. In general, as noted above, a “hobby” is any activity that is not engaged in primarily for profit. If a taxpayer’s gross income from an activity exceeds deductions for three or more of the last five years, a presumption arises that the activity is not a hobby. In other words, an activity is presumed to be a business if there are profits for three or more of the last five years. For activities consisting of breeding, training, showing or racing horses, however, the presumption arises if there is a profit in any two out of the last seven years. The IRS can rebut the presumption by carrying the burden of proof and establishing a lack of profit motive. Thus, for farms or ranches operated for pleasure or recreation and not as commercial enterprises, the deduction of expenses is permitted if a profit occurs over a long enough period.
If the presumption does not resolve the issue of whether a farm is being operated for pleasure or recreation and not as a commercial enterprise, a determination must be made as to whether the taxpayer was conducting the activity with the primary purpose and intention of realizing a profit. The expectation of profit need not be reasonable, but there must be an actual and honest profit objective. Whether the requisite intention to make a profit is present is determined by the facts and circumstances of each case with the burden of proof on the taxpayer attempting to deduct the losses. See, e.g., Ryberg v. Comr., T.C. Sum. Op. 2012-24.
Nine-Factor Test of the Regulations
The hobby loss rules won't apply if the facts and circumstances demonstrate that the taxpayer has a profit-making objective. The IRS has developed nine factors) that are to be examined in determining whether the requisite profit motive exists. See, e.g., Treas. Reg. §1.183-2(b).
Business-like manner. The first IRS factor is concerned with the manner in which the activity is conducted. Is the activity being conducted in a manner that demonstrates that the taxpayer had a business purpose in mind, or is the taxpayer really conducting the activity as would be expected of someone engaged in a hobby? For instance, does the taxpayer keep adequate records and use them in a manner that is designed to aid the profitability of the business? See, e.g., Knudsen v. Comm’r, T.C. Memo. 2007–340. If the activity is conducted in a “business-like” manner, with accurate and complete records and books of account, the hiring of experienced supervisors or managers, or the seeking of expert advice, this factor will weigh in the taxpayer’s favor.
Expertise. The second factor focuses on the taxpayer’s expertise. If the taxpayer or an advisor has expertise in the particular agricultural area involved, a profit intent is shown. If, for example, the taxpayer has a small beef herd, does the taxpayer know anything about beef breeding or nutrition? What about health problems, etc.?
Time commitment. The third factor involves an examination of how much time the taxpayer devotes to the activity. Sufficient manual labor by the taxpayer may overcome an IRS argument that the taxpayer was engaged in a hobby operation. The question often boils down to whether the taxpayer put in enough time into the activity to reduce or eliminate successive years’ worth of losses.
Expectation of asset appreciation. The fourth factor recognizes that a realistic expectation of asset appreciation can show an intent to profit overall from the activity. See, e.g., Stromatt v. Comm’r, T.C. Sum. Op. 2011-42
Experience. The sixth factor looks at whether the taxpayer has been involved in a loss venture in the past that was turned around into a profitable venture. With respect to this factor, it is appropriate to examine the history of income on all sides of the activity.
History of income or loss. The sixth factor involves an examination of the history of income or loss from the activity. While start-up losses are to be expected in many ventures, continuing losses beyond the period usually required to achieve profitability may indicate a lack of a profit motive. There must be a prospect, not only for earning future profits, but for profits sufficient to offset losses sustained during the early years of operation. A taxpayer's subjective intent must be demonstrated with objective facts, such as comparing the taxpayer's income and loss numbers to comparable neighboring operations.
Amount of profit. The seventh factor examines the amount of profits earned from the activity. Activities generating large losses that occasionally produce a profit are not necessarily indicative of a profit intent. Also important are whether the only gross receipts are federal farm program payments.
Financial status. If the taxpayer has sufficient non-farm income to maintain a comfortable standard of living even with the losses from the “farming” activity, the factor will weigh in the favor of the IRS.
Elements of recreation and/or pleasure. If a taxpayer derives pleasure or recreational benefits from the activity, this factor will cut in favor of the IRS.
Two recent cases illustrate the application of the hobby loss rules to agricultural activities.
Large losses don’t necessarily negate profit intent. In Welch, et al. v. Comr., T.C. Memo. 2017-229, the taxpayer was a professor that taught at several universities over a 40-year span. In the 1970s he founded a consulting business. In the early 1980s he formed another business that provided software to researchers, and developed a statistical program in 2007 to assist businesses in their hiring practices. In 1987, he purchased an initial 130-acre tract with the original intent to grow hay as a cash crop and to raise some cattle.
Over time, the ranch grew to become a multi-operational, 8,700-acre ranch with 25 full-time employees. The ranch also had a vet clinic that provided services for large and small animals. In addition, the ranch had a trucking operation and owned numerous 18-wheel trucks that were used to move cattle and hay around the ranch and to transport cattle to and from market and perform backhauls. The ranch also conducted timber operations and employed a timber manager.
The taxpayer subscribed to numerous professional publications, and changed the type of cattle that the ranch raised to increase profitability. Steadily increasing herd size. The hay operation was also modified to maximize profitability due to weather issues. In addition, the ranch built its own feed mill that was used to chopping and dry storage of the hay. In 2003, the taxpayer also started construction of a horse center as part of the ranch headquarters, including a breeding facility that operated in tandem with the veterinary clinic. Ultimately, the taxpayer’s horses were entered in cutting competitions, with winnings increasing annually from 2007 to 2010.
The IRS issued notices of deficiency for 2007-2010. For those years, the taxpayer had total losses of approximately $15 million and gross income of approximately $7 million. Also, for those years, the taxpayer’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income.
The Tax Court determined that all of the taxpayer’s activities were economically intertwined into a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations favored the IRS. Accordingly, the taxpayer’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated.
Reasonable jury could find profit intent. In Wicks v. United States, No. 16-CV-0638-CVE-FHM, 2018 U.S. Dist. LEXIS 9352 (N.D. Okla. Jan. 22, 2018), the plaintiff owned and operated a company that provided mechanical inspection services for major oil refineries and gas plants. That business was quite profitable. In addition to his business, the plaintiff, in the late 1990’s, started in the cattle business when he bought 80 acres of land containing a dilapidated barn and unusable fence. He repaired the fence and barn and purchased two longhorn heifers, built a new barn, bought and adjacent 180-acre tract so he could increase the herd to make the venture ultimately profitable, and improved the entire property by replacing fence, enlarging an existing pond, installing rural water and constructing a cattle working facility and loafing shed. The plaintiff also consulted with a successful local rancher regarding profitable methods of cattle ranching. He also purchased 20 cows to crossbreed so as to produce quality milk and beef, knowing that obtaining a crossbreed would take at least four years. The plaintiff also purchased new hay baling equipment and feed bins.
The plaintiff performed all of the labor and spent three to four days weekly working on the ranching activity. However, the cattle ranching activity never showed a year of profitability, with total gross receipts from 1997 through 2015 totaling $32,602 and net losses totaling $807,380. The plaintiff did not establish a written business plan or have any written financial projections, and did not use any accounting software or form a business entity for the cattle operation, although he did use a spreadsheet to track his expenses. He also did not market or promote the cattle operation, insure the herd against catastrophic loss or consult a financial advisor. Before 1997, the plaintiff’s only experience with cattle was feeding and working them as a child. He sold cattle in 2013, after the cattle market had rebounded from prior lows, and also attended seminars on cattle breeding and pasture management and read as much as he could about raising cattle. He also joined two different state cattlemen’s associations.
For 2010 and 2011, the IRS denied the loss deductions from the plaintiff’s cattle ranching activity, and assessed penalties with the total amount of tax and penalties (including interest) due being $89,838.09. The plaintiff paid the deficiency (plus interest) and sued for a refund, claiming that he engaged in the cattle ranching activity with profit intent). The IRS moved for summary judgment, arguing that the activity was not engaged in for profit and the resulting losses were non-deductible under the hobby loss rules of I.R.C. §183. On an evidentiary question, the court allowed tax return information from post-2011 years into evidence because it was relevant in showing whether the plaintiff had a profit intent for the tax years in issue. The court also allowed into evidence testimony of an ag economist for the plaintiff to the extent the testimony bore on economic conditions and their impact on the plaintiff’s cattle ranching activity.
The court examined each of the nine factors in the regulations and ultimately determined that, based on the totality of the circumstances, and viewing the evidence in the light most favorable to the plaintiff, a reasonable jury could conclude that the plaintiff engaged in the cattle ranching activity with a profit intent. The court denied the IRS motion for summary judgment.
The IRS is looking closely at agricultural activities that it believes might be a hobby. Operating the activity in conformity with the regulations is a must for maintaining full deductibility of expenses associated with the activity.
Monday, January 29, 2018
The Economic Recovery Tax Act of 1981 introduced the “Credit for Increasing Research Activities.” The credit is better known as the research and development credit, or simply the “R&D” credit. It’s a general business credit that, for a business with under $50 million in average annual gross receipts, offsets both regular tax and alternative minimum tax. For certain defined smaller businesses, it can offset the employer portion of Social Security taxes up to $250,000 (with some limitations). The purpose of the credit as enacted is still the same today – to incentivize research and experimentation by providing a tax credit for activities that develop a new component of a taxpayer’s business or improve an existing component’s performance, functionality, reliability or quality. I.R.C. §41(d)(3)(A).
While the credit is available to a wide array of businesses, including farming businesses, what is the scope of its application? Does it apply to a farmer that utilizes cover crops or installs a bioreactor? What about a farmer that uses nitrification inhibitors? If the farmer receives a cost-share amount from the government, does that impact the ability to claim the R&D credit?
Today’s post takes a look at the R&D credit and its potential application to farming and ranching operations.
Mechanics of The Credit
As noted above, the R&D credit applies to activities (including research and software development) that develop a new business component or improve an existing component’s performance, functionality, reliability or quality. Treas. Reg. §1.41-4(a). What is a business component? It’s “any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license,” or which is used by the taxpayer in the taxpayer’s trade or business. An activity qualifies for the credit by means of a four-part test: (1) the activity must develop or improve the functionality, quality, etc., of a business component; (2) the activity must rely on technological principles; (3) substantially all of the activity must employ a process of experimentation that is designed to evaluate one or more alternatives; and (4) the process of experimentation must be designed to eliminate uncertainty (regarding the company’s capability, methodology, or appropriateness of design of a business component). I.R.C. §41(d).
Expenses that are incurred with respect to a qualified activity are used to compute the R&D credit and are termed “qualified research expenditures” (QREs). QREs can result for in-house activity as well as expenses incurred via contract. For in-house activity, QRE includes W-2 wages paid to employees that are either directly involved in an activity (including research) that develops a new business component, or supervise it or support it, as well as the cost of supplies and payments for qualified services (e.g., consultants and engineers). I.R.C. §41(b); see also Suder v. Comr., T.C. Memo. 2014-201.
Note: Under certain federal farm programs, especially those programs designed to provide environmental benefits, the USDA shares in part of the expense associated with complying with the program. While the expense associated with establishing a conservation/environmental structure/program on the farm might otherwise qualify as a QRE, the portion that the government subsidizes (via I.R.C. §126) would not be a QRE because the taxpayer did not incur the cost. In addition, as noted below, qualified expenses would be limited to a test plot rather than applying to expenditures incurred for the entire farm.
Once the qualified activities and QREs are determined, the credit is six percent of eligible expenses for each of the first three years that qualified research activities are conducted. I.R.C. §41(c)(5)(B)(ii). After that, the alternative simplified method that sets the R&D credit at 14 percent of the excess of QREs for the tax year over 50 percent of the average QREs for the three preceding tax years multiplied by 65 percent (factoring in a reduction via I.R.C. §280C). I.R.C. §§41(c)(5); I.R.C. §41(h).
Bill is trying to determine his R&D credit for 2018. Assume that Bill incurs QREs of $50,000 in 2015; $62,500 in 2016 and $75,000 in 2017. The average over those three years is $62,500. 50 percent of that three-year average is $31,250. For 2017, he incurred $75,000 of QREs. From that amount, Bill subtracts 50 percent of the average QREs for the prior three years, or $31,250. That amount is then multiplied by 14 percent (.14 x $31,250 = $4,375). The $4,375 amount is then multiplied by 65 percent (the I.R.C. §280C credit reduction), which yields an R&D credit of $2,843.75.
The R&D credit is claimed on Form 6765 and the associated instructions are instrumental in properly computing the credit and completing Form 6765 properly.
If a farmer doesn’t incur at least the level of QREs that Bill did in the example, it may not be worth the extra recordkeeping and tax preparation cost of claiming the credit.
As an additional point, for privately held businesses that have $50 million or less in average gross receipts for the three preceding tax years can use the R&D credit to offset the alternative minimum tax. Also, start-up companies, or those with less than $5 million in gross receipts for the current tax year and no gross receipts for the five preceding years may use R&D credits against their payroll tax liability up to $250,000.
Application to Agriculture
As noted above, the R&D credit applies costs incurred associated with research to develop new products or improve existing ones. It’s important that the research involves technological information or some sort of application that is intended to develop new or improved business products or processes. It’s also important that the research activities have a process of experimentation that relates to a new or improved function, performance, reliability, efficiently or quality.
So what kind of research activities on a farm will generate qualified expenses for the R&D credit? It is those research activities that are new to the farm and involves testing of something before it can be used on a larger scale. For farmers, the credit could potentially have a wide application – farmers often are “tinkering” or investigating ways to improve productivity or efficiency of crop and/or livestock production. Common examples might include testing new fungicides and seed treatment in an attempt to control insect disease; testing precision planting equipment in an effort to find ways to increase efficiency and/or yield; experimenting with organic fertilizer or with a with a cover crop to determine the impact on soil fertility and/or soil erosion; trying new cultivation techniques such as strip tillage; experimenting with irrigation and drainage and determining the impact on soil productivity and/or erosion; coming up with new weed/pest management techniques; experimenting with crop genetics; testing various planting dates, plant population, and row spacing to determine the impact on plant growth and development; testing combines and other harvesting equipment to minimize crop waste and/or decrease harvest time; working on customized animal feed formulations; developing customized software; researching and designing new grain bins. The list could go on, but you get the point.
The R&D credit can have a broad application to many activities that occur on a farm or ranch. But, don’t expect the IRS to allow the R&D credit to be applied to the whole farm. The credit is for research and development – in other words something that would occur in a laboratory. The entire farm is not a laboratory, but a test plot is. It is likely that the IRS will argue that the qualified research activities (which give rise to QREs) would have to occur in a test plot, with expenses (including qualified wages, and the cost of chemicals, fertilizer, seed, etc.) allocated to the specific area of the test plot. That will result in a small number for most farmers, especially in the Midwest. Higher value crops, such as potatoes, onions and fruits, might have bigger numbers, but the point remains that the QREs (and, hence the R&D credit) must be associated with a test plot and not the entire farm.
Thursday, January 25, 2018
A taxpayer can elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenses paid or incurred in connection with a trade or business. This is I.R.C. §174. The R&D credit, computed based upon qualified research expenditures, is a general business tax credit which reduces tax liability (rather than reducing taxable income), if allowed. I.R.C. §41.
Can farmers use the credit? Does it apply for the “testing” of chemicals and fertilizers on crops? If so, the credit could be a very valuable tax planning tool. That’s particularly the case because the credit offsets alternative minimum tax (AMT) and can also offset payroll tax in lieu of income tax (if certain tests are met). Does the recently enacted Tax Cuts and Jobs Act (TCJA) assist farming operations in utilizing the credit?
The benefit from R&E expenditures in farming operations – that’s the topic of today’s post.
Deductions for R&E Expenses
Under prior law, taxpayers could elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenditures paid or incurred in connection with a trade or business. Instead of making the election, a taxpayer could forgo a current deduction, capitalize their research expenses, and recover them ratably over the useful life of the research, up to five years. Alternatively, an election could be made to recover them over a period of 10 years. By doing so, the taxpayer would avoid AMT preferences and adjustments.
Generally, no current deduction under I.R.C. §174 is allowable for expenditures for the acquisition or improvement of land or of depreciable or depletable property used in connection with any research or experimentation. In addition, no current deduction is allowed for research expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.
What is qualified research? It’s basically related to developing a product that can be used in the taxpayer’s trade or business. It’s an activity or project that a taxpayer undertakes to create a new or improved component of the taxpayer’s business utilizing a systemic experimentation process that relies on principles of physical or biological sciences, engineering or computer science that is designed to evaluate one or more alternatives to achieve a result that was uncertain when the research activity began.
R&E Expenses under the TCJA?
The TCJA specifies that for amounts paid or incurred in tax years beginning after Dec. 31, 2021, “specified R&E expenses” incurred in the United States must be capitalized and amortized ratably over a 5-year period beginning with the midpoint of the tax year in which the specified R&E expenses were paid or incurred. TCJA, Sec. 13206, amending I.R.C. §174. In addition, it’s treated as a change in the taxpayer's accounting method (I.R.C. §481) initiated by the taxpayer, and made with IRS's consent. If the expenses are incurred in tax years beginning after Dec. 31, 2025, the provision is applied on a cutoff basis. That means that there would be no adjustment under I.R.C. §481(a) for expenses paid or incurred in tax years that begin before 2026.
So, in essence there isn’t any change in the mix for the R&E expenditures until 2022.
Application to Farming and Ranching Operations
Ag businesses deduct R&E expenditures every year, as farmers experiment with different chemicals and fertilizers, the benefit of which depend upon weather, soil types and hardiness of the plants. Expenses associated with product development activities can count, and they may also generate an R&D credit. Over the years, numerous products have been created by innovations developed by a farmer or rancher. Expenses associated with innovative activities that develop a new business product are deductible R&E expenditures, even though the innovations provide future benefits. That can also apply to activities that develop a new chemical that can be applied to seed or crops that enhances productivity. In short, due to the R&E expenditures, the farmer doesn’t need to determine if the expense provides only a current benefit, or a benefit that may last into the future. That’s what I.R.C. §174 is all about: allowing current deductions for researching better ways of doing things.
For farmers, researching and experimenting with different products and procedures generates current tax deductions. The R&D credit is another provision and the topic of my next post.
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.