Monday, August 13, 2018
As a result of the Tax Cuts and Jobs Act (TCJA), for tax years beginning after 2017 and before 2026, a non C corporate business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the taxpayer’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States. I.R.C. 199A. The QBID replaces the DPAD, which applied for tax years beginning after 2004. The TCJA repealed the DPAD for tax years beginning after 2017.
The basic idea behind the provision was to provide a benefit to pass-through businesses and sole proprietorships that can’t take advantage of the lower 21 percent corporate tax rate under the TCJA that took effect for tax years beginning after 2017 (on a permanent basis). The QBID also applies to agricultural/horticultural cooperatives and their patrons.
Last week, the Treasury issued proposed regulations on the QBID except as applied to agricultural/horticultural cooperatives. That guidance is to come later this fall. The proposed regulations did not address how the QBID applies to cooper
The proposed regulations for the QBID – that the topic of today’s post.
The QBI deduction (QBID) is subject to various limitations based on whether the entity is engaged manufacturing, producing, growing or extracting qualified property, or engaged in certain specified services (known as a specified service trade or business (SSSB)), or based on the amount of wages paid or “qualified property” (QP) that the business holds. These limitations apply once the taxpayer’s taxable income exceeds a threshold based on filing status. Once the applicable threshold is exceeded the business must clear a wages threshold or a wages and qualified property threshold.
Note: If the wages or wages/QP threshold isn’t satisfied for such higher-income businesses, the QBID could be diminished or eliminated.
What is the wage or wage/QP hurdle? For farmers and ranchers (and other taxpayers) with taxable income over $315,000 (MFJ) or $157,500 (other filing statuses), the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all QP. But those limitations don’t apply if the applicable taxable income threshold is not met. In addition, the QBID is phased out once taxable income reaches $415,000 (MFJ) or $207,500 (all others).
On August 8, the Treasury issued proposed regulations on the QBID. Guidance was needed in many areas. For example, questions existed with respect to the treatment of rents; aggregation of multiple business activities; the impact on trusts; and the definition of a trade or business, among other issues. The proposed regulations answered some questions, left some unanswered and raised other questions.
Rental activities. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations do confirm that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s the case if the rental is between “commonly controlled” entities – defined as common ownership of 50 percent or more in each entity (e.g., between related parties). This part of the proposed regulations is generous to taxpayers, and will be useful for many rental activities. It’s also aided by the use of I.R.C. §162 for the definition of a “trade or business” as opposed to, for example, the passive loss rules of I.R.C. §469.
But, the proposed regulations may also mean that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation is correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.
The proposed regulations use an example or a rental of bare land that doesn’t require any cost on the landlord’s part. This seems to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. There is another example in the proposed regulations that also seems to support this conclusion. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. That means it may be crucial to be able to aggregate (group) those activities together.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations creates confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also states that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, does that mean that those separate rental activities can’t be aggregated (discussed below) unless each rental activity is a trade or business? If the Treasury is going to be making the trade or business determination on an entity-by-entity basis, triple net leases might be problematic.
Perhaps the final regulations will clarify whether rentals, regardless of the lease terms, will be treated as a trade or business (and can be aggregated).
Aggregation of activities. Farmers and ranchers often utilize more than a single entity for tax as well as estate and business planning reasons. The common technique is to place land into some form of non C corporate entity (or own it individually) and lease that land to the operating entity. For example, many large farming and ranching operations have been structured to have multiple limited liability companies (LLCs) with each LLC owning different tracts of land. These operations typically have an S corporation or some other type of business entity that owns the operating assets that are used in the farming operation. It appears that these entities can be grouped under the aggregation rule. For QBID purposes (specifically, for purposes of the wages and qualified property limitations) the proposed regulations allow an election to be made to aggregate (group) those separate entities. Thus, the rental income can be combined with the income from the farming/ranching operation for purposes of the QBID computation. Grouping allows wages and QP to also be aggregated and a single computation used for purposes of the QBID (eligibility and amount). In addition, taxpayers can allocate W2 wages to the appropriate entity that employs the employee under common law.
Note: The wages and QP from any trade or business that produces net negative QBI is not taken into account and is not carried over to a later year. The taxpayer has to offset the QBI attributable to each trade or business that produced net positive QBI.
Without aggregation, the taxpayer must compute W-2 wages for each trade or business, even if there is more than one within a single corporation or partnership. That means a taxpayer must find a way to allocate a single payroll across different lines.
To be able to aggregate businesses, they must meet several requirements, but the primary one is that the same person or group of persons must either directly or indirectly own 50 percent or more of each trade or business. For purposes of the 50 percent test, a family attribution rule applies that includes a spouse, children, grandchildren and parents of the taxpayer. However, siblings, uncles, and aunts, etc., are not within the family attribution rule. To illustrate the rule, for example, the parents and a child could own a majority interest in three separate businesses and all three of those businesses could be aggregated. But, the bar on siblings, etc., counting as "family" is a harsh rule for agricultural operations in particular. Perhaps the final regulations will modify the definition of "family."
Note: A ”group of persons” can consist of unrelated persons. It is important that the “group” meet the 50 percent test. It is immaterial that no person in the group meets the 50 percent test individually.
Common ownership is not all that is necessary to be able to group separate trade or business activities. The businesses to be grouped must provide goods or services that are the same or are customarily offered together; there must be significant centralized business elements; and the businesses must operate in coordination with or reliance upon one another. Meeting this three-part test should not be problematic for most farming/ranching operations, but there is enough "wiggle room" in those definitions for the IRS to create potential issues.
Once a taxpayer chooses to aggregate multiple businesses, the businesses must be aggregated for all subsequent tax years and must be consistently reported. The only exception is if there is a change in the facts and circumstances such that the aggregation no longer qualifies under the rules. So, disaggregation is generally not allowed, unless the facts and circumstances changes such that the aggregation rules no longer apply.
Losses. If a taxpayer’s business shows a loss for the tax year, the taxpayer cannot claim a QBID and the loss carries forward to the next tax year where it becomes a separate item of QBI. If the taxpayer has multiple businesses (such as a multiple entity farming operation, for example), the proposed regulations require a loss from one entity (or multiple entities) to be netted against the income from the other entity (or entities). If the taxpayer’s income is over the applicable threshold, the netting works in an interesting way. For example, if a farmer shows positive income on Schedule F and a Schedule C loss, the Schedule C loss will reduce the Schedule F income. The farmer’s QBID will be 20 percent of the resulting Schedule F income limited by the qualified wages, or qualified wages and the QP limitation. Of course, the farmer may be able to aggregate the Schedule F and Schedule C businesses and would want to do so if it would result in a greater QBID.
Note: A QBI loss must be taken and allocated against the other QBI income even if the loss entity is not aggregated. However, wages and QP are not aggregated.
If the taxpayer had a carryover loss from a pre-2018 tax year, that loss is not taken into account when computing income that qualifies for the QBID. This can be a big issue if a taxpayer had a passive loss in a prior year that is suspended. That's another taxpayer unfriendly aspect of the proposed regulations.
Trusts. For trusts and their beneficiaries, the QBID can apply if the $157,500 threshold is not exceeded irrespective of whether the trust pays qualified wages or has QP. But, that threshold appears to apply cumulatively to all trust income, including the trust income that is distributed to trust beneficiaries. In other words, the proposed regulations limit the effectiveness of utilizing trusts by including trust distributions in the trust’s taxable income for the year for purposes of the $157,500 limitation. Prop. Treas. Reg. §1.199A-6(d)(3)(iii). This is another taxpayer unfriendly aspect of the proposed regulations.
Based on the Treasury's position, it will likely be more beneficial for parents, for example, for estate planning purposes, to create multiple trusts for their children rather than a single trust that names each of them as beneficiaries. The separate trusts will be separately taxed. The use of trusts can be of particular use when the parents can't utilize the QBID due to the income limitation (in other words, their income exceeds $415,000). The trusts can be structured to qualify for the QBID, even though the parents would not be eligible for the QBID because of their high income. However, the proposed regulations state that, “Trusts formed or funded with a significant purpose of receiving a deduction under I.R.C. §199A will not be respected for purposes of I.R.C. §199A.” Again, that's a harsh, anti-taxpayer position that the proposed regulations take.
Under I.R.C. §643(f) the IRS can treat two or more trusts as a single trust if they are formed by substantially the same grantor and have substantially the same primary beneficiaries, and are formed for the principle purpose of avoiding income taxes. Does the statement in the proposed regulations referenced above mean that the Treasury is ignoring the three-part test of the statute? By itself, that would seem to be the case. However, near the end of the proposed regulations, there is a statement reciting the three-part test of I.R.C. §643(f). Prop. Treas. Reg. §1.643(f)-1). Hopefully, that means that any trust that has a reasonable estate/business planning purpose will be respected for QBID purposes, and that multiple trusts will not be aggregated that satisfy I.R.C. §643(f). Time will tell what the IRS position on this will be.
Unfortunately, the proposed regulations do not address how the QBID is to apply (or not apply) to charitable remainder trusts.
Here are a few other observations from the proposed regulations:
- Guaranteed payments in a partnership and reasonable compensation in an S corporation are not qualified wages for QBID purposes.
- Inherited property that the heir immediately places in service gets a fair market value as of date of death basis, but the proposed regulations don’t mention whether this resets the property’s depreciation period for QP purposes (as part of the 2.5 percent computation).
- For purposes of the QP computation, the 2.5 percent is multiplied by the depreciated basis of the asset on the day it is transferred to an S corporation, for example, but it’s holding period starts on the day it was first used for the business before it is transferred.
- A partnership’s I.R.C. §743(b) adjustment does not count for QP purposes. In other words, the adjustment does not add to UBIA. Thus, the inheritance of a fully depreciated building does not result in having any QP against which the 2.5 percent computation can be applied. That's a harsh rule from a taxpayer's standpoint.
- R.C. §1231 gains are not QBI. But, any portion of an I.R.C. §1231 gain that is taxed as ordinary income will qualify as QBI.
- Preferred allocations of partnership income will not qualify as QBI to the extent the allocation is for services. This forecloses a planning opportunity that could have been achieved by modifying a partnership agreement to provide for such allocations.
The proposed regulations are now subject to a 45-day comment period with a public hearing to occur in mid-October. The proposed rules do not have the force of law, but they can be relied on as guidance until final regulations are issued. From a practice standpoint, rely on the statutory language when it is more favorable to a client than the position the Treasury has taken in the proposed regulations.
Numerous questions remain and will need to be clarified in the final regulations. The Treasury will be hearing from the tax section of the American Bar Association, the American Institute of CPAs, other tax professionals and other interested parties. Hopefully, some of the taxpayer unfavorable positions taken in the proposed regulations can be softened a bit in the final regulations. In addition, it would be nice to get some guidance on how the rules will apply to cooperatives and their patrons.
Also, this post did not exhaust all of the issues addressed in the proposed regulations, just the one that are most likely to apply to farming and ranching businesses. For example, a separate dimension of the proposed regulations deals with “specialized service businesses.” That was not addressed.
Friday, August 3, 2018
The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under IRC §179 to $1 million. The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017. The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018.
Is property held in trust eligible to be expensed under I.R.C. §179? That’s a big issue for farm and ranch families (and others). Trusts are a popular part of many estate and business plans, and if property contained in them is not eligible for I.R.C. §179 their use could be costly from an income tax standpoint.
Trusts and eligibility for I.R.C. §179 - that’s the topic of today’s post.
Does the Type of Trust Matter?
I.R.C. §179(d)(4) states that an estate or trust is not eligible for I.R.C. §179. That broad language seems to be all inclusive – all types of trusts and in addition to estates are included. If that is true, that has serious implications for estate planning for farmers and ranchers (and others). Revocable living trusts are a popular estate planning tool in many estate planning situations, regardless of whether there is potential for federal estate tax. If property contained in a revocable trust (e.g., a “grantor” trust) is not eligible for I.R.C. §179, that can be a significant enough income tax difference that would mean that the estate plan should be changed to not utilize a revocable trust.
Grantor trusts. A grantor trust is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust. Because of this retained power, the trust's income is taxable to the grantor. From a tax standpoint, the grantor is treated as the owner of the trust with the result that all items of income, loss, deduction and credit flowing through to the grantor during the period for which the grantor is treated as the owner of the trust. I.R.C. §671; Treas. Reg. § 1.671-3(a)(1); Rev. Rul. 57-390, 1957-2 C.B. 326. Another way of stating the matter is that a grantor trust is a disregarded entity for federal income tax purposes. C.C.A. 201343021 (Jun. 17, 2013). Effectively, the grantor simply treats the trust property as their own.
This is the longstanding position of the IRS. In Rev. Rul 85-13, 1985-1 C.B. 184, the IRS ruled that a grantor of a trust where the grantor retains dominion and control resulted in the grantor being treated as the trust owner. In other words, a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under I.R.C. §§671-677. In the ruling, the IRS determined that a transfer of trust assets to the grantor in exchange for the grantor's unsecured promissory note did not constitute a sale for federal income tax purposes. The facts of the ruling are essentially the same as those at issue in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984). In Rothstein, while the court found the trust at issue to be a grantor trust, the court concluded that the trust was separate from the taxpayer. But, in the 1985 ruling based on the same facts, the IRS stated that it would not follow Rothstein and reasserted its position that a taxpayer is deemed to own the assets contained in a grantor trust for federal tax purposes.
Thus, there is substantial authority for the position that property contained in a grantor trust, such as a revocable living trust, is eligible for expense method depreciation under I.R.C. §179. The grantor is the same thing for tax purposes as the grantor trust.
Irrevocable trusts. An irrevocable trust can't be modified or terminated without the beneficiary's permission. The grantor, having transferred assets into the trust, effectively removes all rights of ownership to the assets and control over the trust assets. This is the opposite of a revocable trust, which allows the grantor to modify the trust. That means that an irrevocable trust is a different entity from the taxpayer and the property contained in the trust is not eligible for expense method depreciation under I.R.C. §179 pursuant to I.R.C. §179(d)(4), unless the grantor retains some degree of power over trust income or assets. For instance, a common situation when an irrevocable trust will be treated by the IRS as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property. The same result occurs when the grantor retains any significant level of administrative control over the trust such as discretionary authority to distribute trust property to the grantor or the power to borrow money from the trust without paying a market rate of interest.
Pass-Through Entities and Irrevocable Trusts
The 20 percent deduction for qualified business income under I.R.C. §199A in effect for tax years beginning after 2017 and before 2026 for taxpayers with business income that are not C corporations, may spark increased interest in pass-through entities. With respect to a pass-through entity, though, questions concerning the use of I.R.C. §179 arise when an irrevocable trust has an ownership interest in the entity. Under Treas. Reg. § 1.179-1(f)(3), a trust that is a partner or S corporation shareholder is barred from deducting its allocable share of the I.R.C. §179 depreciation that is elected at the entity level. The pass-through entity’s basis in the I.R.C. §179 property is not reduced to reflect any portion of the I.R.C. §179 expense that is allocable to the trust or estate. Consequently, the entity claims a regular depreciation deduction under I.R.C. §168 with respect to any depreciable basis that results from the inability of a non-grantor irrevocable trust or the estate to claim its allocable portion of the I.R.C. §179 depreciation. Id. The irrevocable trust or estate does not benefit from the entity’s I.R.C. §179 election.
A revocable living trust, as a grantor trust, can claim I.R.C. §179 depreciation. Thus, that common estate planning vehicle won’t present an income tax planning disadvantage by taking I.R.C. §179 depreciation off of the table. However, when an irrevocable trust is involved, the result is different, unless the trust contains language that gives the grantor sufficient control over trust income or assets. Business property that is contained in an irrevocable trust is generally not eligible for I.R.C. §179 depreciation. But, trust language may change that general result. In addition, if a pass-through entity claims I.R.C. §179 depreciation, none of that depreciation flows to the irrevocable trust (or estate). That means that the entity will need to make special basis adjustments so that the deduction (or a portion thereof) is not wasted. Likewise, the depreciation should be “separately stated items” on the K-1 whenever an irrevocable trust or an estate owns an interest in the entity. Likewise, existing partnership agreements may need to be modified so that I.R.C. §179 deductions are allocated to non-trust partners and other expenses to owners of interests that are irrevocable trusts and estates.
This potential difference in tax treatment between revocable grantor trusts and irrevocable trusts should be considered as part of the overall tax planning and estate/business planning process.
Wednesday, August 1, 2018
Naming one person to receive the income and/or use of property until death and naming another person to receive ultimate ownership of the property is done for various reasons. One primary reason is to allow one person (or persons) to have the use of property during life and then have someone else own the property after the life estate expires. Life estate/remainder arrangements are also used for estate tax planning purposes. In that instance, the intent of the person creating the life estate/remainder arrangement is to effectively use the estate tax exemptions of both the husband and wife.
The life estate/remainder arrangement also raises some tax issues. One of those issues concerns the income tax basis of the property that is the subject of the arrangement. The cost basis of inherited property is almost always the fair market value of the property as of the testator's date of death. However, what is the income tax basis of property when the various rights to the property are not owned by the same people?
Income tax basis issues associated with property subject to a life estate/remainder arrangement. That’s the subject of today’s post.
The general rule is that property is valued in a decedent’s gross estate at its fair market value as of the date of the decedent’s death. I.R.C. §1014. It is that fair market value that determines the basis of the property in the hands of the recipient of the property. That’s fairly simple to understand when the decedent owns the entire property interest at death. However, that’s not the case with property that is held under a life estate/remainder arrangement. In that situation, the remainder holder does not benefit from the property until the life tenant dies. That complicates the income tax basis computation.
Uniform basis. The general idea of uniform basis is that the cost basis of inherited property should equal the value used for estate tax purposes. The new cost basis after death is usually referred to as the “stepped-up” basis, although the new basis can be lower than the original cost. As noted above, it’s tied to the property’s fair market value as of the date of death for purposes of inclusion in the decedent’s estate. The regulations state that the basis of property acquired from a decedent is uniform in the hands of every person having an interest in the property. Treas. Reg. §1.1014-4. As explained in the regulations, under the laws governing transfers from decedents, all ownership interests relate to the death of the decedent, whether the interests are vested or contingent. That means that there is a common acquisition date and a common basis for life tenants and remainder holders.
The uniform basis rule is easy to implement after the death of the life tenant, as shown in the following example.
Example. Boris leaves his entire estate to his son, Rocky, as a remainder holder. However, all income from the estate is payable to his wife, Natasha, until her death. The value of the property is $200,000 at the time of his death.
Natasha collects the income from the inherited property for 20 years. When she dies, the appreciated value of the property is $500,000.
When Natasha dies, Rocky becomes the sole owner of both the property and the future income. However, because Rocky's ownership of the property is based initially on his father's death, Rocky's basis is $200,000 - the value at the time his father died.
The result of the example makes sense when you consider that the value of the life estate interest is excluded from Natasha’s estate. Because it was excluded from her estate, there is not basis step-up in Rocky’s hands – the person who receives the right to the income after Natasha dies.
If the inherited property is subject to depreciation, the holder of the life interest is allowed to claim the depreciation expense attributable to the entire inherited basis of the depreciable property.
Sale of the Life Estate Interest
The basis rules change dramatically for the holder of a life estate interest if the rights to the income are sold without the remainder interest being sold as part of the same transaction. If the life interest is sold separately, the seller's basis for tax purposes is $0. I.R.C. 1001(e). The buyer of the life interest can amortize the cost of the purchase over the life expectancy of the seller.
Example. Bill leaves a life interest in stock to his neighbor, Dale, and a remainder interest to another neighbor, Bobbi. The value of the stock for estate tax purposes is $5,000 at the time Bill dies. Dale immediately sells his life interest to LuAnn for $100.
Dale's cost basis in his life interest is $0. Dale reports the gain of $100 on Schedule D, Capital Gains and Losses, as a long-term capital gain. I.R.C. §1223(10). This transaction has no effect on the uniform basis. The cost basis allocable to Bobbi's remainder interest will continue to increase each year as the life interest's value decreases. Treas Reg. §1-1014. LuAnn is entitled to subtract a portion of the $100 she paid Dale each year against her dividend income. The subtraction is based upon Dale's life expectancy at the time of the sale. Treas. Reg. 1.1014-5(c).
Technically, there is no authority directing LuAnn where.to include this subtraction on her return. The conservative approach is to include it in investment expense on Schedule A, Itemized Deductions. An aggressive approach is to treat it in the same way as premiums paid for bonds, which is as a subtraction on Schedule B, Interest and Ordinary Dividends.
Death of the Remainder Holder
If the holder of the remainder interest dies before the holder of the life interest, the uniform basis is not adjusted and the life tenant's basis is still calculated as explained previously.
However, the value of the remainder interest is included in the estate of the remainder holder. The regulations, therefore, allow the beneficiary of the remainder holder's estate to adjust the basis for a portion of the value that is included in the estate.
This basis adjustment is calculated by subtracting the portion of the uniform basis allocable to the decedent immediately prior to death from the value of the remainder interest included in the estate.
Example. Marge died in 2006. In her will, she left Bart, her son, a life estate interest in their family home. She left Lisa, her daughter, the remainder interest. In 2010, Lisa died. In Lisa's will, Maggie, her sister, is the sole heir. Bart is still alive.
The fair market value of the house in 2006 when Marge died was $100,000. At the time of Lisa's death, her share in the uniform basis was $15,000, based on Bart's life expectancy and the fair market value. The value of the home in 2010 when Lisa died was $200,000. The value of the remainder interest included in Lisa's estate was $30,000.
Maggie's basis adjustment in the inherited house is shown below:
Value of the house included in Lisa's estate
Less: Lisa's portion of the uniform basis at her death
Maggie's basis adjustment in the house
When the beneficiary to the remainder interest sells the property, the basis is calculated using the beneficiary's current portion of the uniform basis at the time of the sale plus the adjustment.
Most people have a pretty good understanding that the income tax basis of property received from a decedent that was included in that decedent’s estate is the fair market value of the property as of the date of the decedent’s death. But, the basis issue becomes more complex when the property at issue is part of a life estate/remainder arrangement. It’s a common estate planning technique, so the issue often arises. Hopefully, today’s post helped sort it out.
Monday, July 30, 2018
Last week, House Ways and Means Committee Chairman Kevin Brady released the committee’s working outline for a tax legislative proposal that they are presently working on with hopes of passage later this summer or fall. It appears to be a framework at this time, with not much substantive Code structure attached to it. But, the framework is something to go on in anticipating what might be a forthcoming legislative proposal. In any event, it’s worth noting what has been released so that feedback from tax professionals can be provided to tax staffers as the drafting process proceeds.
A tax proposal following-up on the Tax Cuts and Jobs Act – that’s the topic of today’s post.
The framework puts the tax proposals into three separate categories: 1) individual and small business tax cuts; 2) promotion of individual savings; and 3) promotion of business innovation.
Individual and small business. The effort seems to be with respect to the first category to make most of the TCJA provisions that apply to individuals and small business permanent. Under the TCJA, many provisions are set to expire at the end of 2025. Remember, however, tax provisions are only “permanent” if they don’t contain a statutory sunset date and the Congress doesn’t otherwise change the law.
Savings. The second area of focus, promoting individual savings, contains several proposals designed not only to spur individual savings, but also incentivize the use of workplace retirement plans. One proposal that is outlined would establish a “Universal Savings Account.” The description of the account is that it would be a “fully flexible savings tool for families.” At this time, however, there are no details as to how the account would be established or function.
While the TCJA did expand the potential use and application of funds contained in a “529” education account, the proposal would attempt to expand further the use of such funds by allowing them (on a tax-favored basis) to be used to pay for apprenticeship fees to learn a trade, cover home schooling expenses and be applied to pay-off student debt.
This prong of the proposal would also allow money to be withdrawn without penalty from existing retirement accounts to pay for childbirth or adoption costs. In addition, amounts withdrawn for such purposes could be paid back at a later time.
Innovation. The third prong of the proposal focuses on spurring small business entrepreneurship and innovation. To accomplish this objective, the proposal would allow qualified small businesses to write off a greater amount of initial start-up costs than is permitted under present law. There is no specification as to the additional amount, nor is there any “meat” to the comment in the proposal that new tax provisions would be used to “remove barriers to growth.”
In recent years, tax legislation (or most legislation, for that matter) passes the House and then goes to the Senate to either die or not get acted upon – largely because of the 60-vote requirement to pass tax legislation in the Senate without the reconciliation process. That same process could also be true for this proposal. A likely scenario is that the House passes a tax bill, but the Senate fails to take action before the end of the year (or takes action at the last minute in December). For this reason, it looks as if (at least right now) the House will introduce its tax proposals in three separate bills – one for each of the prongs mentioned above. It is believed that such a strategy will assist in the process of getting the necessary 60 votes by tailoring each proposal to specific provisions. But, then there is always the politics of the situation. The Senate majority leader could call for a vote before the fall congressional election. Or, on the other hand, the vote could be put off until after the election on anticipation that the Republican majority in the Senate will widen.
While some in the Congress could balk at what is likely to be budget scoring that will say that additional tax cuts will widen the deficit, that may be counterbalanced by those wanting deeper cuts and pointing to the strength of the overall economy. In addition, I am already hearing talk from some tax staffers that there could be an attempt to tweak the TCJA by repealing the tax on private college endowments, modifying the new qualified business income deduction of I.R.C. §199A and indexing capital gains. The I.R.C. §199A issue is an interesting one. There are many unanswered question concerning it and the first set of regulations involving the new deduction have yet to be released. Also, politicians from high tax states may push for a full reinstatement of the state and local tax deduction.
Another possibility is that any new tax legislation will contain technical corrections to TCJA provisions. That is probably a slim possibility, however, until after the midterm election. That means that technical corrections, if any, won’t be until later in November or December. Of course, those are needed now (actually they were needed months ago) as are regulations and forms so that tax pros can give advice to clients and take appropriate planning steps.
As for health care, on July 25, the U.S. House passed two health care reform bills which would do numerous things but, in particular, expand access to tax-preferred health savings accounts (HSAs). As usual, it remains to be seen whether the Senate will even take up either or both of the bills.
The first of the two bills, H.R. 6311, would allow individuals to bypass the Obamacare restriction on using premium tax credits to buy catastrophic health care plans and would broaden eligibility for contributions to an HSA. Specifically, the bill would raise the contribution limit to $6,650 for individuals and $13,000 for families. That’s the combination of the annual limit for out-of-pocket and deductible expenses for 2018. The bill would also permit HSA funds to pay for qualified medical expenses at the start of coverage of the high deductible health policy (HDHP) if the HSA has been opened within 60 days of the HDHP start date. The bill would also suspend until 2022 Obamacare’s annual fee on health insurers.
The other bill concerning health care that was passed on July 25 is H.R. 6199. This legislation repeals the portions of Obamacare that limit payments for medications from HSAs, medical savings accounts, health FSAs, and health reimbursement arrangements to only prescription drugs or insulin. As a result, distributions from such accounts can be made without penalty for over-the-counter medications and products. The bill would also allow persons with health insurance that qualifies as HSA family coverage to contribute to an HSA if their spouse is enrolled in a medical FSA. It would also allow an HDHP to annually cover up to $250 (self) and $500 (family) of non-preventative services (e.g., chronic care) that may not be covered until after the deductible is reached.
Tax policy will remain a key topic over the weeks leading up to the midterm election. Whether any legislation is enacted remains to be seen. Certainly, technical corrections are needed to deal with certain aspects of the TCJA. From there, additional legislation is an add-on. In any event, certainty in tax policy will not likely be part of the future for some time. All of this makes providing tax advice to clients difficult.
Thursday, July 26, 2018
Financial distress in the farm sector continues to be a real problem. Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years. As an example, the level of working capital in the farm sector has fallen sharply since 2012. Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak. In the past year alone, working capital dropped by 18 percent. It has also declined precipitously as a percentage of gross revenue. This means that many farmers have a diminished ability to reinvest in their farming operations. It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate. When that happens, the sellers of the assets that repossess have tax consequences to worry about.
Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains. Other times, farmland might be repossessed.
Tax issues upon repossession of farmland – that’s the topic of today’s post.
Repossession of Farmland
Special exception. A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt. It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale. However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved. See I.R.C. §453B(f)(2). In addition, for the special rules to apply, the debt must be secured by the real property.
When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition.
Handling interest. Amounts of interest received, stated or unstated, are excluded from the computation of gain. Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt. However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income. I.R.C. §453B(f)(2). But, a question exists as to whether that provision applies in financial distress situations.
The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts.
Debt secured by the real property. The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property. Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules.
Character of gain. The character of the gain from reacquisition is determined by the character of the gain from the original sale. For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation. If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income. If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain.
Basis issues. Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property. The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs.
The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition. However, the holding period does not include the time between the original sale and the date of reacquisition.
Is the personal residence involved? The provisions on reacquisition of property generally apply to residences or the residence part of the transaction. However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale. An adjustment is made to the sales price of the old residence and the basis of the new residence. If not resold within one year, gain is recognized under the rules for repossession of real property. An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election. The exclusion can, therefore, be made after reacquisition. An election can be made at any time within three years after the due date of the return.
No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero. Losses are not deductible on sale or repossession of a personal residence. When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property. Adjustment is made to the income tax basis of the reacquired residence.
Special situations. In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69-83, 1969-1 C.B. 202. A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent. However, the Installment Sales Revision Act of 1980 changed that result. The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980. Presumably, that means acquisitions by the estate or beneficiary. Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been. The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable.
The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.
Tax planning is important for farmers that are in financial distress and for creditors of those farmers. As usual, having good tax counsel at the ready is critical. Tax issues can become complex quickly.
Wednesday, July 18, 2018
Next month, Washburn Law School and Kansas State University (KSU) will team up for its annual symposium on agricultural law and the business of agriculture. The event will be held in Manhattan at the Kansas Farm Bureau headquarters. The symposium will be the first day of three days of continuing education on matters involving agricultural law and economics. The other two days will be the annual Risk and Profit Conference conducted by the KSU Department of Agricultural Economics. That event will be on the KSU campus in Manhattan. The three days provide an excellent opportunity for lawyers, CPAs, farmers and ranchers, agribusiness professionals and rural landowners to obtain continuing education on matters regarding agricultural law and economics.
This year’s symposium on August 15 will feature discussion and analysis of the new tax law, the Tax Cuts and Jobs Act, and its impact on individuals and businesses engaged in agriculture; farm and ranch financial distress legal issues and the procedures involved in resolving debtor/creditor disputes, including the use of mediation and Chapter 12 bankruptcy; farm policy issues at the state and federal level (including a discussion of the status of the 2018 Farm Bill); the leasing of water rights; an update on significant legal (and tax) developments in agricultural law (both federal and state); and an hour of ethics that will test participant’s negotiation skills.
The symposium can also be attended online. For a complete description of the sessions and how to register for either in-person or online attendance, click here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
Risk and Profit Conference
On August 16 and 17, the KSU Department of Agricultural Economics will conduct its annual Risk and Profit campus. The event will be held at the alumni center on the KSU campus, and will involve a day and a half of discussion of various topics related to the economics of the business of agriculture. One of the keynote speakers at the conference will be Ambassador Richard T. Crowder, an ag negotiator on a worldwide basis. The conference includes 22 breakout sessions on a wide range of topics, including two separate breakout sessions that I will be doing with Mark Dikeman of the KSU Farm Management Association on the new tax law. For a complete run down of the conference, click here: https://www.agmanager.info/risk-and-profit-conference
The two and one-half days of instruction is an opportunity is a great chance to gain insight into making your ag-related business more profitable from various aspects – legal, tax and economic. If you are a producer, agribusiness professional, or a professional in a service business (lawyer; tax professional; financial planner; or other related service business) you won’t want to miss these events in Manhattan. See you there, or online for Day 1.
July 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engaged in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners were a married couple who lived in the San Francisco Bay area. The husband worked in the technology sector, and during the years in issue (2010-2014) the husband’s salary ranged from $1.4 million to $10.5 million. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The wife sold her physical therapy practice to focus her time on the administrative side of their new ranching activity.
The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of a woodshop and cement factory as the property’s remote location made repair work and build-out necessary to conduct on-site. The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually, and presumably because of the continued claimed losses, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also determined that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, the couple moved to Park City, Utah, with the husband devoting full-time to the ranching activity along with his wife. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS hired an expert who spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. The expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. They had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions. However, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible. Indeed, on the material participation issue, due to the presence of the ranch manager, all of the personal actions and involvement of the petitioners on which the court based its determination of their profit motive were dismissed as “investor” hours.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.
Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.
Tuesday, July 10, 2018
The Tax Cuts and Jobs Act made significant changes in the tax law. That’s an obvious conclusion. It also changed some of the rules associated with charitable giving, and other rules that have an impact are likely to impact a taxpayer’s decision to donate to charity. Because of these changes, some charities have expressed concerns about a potential decline in charitable giving overall.
Is a drop in overall charitable giving likely? If so, are there planning options that can be utilized to preserve charitable deductions for charitable gifts?
Post-2017 charitable giving. That’s the topic of today’s post.
For tax years beginning before 2018, taxpayers that itemized deductions (Schedule A) could deduct charitable donations of cash or property to qualifying organizations. That remains true for tax years beginning after 2017. However, the TCJA has made a couple of important changes. Pre-TCJA, most cash contributions were generally limited to 50 percent of the taxpayer’s “contribution base.” “Contribution base” is defined as the taxpayer’s adjusted gross income (AGI). For this purpose, AGI is computed without including any net operating loss carryback to the tax year. I.R.C. §170(b)(1)(H).
The 50 percent limit applies to donations of ordinary income property and cash to charitable organizations described in I.R.C. §170(b)(1)(A). Those charities include public charities, private foundations other than nonoperating private foundations, and certain governmental units. Donations of capital gain property to these entities are limited to 30 percent of the taxpayer’s contribution base. Donated capital gain property to these organizations that are for the purpose of allowing the charity to use the property is capped at 20 percent of the donor’s contribution base. Gifts to non-operating foundations are capped at 30 percent of the donor’s contribution base for gifts of ordinary income property and case. The cap is 20 percent for capital gain property gifted to a non-operating foundation.
Under the TCJA, effective for tax years beginning after 2017 and before 2026, the 50 percent limitation is increased to 60 percent. Thus, an individual taxpayer can deduct cash contributions up to 60% of contribution base for donations to I.R.C. §170(b)(1)(A) organizations. I.R.C. §170(b)(1)(G)(i). Any amount that is disallowed due to the limitation can be carried forward for five years. In addition, for taxpayers that have contributions of both cash and capital gain property in the same tax year, the cash contribution will reduce the amount of deduction for the donated capital gain property.
Example: Tammy has a contribution base of $75,000 for 2018. She donates $10,000 of cash to various I.R.C. §170(b)(1)(A) organizations. The 60 percent limitation would limit her cash contributions for 2018 to $45,000. Tammy also donated her 1969 John Deere 4020 tractor to an I.R.C. §170(b)(1)(A) organization in 2018. The tractor was valued at $32,500. Her limitation on donated capital gain property for 2018 is $22,500 (30 percent of $75,000). However, the $22,500 is reduced by her $10,000 cash contribution. Thus, her limit in 2018 for capital gain donations (30 percent property) is $12,500. Tammy will be able to deduct $12.500 of the tractor’s value in 2018 and carry forward the balance of the donated value ($20,000).
The increase from 50 percent to 60 percent on the AGI maximum deduction amount is certainly good news for taxpayers with charitable inclinations. In addition, the TCJA eliminates the “Pease limitation” (I.R.C. §68) through 2025. That rule phased-out itemized deductions at particular income levels. These two TCJA changes could, by themselves, trigger a significant increase in charitable giving – particularly by higher income taxpayers. However, the TCJA made other changes that could have an offsetting effect.
Other TCJA Changes That Could Impact Giving
The TCJA significantly increases the standard deduction – to $12,000 for single filers and $24,000 for married filing jointly taxpayers. Also, many expenses that were deductible for tax years beginning before 2018 are either non-deductible or are limited. For example, the deduction for state and local taxes associated with non-business property is limited to $10,000. The increase in the standard deduction coupled with the elimination/limitation of various deductions will have an impact on giving, particularly by taxpayers that make relatively smaller gifts. That’s because the TCJA has made it more difficult for Schedule A deductions to exceed the standard deduction. More taxpayers are likely to simply claim the standard deduction rather than file Schedule A. Without filing Schedule A to itemize deductions, there is no deduction for charitable gifts.
Normally, a tax deduction cannot be taken for a donation to a qualified charity when there is a quid pro quo. However, for tax years beginning before 2018, a taxpayer could deduct 80 percent of charitable contributions made to an institution of higher learning for the right to buy tickets or seating at an athletic event. However, the TCJA changed this rule. For tax years beginning after 2017, the 80 percent rule is eliminated.
The TCJA also increased the federal unified credit for estate and gift tax purposes such that, beginning in 2018, federal estate tax doesn’t apply until a decedent’s taxable estate value exceeds $11.18 million. That’s practically twice the amount that it was for 2017. It’s likely that this significant increase will dampen charitable bequests. Presently, about 8 percent of charitable giving derives from bequests.
Will these changes be enough to cause taxpayers to curb charitable giving? To the extent a taxpayer donates to charity based on getting a tax break, that could be the case to the extent the TCJA changes reduce the deduction associated with charitable gifts. Many charities are concerned. Historically, taxpayers that itemize deductions are more likely to give to charity than are non-itemizers. Similarly, non-itemizers make up a relatively small percentage of total charitable giving. One estimate is that, for tax years beginning after 2017, less than five percent of taxpayers will itemize by filing Schedule A. The Indiana University School of Philanthropy and Independent Sector has estimated that the TCJA changes will reduce overall charitable giving by 1.7 percent to 4.6 percent. Those percentages convert to an annual reduction in giving between $4.9 billion and $13.1 billion.
Are there options to plan around the TCJA impacts on charitable giving? There might be, at least for some taxpayers. One approach is for a taxpayer to aggregate charitable gifts – make them in one year but not the following year, etc., so that there is a larger amount gifted in any particular year. This technique is designed to get the level of itemized deductions to an amount that is greater than the standard deduction for the years of the gifts.
If “gift stacking” won’t work for a taxpayer, other techniques may include gifting to private foundations, using charitable trusts or a donor advised fund. A donor advised fund allows a donor to make a charitable contribution, get an immediate tax deduction and then recommend grants from the fund to qualified charities. Of course, these various donation vehicles come with their own limitations on deductions and how they can operate. Likewise, there is no “one size fits all” when it comes to putting together a charitable giving plan. Some techniques just simply won’t work unless large gifts are made.
The TCJA made significant changes to the rules surrounding charitable giving. For many taxpayers, planning steps need to be taken to alter existing approaches to account for the new rules. Make sure to get good tax advice for your own situation. Also, when it comes to charitable giving, make sure to keep good records to substantiate your gifts. The IRS looks at the substantiation issue very closely.
Friday, July 6, 2018
Owner-lessors and operator-lessees of oil and gas interests can claim depletion associated with the production of oil and gas. Although conceptually similar to depreciation, the depletion deduction differs in significant ways from depreciation. The depletion deduction is based on the depletion of the mineral resource, whereas depreciation is based on the exhaustion of an asset that is used in the taxpayer’s trade or business.
The depletion deduction associated with oil and gas interests – that’s the topic of today’s post.
Requirements for the Deduction
To claim a depletion deduction, the taxpayer must have an economic interest in the mineral property, and the legal right to the income from the oil and gas extraction. Treas Reg. §1.611-1(b). If these two requirements are met, the deduction is allowed upon the sale of the oil and gas when income is reported. For the owner-lessor, the deduction can offset royalty payments but not bonus lease payments (because the deduction is allowed only when oil or gas is actually sold and income is reportable). For the operator-lessee, the depletable cost is the total amount paid to the lessor (the lease bonus) and other costs that are not currently deducted such as exploration and development costs as well as intangible drilling costs.
Conceptually, the taxpayer is entitled to a deduction against the revenue received as the income tax basis in the mineral property is depleted. For the owner-lessor, a cost basis in the minerals must have been established at the time basis in the taxpayer’s property (surface and mineral estate) was established. This may have occurred as part of an estate tax valuation in which the minerals and surface were separately valued or upon allocation of the purchase price at the time of acquisition. For the operator- lessee, the operator’s historical investment cost is the key.
When a lease of minerals is involved, the depletion deduction must be equitably apportioned between the lessor and the lessee. IRC §611(b). If a life estate is involved (the property is held by one person for life with the remainder to another person), the deduction is allowed to the life tenant but not the remainderman. For property held in a trust, the deduction is apportioned between the income beneficiaries and the trustee in accordance with the terms of the trust. If the trust instrument does not contain such provisions, the deduction is apportioned on the basis of the trust income allocable to each. For a decedent’s estate, the deduction is apportioned between the estate and the heirs on the basis of the estate income allocable to each.
There are two methods available for computing the depletion deduction: the cost depletion method and the percentage depletion method. A comparison should be made of the two methods and the one that provides the greater deduction should be used.
Cost depletion. For the owner-lessor, the cost depletion method is a units-of-production approach that is associated with the owner’s basis in the property. Cost depletion, like depreciation, cannot exceed the taxpayer’s basis in the property. The basis includes the value of the land and any associated capital assets (e.g., timber, equipment, buildings, and oil and gas reserves). See I.R.C. §612. Basis also includes any other expenses that were incurred in acquiring the land (e.g., attorney fees, surveys, etc.). Basis is tied to the manner in which a property is acquired. For example, mineral property can be acquired via purchase (purchase price basis), inheritance (basis equals the property’s FMV at the time of the decedent’s death) or gift (carryover basis from the donor). Basis is allocated among the various capital assets and is determined after accounting for the following items:
- Amounts recovered through depreciation deductions, deferred expenses, and deductions other than depletions;
- The residual value of land and improvements at the end of operations; and
- The cost or value of land acquired for purposes other than mineral production
Under the cost depletion approach, the taxpayer must know the total recoverable mineral units in the property’s natural deposit and the number of mineral units sold during the tax year. The total recoverable units is the sum of the number of mineral units remaining at the end of the year plus the number of mineral units sold during the tax year. The landowner must estimate or determine the recoverable units of mineral product using the current industry method and the most accurate and reliable information available. A safe harbor can be elected to determine the recoverable units. Rev. Proc. 2004-19, 2004-10 IRB 563. The mechanics of the computation are contained in Treas. Reg. §1.611-2.
The number of mineral units sold during the tax year depends on the accounting method that the taxpayer uses (i.e., cash or accrual). Many taxpayers, particularly landowners, are likely to be on the cash method. Thus, for these taxpayers, the units sold during the year are the units for which payment was received. Under the cost depletion approach, an estimated cost per unit of the mineral resource is computed annually by dividing the unrecoverable depletable cost at the end of the year by the estimated remaining recoverable units at the beginning of the year. The cost per unit is then multiplied by the number of units sold during the year.
Let’s look at an example:
Billie Jo’s father died in 2014. His will devised a 640-acre tract of land to Billie Jo. The value of the tract as reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for estate tax purposes was $6.4 million. Of that amount, $1 million was allocated to the mineral rights in the tract.
In 2018, a well drilled on the property produced 300,000 barrels of oil. Geological and engineering studies determined that the deposit contained 2 million barrels of usable crude oil. In 2018, the 300,000 barrels produced were sold. Billie Jo’s cost depletion deduction for 2018 is $150,000 and is calculated as follows.
Unrecoverable depletable cost at the end of the year × Number of units Estimated remaining recoverable units at the beginning of the year sold during the year
$1,000,000 /$2,000,000 × 300,000 = $150,000
Billie Jo deducts the $150,000 on her 2018 Schedule E. Billie Jo’s adjusted basis in the mineral deposit for 2019 that is eligible for cost depletion is $850,000 ($1 million − $150,000).
Also, consider this example:
Acme Drilling Corporation paid Bubba $300,000 to acquire all of the oil rights associated with Bubba’s land. The $300,000 was Acme’s only depletable cost. Geological and engineering studies estimated that the deposit contains 800,000 barrels of usable crude oil.
In 2018, 200,000 barrels of oil were produced and 180,000 were sold. Acme’s cost depletion deduction for 2015 is $67,500 and is calculated as follows.
Unrecoverable depletable cost at the end of the year x Number of units
Estimated remaining recoverable units at the beginning of the year sold during the year
$300,000 /$800,000 × 180,000 = $67,500
Percentage depletion. As noted previously, the amount allowed as a depletion deduction is the
greater of cost or percentage depletion computed for each property (as defined in I.R.C. §614(a) for the tax year. See IRC §§613 and 613A and Treas. Reg. §1.611-1(a).
Landowners without an established cost basis may be able to claim percentage depletion (discussed later). It is common for a landowner to not allocate any part of the property’s basis to the oil and gas reserves. Thus, percentage depletion may be the only depletion method available.
Under the percentage depletion method, the taxpayer (owner-lessor or a producer that is not a retailer or refiner) uses a percentage of gross income from the property, which is limited to the lesser of the following:
- 15% of the gross income from the oil/gas property (for an operator-lessee, this is defined as gross income from the property less expenses attributable to the property other than depletion and the production deduction, but including an allocation of general )
- 65% of the taxable income from all I.R.C. §613A(d).
For percentage depletion purposes, total taxable income is a function of gross income. Gross income from the property includes, among other things, the amount received from the sale of the oil or gas in the immediate vicinity of the well. Treas. Reg. §1.613-3. Gross income does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. I.R.C. §613A(d)(5).
Any amount not deductible due to the 65% limitation can be carried over to the following year, subject to the same limitation. Any amount carried over is added to the depletion allowance before any limits are applied for the carryover year. I.R.C. §613A and the underlying regulations set forth a detailed multi-step process that is utilized to compute percentage depletion allowed to independent producers and royalty owners.
A production limit also applies. For partnerships, all depletion is computed at the partner level and not by the partnership. Prop. Treas. Reg. §1.613A-3(e). The partnership must allocate the adjusted basis of its oil and gas properties to its partners in accordance with each partner’s interest in capital or income.
Consider the following example:
In 2018, Rusty received $50,000 of royalty income from a well on his farm. His taxable income from all sources in 2018 is $432,000. Of that amount, $300,000 is income from crops and livestock. He has $82,000 of income from other sources.
Rusty computes his percentage depletion deduction by multiplying his $50,000 gross income from the oil/gas property by 15%, which is $7,500. His taxable income from all sources is $432,000, and 65% of that amount is $280,800. Thus, Rusty’s depletion deduction is the lesser of $7,500 or $280,800. Rusty can claim the $7,500 deduction on line 18 (depreciation expense or depletion) of his 2018 Schedule E.
Oil and gas taxation is complex. But, the Code does provide some beneficial rules to offset the cost of production. That’s true for other lines of businesses also. The cost of production associated with business property typically generates a tax write-off. When it comes to oil and gas, the rules may be more difficult. If you have these issues, it will pay to hire tax counsel that is well versed in the tax rules associated with oil and gas.
Tuesday, June 26, 2018
Last week, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., No. 17-494, 2018 U.S. LEXIS 3835 (U.S. Sup. Ct. Jun. 21, 2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court overruled 50 years of Court precedent on the issue.
Other states will certainly take note of the Court’s decision, and some (such as Iowa) were banking on the Court ruling in the manner that it did and passed legislation similar to the South Dakota legislation that will take effect in the future. But, as I wrote last fall, a victory for South Dakota could do damage to the Commerce Clause and the concept of due process and contemporary commerce.
An update on state taxation of internet sales, the possible implications of the Court’s recent decision and what the impact could be on small businesses – that’s the focus of today’s post.
In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe. Interestingly, S.B. 106 authorized the state to bring a declaratory judgment action in circuit court against any person believed to be subject to the law. The law also authorized a motion to dismiss or a motion for summary judgment in the court action, and provided that the filing of such an action “operates as an injunction during the pendency of the” suit that would bar South Dakota from enforcing the law.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. Jan. 17, 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota announced shortly after the South Dakota Supreme Court’s decision that it would file a petition for certiorari with the U.S. Supreme Court by mid-October. They did, the U.S. Supreme Court granted the petition and heard the case which lead to last week’s opinion.
U.S. Supreme Court Decision
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” Apparently, that is not the case anymore, at least according to the majority in Wayfair – Justices Kennedy, Thomas, Ginsburg, Alito and Gorsuch. Under the new interpretation of the Commerce Clause, states can impose sale tax obligations on businesses that have no physical presence in the state. But is that completely true? Can the Court’s opinion be construed as giving the states a “blank check” to tax out-of-state businesses? Maybe not.
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
The dissent in Wayfair, authored by Chief Justice Roberts, noted that there was no need for the Court to overturn Quill. The Chief Justice noted that, “E-commerce has grown into a significant and vibrant part of our national economy against the backdrop of established rules, including the physical-presence rule. Any alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.” That’s precisely the point of the Commerce Clause, and Chief Justice Roberts pointed it out – the Court had no business wading into this issue. In fact, several members of the Congress filed briefs with the Court in the case to inform the Court that various pieces of legislation were pending that would address the issue.
The question then is what, if any, type of a state taxing regime imposed on out-of-state sellers would be determined to violate the Commerce Clause post-Wayfair. Of course, the answer to that question won’t be known until a state attempts more aggressive taxation on out-of-state sellers than did South Dakota, but a few observations can be made. Presently, 23 states are “full members” of the Streamlined Sales and Use Tax Agreement. For those states, the Wayfair majority seemed to believe that had the effect of minimizing the impact on interstate commerce. Also, it would appear that any state legislation would have to have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
Now, it appears that state legislatures crafting tax statutes need not give much, if any, thought to the reason for the tax or who the parties subject to the tax might be. The only consideration appears to be the relative burden of the tax. With Wayfair, states have gained more power – the power to tax people and businesses for whom the state provides no services and who cannot vote the people out of office that created the tax. That would not appear to square with traditional concepts of due process.
The whole notion of a state taxing a business that has no physical presence in the state is incompatible with the principles of federalism that bar states from taxing (whether income, property or sales tax, for instance) non-resident individuals or businesses (with a few, minor exceptions). As noted earlier, a state that imposes such a taxing regime would be able to generate revenue from taxpayers who use none of the services provided by the taxing jurisdiction.
Post Wayfair, where will the line be drawn? Wayfair involved state sales tax. Will states attempt to go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income?
Only time will tell.
Thursday, June 14, 2018
Self-employment tax is a concern for many farmers and ranchers, with many having an as an objective the avoidance of self-employment tax through whatever planning techniques can be utilized. That’s especially the case for those farmers and ranchers that are fully “vested” in the Social Security system.
But, what about the farmer that leases out machinery and equipment to someone else? Is the income from machinery and equipment leases subject to self-employment tax? Such an arrangement may be entered into, for example, to assist another person get established in farming or supply a need that another person has with respect to that other person’s farming operation.
As is the case with many answers to tax questions, the answer is “it depends.” Today’s post takes a look at leases of farm machinery and equipment and the self-employment tax implications.
Under I.R.C. §1402(a) “net earnings” from self-employment” means the gross income derived by an individual from any trade or business that the individual conducts. However, rental income is generally reported on Schedule E of Form 1040. From there, it flows to page one of the Form 1040. As such, it is not subject to self-employment tax. A rental activity is just that – it’s a rental activity. Under I.R.C. §1402(a)(1), “rentals from real estate” are excluded from the I.R.C. §1402(a) definition of “net earnings from self-employment.”
Exception for Personal Property Leases
The I.R.C. §1402(a)(1) exception from self-employment tax for “rentals from real estate” says, in full, “there shall be excluded rentals from real estate and from personal property leased with the real estate…” [emphasis added]. But, the non-application of self-employment tax only applies to the rental of real estate or the rental of personal property in connection with real estate.
Inapplicability of Exception
If the personal property is not tied to a land lease, the income from leasing personal property is subject to self-employment tax if the rental activity is conducted as a regular business activity of the taxpayer. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357. Indeed, a notation at the top of Schedule E indicates that if the taxpayer has a business of renting personal property then the income should be reported on Schedule C. Those same instructions also direct a taxpayer to use Schedule C to report income an expense associated with renting personal property if the rental activity is a business activity of the taxpayer. The rental activity constitutes a business if it is engaged in with the primary purpose of making a profit and the activity is engaged in with regularity and continuity. See, e.g., Comr. v. Groetzinger, 480 U.S. 23 (1987).
But, if an activity is engaged in on a one-time only basis the income derived from the activity will not be subject to self-employment tax because the activity is not engaged in on a basis that is regular and continuous. See, e.g., Batok v. Comr., T.C. Memo. 1992-727. Thus, if the rental of personal property is merely casual the Schedule E instructions state that the rental receipts should be reported as “Other Income” on page 1 of Form 1040. Any related deductions are to be reported on the total deduction line (Total Adjustments) on the bottom of page 1 of Form 1040 and the notation “PPR” is to be entered on the dotted line next to the amount. That is what indicates a personal property rental.
For a farmer that owns machinery and equipment and leases it to someone else or to their own farming business entity, the risk is real that the rental income will be subject to self-employment tax. That will be the result if the rental activity in engaged in with regularity and continuity such that the activity rises to the level of a trade or business. Self-employment tax can be avoided if the lease of the personal property is tied in with a land lease. Alternatively, a farm taxpayer could transfer the machinery and equipment to a pass-through entity with the income flowing through to the taxpayer without self-employment tax. In that situation, however, compensation from the entity would be required for any personal services provided.
An additional consideration is that, at least in some states, paying rent to lease farm equipment and machinery is subject to sales tax at the state level. Also, income from a rental activity may trigger the application of the passive loss rules under I.R.C. §469. That last point is a topic for discussion in a subsequent post.
Friday, May 25, 2018
The Tax Cuts and Jobs Act (TCJA) made significant changes to individual income taxes, the tax on C corporations, and also created a new deduction for pass-through entities. The TCJA also modified some of the rules applicable to I.R.C. 529 College Savings Plans (“Section 529 Plans”). In light of the changes applicable to Section 529 plans, it’s worth examining those changes and how they might impact planning.
That’s the focus of today’s post – the TCJA changes to Section 529 plans.
Origination. Section 529 plans originated at the state level, particularly the pre-paid tuition program of the State of Michigan. The idea was to provide a vehicle to help minimize the cost of college tuition be creating a fund to which Michigan residents could pay a fixed amount in exchange for a promise that the fund would pay a designated beneficiary’s college tuition at a Michigan public college or university. The trust invested the contributed amounts to pay tuition costs of beneficiaries in the future. Basically, this allowed the prepayment of college education at a fixed rate un-impacted by tuition increases in future years. The concept was aided by the IRS when the IRS determined that purchasers of the "prepaid tuition contract" were not taxed on the contract value accruing value until the year(s) in which funds were either distributed or refunded. 1996 federal legislation authorized qualified state tuition programs.
Types. A Section 529 plan can be one of two types – a prepaid tuition plan or a college savings plan. All states have at least one type of plan. Under a prepaid tuition plan, the account holder buys units (credits) at a participating “eligible educational institution” for future tuition and fees at current prices for the beneficiary of the account. With a “college savings plan,” a person opens an investment account to save for the beneficiary’s future tuition fees as well as room and board.
There can be numerous tax benefits at the state level that apply to contributions to a Section 529 plan. These can include the ability to deduct contributions from state income tax or the availability of matching grants. If funds in an account are withdrawn to pay qualified education expenses, then the account earnings are not subject to federal (and often) state income tax. If the withdrawals aren’t used to pay qualified educational expenses, a penalty applies. In that situation, each withdrawal is treated as containing a pro-rata portion of earnings and principal. The earnings portion of a non-qualified withdrawal is taxed at ordinary income rates and is also subjected to a 10 percent additional tax absent an exception.
Distributions from a Section 529 plan for an eligible student that are used for qualifying higher education expenses at an eligible institution are not include in income. An “eligible student” is one that is enrolled in a program leading to recognized educational credentials; enrolled at least one-half time; and without any federal or state felony drug conviction.
Eligible Educational Institution
An “eligible educational institution” includes colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. Under the TCJA, an “eligible educational institution” is expanded to include public, private or religious elementary schools and secondary schools. As originally proposed, homeschool expenses would have also qualified for Section 529 plans but were struck by the parliamentarian in the Senate as a violation of the “Byrd Rule.”
Section 529 plans can be used to fund up to $10,000 of tuition cost per year per beneficiary that is required for attendance at an eligible educational institution. In other words, under the TCJA Section 529 plan funds can be used to pay tuition expenses of up to $10,000 per student annually from all of a taxpayer’s Section 529 accounts for tuition of a beneficiary that is incurred for enrollment or attendance at a public, private or religious elementary or secondary level.
Definition. “Qualified Expenses” include reasonable costs for room and board. That is generally limited to the lesser of room and board costs of attendance as published by the educational institution or actual expenses. However, if the student beneficiary is living on campus, actual costs can be used even if in excess of published room and board costs. Likewise, Section 529 plan funds can be used to cover fees, books, supplies and equipment but only if they are required for enrollment or attendance at an eligible educational institution.
“Qualified higher education expenses” included tuition, fees, books, supplies, and required equipment, as well as reasonable room and board if the student was enrolled at least half-time. Eligible schools included colleges, universities, vocational schools, or other postsecondary schools eligible to participate in a student aid program of the Department of Education. This includes nearly all accredited public, nonprofit, and proprietary (for-profit) postsecondary institutions.
The TCJA retools the definition of what constitutes “qualified expenses” for purposes of distributions from a Section 529 plan. For distributions after Dec. 31, 2017, “qualified higher education expenses” is broadened to include (as noted above) tuition at an elementary or secondary public, private, or religious school, up to a $10,000 limit per tax year. I.R.C. §529(c)(7).
As for computer-related technology, qualified costs include the computer and any necessary peripheral equipment. Also included is computer software, internet access and related services. However, expenses associated with computer technology can only be covered by Section 529 funds if the technology is used by a plan beneficiary during the years that they are enrolled in an eligible educational institution. Importantly, computer technology expenses do not include software designed for sports, games, and hobbies unless the software is predominantly educational in nature.
Reduction. Qualifying expenses must be reduced for tax-free scholarships that the beneficiary receives as well as other educational assistance. They must also be reduced for the amount of qualifying expenses that are used to obtain education credit.
Special Needs Beneficiary and ABLE Accounts.
Section 529 plan funds can also be used to provide for expenses associated with a special needs beneficiary. These include special needs services incurred in connection with the enrollment or attendance at an eligible educational institution.
For distributions after December 22, 2017, the TCJA allows amounts from a Section 529 plan to be rolled over to an ABLE account without penalty if the ABLE account owner is either the designated beneficiary of the Section 529 plan account or a member of the designated beneficiary’s family. I.R.C. §529(c)(3). Created by legislation in 2014, ABLE accounts are tax-advantaged savings accounts for individuals with disabilities and their families. The account beneficiary is the account owner, and account earns income tax-free. Contributions to the account (which can be made by any person) must be made using post-tax dollars. As such, account contributions are not tax deductible at the federal level. It is possible, however, that some states may allow deductible contributions on the state return.
Any amount that is rolled-over from a Section 529 plan account to an ABLE account is counted towards the overall limitation on amounts that can be contributed to an ABLE account within a tax year ($15,000 for 2018), and any amount rolled over in excess of this limitation is includible in the distributee’s gross income.
Some expenses cannot be paid with funds from a Section 529 plan. Non-qualifying expenses include books, supplies, or equipment that is not required for enrollment or classes. Also not qualifying are transportation expenses to and from school. This includes car travel expenses, airline tickets and parking, etc.). Health insurance covering the beneficiary also is not a qualifying expenses, nor is any expense for athletic events or activities not required for coursework. Fraternity or sorority dues are likewise not qualified expenses, nor are the costs of cell phones or student loan repayment amounts.
Section 529 plans have been around for some time now. However, the amendments made by the TCJA make them a more powerful tool to fund the education of a beneficiary on a tax-favored basis.
Wednesday, May 23, 2018
The Tax Cuts and Jobs Act (TCJA) that was signed into law on December 22, 2017, represents a major change to many provisions of the tax Code that impact individuals and business entities. I have discussed of the major changes impacting farm and ranch taxpayers and businesses in prior posts. But, the TCJA also makes substantial changes with respect to the income taxation of trusts and estates. Those changes could have an impact on the use of trusts as an estate planning/wealth transfer device. Likewise, the TCJA changes that impact decedent’s estate must also be noted.
The TCJA’s changes that impact trusts and estates – that’s the focus of today’s post.
While the media has largely focused on the TCJA’s rate reductions for individuals and C corporations, the rates and bracket amounts were also modified for trusts and estates. The new rate structure for trusts and estates are located in I.R.C. §1(j)(2)(E) and are as follows: 10%: $0: $2,550; 24%: $2,551-$9,150; 35%: $9,151-$12,500; 37% - over $12,500. As can be noted, the bracket structure for trusts and estates remains very compressed. Thus, the pre-TCJA planning approach of not trapping income or gains inside a trust or an estate remains the standard advice. That’s because the TCJA did not change the tax rates for qualified dividends and long-term capital gains, although the bracket cut-offs are modified slightly as follows: 0%: $0-$2,600; 15%: $2,601-$12,700; 20%: Over $12,700. Those rates and brackets remain advantageous compared to having the income or gain taxed at the trust or estate level.
Other Aspects of Trust/Estate Taxation
Post-TCJA, it remains true that an estate or trust’s taxable income is computed in the same manner as is income for an individual. I.R.C. §641(b). However, the TCJA amends I.R.C. §164(b) to limit the aggregate deduction for state and local real property taxes and income taxes to a $10,000 maximum annually. But, this limit does not apply to any real estate taxes or personal property taxes that a trust or an estate incurs in the conduct of a trade or business (or an activity that is defined under I.R.C. §212). Thus, an active farm business conducted by a trust or an estate will not be subject to the limitation.
The TCJA also suspends miscellaneous itemized deductions for a trust or an estate. That means, for example, that investment fees and expenses as well as unreimbursed business expenses are not deductible. This will generally cause an increased tax liability at the trust or estate level as compared to prior law. Why? With fewer deductions, the adjusted taxable income (ATI) of a trust or an estate will be higher. For simple trusts, this is also a function of distributable net income (DNI) which, in turn, is a function of the income distribution deduction (IDD). I.R.C. §651(b) allows a simple trust to claim an IDD limited to the lesser of fiduciary accounting income (FAI) or DNI. Under prior law, all trust expenses could be claimed when determining DNI, but only some of those expenses were allocated to principal for purposes of calculating FAI. Now, post-TCJA, ATI for a trust or an estate will be higher due to the loss of various miscellaneous itemized deductions (such as investment management fees). As ATI rises, DNI will decline but FAI won’t change (the allocation of expenses is determined by the trust language or state law). The more common result is likely to be that FAI will be the actual limitation on the IDD, and more income will be trapped inside the estate or the trust. That’s what will cause the trust or the estate to pay more tax post-TCJA compared to prior years.
But, guidance is needed concerning the deductibility of administrative expenses such as trustee fees. It’s not clear whether the TCJA impacts I.R.C. §67. That Code section does not apply the two percent limitation to administrative expenses that are incurred solely because the property is held inside a trust or an estate. There is some support for continuing to deduct these amounts. I.R.C. §67(g) applies to miscellaneous itemized deductions, but trustee fees and similar expenses are above-the-line deductions for a trust or an estate that impact the trust or estate’s AGI. Thus, I.R.C. §67 may not apply. I am told that guidance will be forthcoming on that issue during the summer of 2018. We shall see.
A trust as well as an estate can still claim a $600 personal exemption (with the amount unchanged) under I.R.C. §642. Don’t confuse that with the TCJA’s suspension of the personal exemption for individuals. Also, don’t confuse the removal of the alternative minimum tax (AMT) for corporations or the increased exemption and phaseout range for individuals with the application of the AMT to trusts and estates. No change was made concerning how the AMT applies to a trust or an estate. See I.R.C. §55.(d)(3). The exemption stays at $24,600 with a phaseout threshold of $82,050. Those amounts apply for 2018 and they will be subsequently adjusted for inflation (in accordance with the “chained” CPI).
Other TCJA Impacts on Trusts and Estates
The new 20 percent deduction for pass-through entities under I.R.C. §199A can be claimed by an estate or a trust with non-C corporate business income. The deduction is claimed at the trust or the estate level, with the $157,500 threshold that applies to a taxpayer filing as a single person applying to a trust or an estate. The rules under the now-repealed I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital. There is no separate computation required for alternative minimum tax purposes.
The eligibility of a trust or an estate for the I.R.C. §199A deduction may provide some planning opportunities to route pass-through income from a business that is otherwise limited or barred from claiming the deduction through a non-grantor trust so that the deduction can be claimed or claimed to a greater extent. For example, assume that a sole proprietorship farming operation nets $1,000,000 annually, but pays no qualified wages and has no qualifying property (both factors that result in an elimination of the deduction for the business). If business income is routed through a trust (or multiple truss) with the amount of trust income not exceeding the $157,500 threshold, then an I.R.C. §199A deduction can be generated. However, before this strategy is utilized, there are numerous factors to consider including overall family estate planning/succession planning goals and the economics of the business activity at issue.
Clarification is needed with respect to a charitable remainder trust (CRT) that has unrelated business taxable income (UBIT). UBIT is income of the CRT that comes from an unrelated trade or business less deductions “allowed by Chapter 1 of the Code” that are “directly connected” with the conduct of a trade or business. Treas. Reg. §1.512(a)-1(a). Is the new I.R.C. §199A deduction a directly connected deduction? It would seem to me that it is because it is tied to business activity conducted by the trust. If that construction is correct, I.R.C. §199A would reduce the impact of the UBIT on a CRT. Certainly, guidance is needed from the Treasury on this point.
Related to the CRT issue, the TCJA would appear to allow an electing small business trust (ESBT) to claim the I.R.C. §199A deduction on S corporate income. But, again, guidance is needed. An ESBT calculates the tax on S corporate income separately from all other trust income via a separate schedule. The result is then added to the total tax calculated for the trust’s non-S corporate income. Thus, the ESBT pays tax on all S corporate income. It makes no difference whether the income has been distributed to the ESBT beneficiaries. Also, in computing its tax, the deductions that an ESBT can claim are set forth in I.R.C. §641(c)(2). However, the TCJA does not include the I.R.C. §199A deduction in that list. Was that intentional? Was that an oversight? Your guess is as good as mine.
Another limiting factor for an ESBT is that an ESBT can no longer (post-2017 and on a permanent basis) deduct 100 percent of charitable contributions made from the S corporation’s gross income. Instead, the same limitations that apply to individuals apply to an ESBT – at least as to the “S portion” of the ESBT. But, the charitable contribution need not be made from the gross income of the ESBT. In addition, the charitable contribution must be made by the S corporation for the ESBT to claim the deduction. If the ESBT makes the contribution, it is reported on the non-ESBT portion of the return. It is not allocated to the ESBT portion.
Under the TCJA, an ESBT can have a nonresident alien as a potential current beneficiary.
If a trust or an estate incurs a business-related loss, the TCJA caps the loss at $250,000 for 2018 (inflation-adjust for future years). The $250,000 amount is in the aggregate – it applies at the trust or estate level rather than the entity level (if the trust or estate is a partner of a partnership or an S corporation shareholder). I.R.C. §461(l)(2). Amounts over the threshold can be carried over and used in a future year.
The TCJA impacts a broad array of taxpayers. Its impacts are not limited to individuals and corporate taxpayers. Trusts and estates are also affected. For those with trusts or involved with an estate, make sure to consult tax counsel to make sure the changes are being dealt with appropriately.
Tuesday, May 15, 2018
Many farm and ranch clients (and others) are asking about the appropriate entity structure for 2018 and going forward in light of the Tax Cuts and Jobs Act (TCJA). Some may be enticed to create a C corporation to get the 21 percent flat tax rate. Other, conversely, may think that a pass-through structure that can get a 20 percent qualified business income deduction is the way to go.
But, what is the correct approach? While the answer to that question depends on the particular facts of a given situation, if an existing C corporation elects S-corporate status, passive income can be a problem. The conversion from C to S may be desirable, for example, if corporate income is in the $50,000-$70,000 range. Under the TCJA, a C corporate income in that range would be taxed at 21 percent. Under prior law it would have been taxed at a lower rate – 15 percent on the first $50,000 of corporate taxable income.
Today’s post takes a look at a problem for S corporations that used to be C corporations – passive income.
S Corporation Passive Income
While S corporations are not subject to the accumulated earnings tax or the personal holding company tax (“penalty” taxes that are in addition to the regular corporate tax) as are C corporations, S corporations that have earnings and profits from prior C corporate years are subject to certain limits on passive investment income. I.R.C. §1362. Under I.R.C. §1375, a 21 percent tax is imposed on "excess net" passive income in the meantime if the corporation has C corporate earnings and profits at the end of the taxable year and greater than 25 percent of its gross receipts are from passive sources of income. For farm and ranch businesses, a major possible source of passive income is cash rent.
If passive income exceeds the 25% limit for three years, the S election is automatically terminated, and the corporation reverts to C status immediately at the end of that third taxable year. I.R.C. §1362(d)(3).
How Can Passive Income Be Avoided?
There may be several strategies that can be utilized to avoid passive income exceeding the 25 percent threshold. Here are some of the more common strategies:
Pre-paying expenses. The S corporation can avoid reporting any excess net passive income if the corporation is able to prepay sufficient expenses to offset all passive investment income and/or create negative net passive income.
Distribution of earnings and profits. In addition, another method for avoiding passive income issues is for the corporation to distribute all accumulated C corporate earnings and profits to shareholders before the end of the first S corporate year-end. I.R.C. §1375(a)(1). However, corporate shareholders will always have to deal with the problem of income tax liability that will be incurred upon the distribution of C corporate earnings and profits unless the corporation is liquidated. Generally, distributions of C corporate earnings and profits should occur when income taxation to the shareholders can be minimized. Consideration should be given to the effect that the distribution of earnings and profits will have upon the taxability of social security benefits for older shareholders. In order to make a distribution of accumulated C corporation earnings and profits, an S corporation within accumulated adjustments account (AAA) can, with the consent of all shareholders, treat distributions for any year is coming first from the subchapter C earnings and profits instead of the AAA. I.R.C. §1368(e)(3).
Deemed dividend election. If the corporation did not have sufficient cash to pay out the entire accumulated C corporation earnings and profits, the corporation may make a deemed dividend election (with the consent of all of the shareholders) under Treas. Reg. §1.1368-1(f)(3). Under this election, the corporation can be treated as having distributed all or part of its accumulated C corporate earnings and profits to the shareholders as of the last day of its taxable year. The shareholders, in turn, are deemed to have contributed the amount back to the corporation in a manner that increases stock basis. With the increased stock basis, the shareholders will be able to extract these proceeds in future years without additional taxation, as S corporate cash flow permits.
The election for a deemed dividend is made by attaching an election statement to the S corporation's timely filed original or amended Form 1120S. The election must state that the corporation is electing to make a deemed dividend under Treas. Reg. §1.1368-1(f)(3). Each shareholder who is deemed to receive a distribution during the tax year must consent to the election. Furthermore, the election must include the amount of the deemed dividend that is distributed to each shareholder. Treas. Reg. §1.1368-1(f)(5).
It should be noted that S corporation distributions are normally taxed to the shareholders as ordinary income dividends to the extent of accumulated earnings and profits (AE&P) after the accumulated adjustments account (AAA) and previously taxed income (pre-1983 S corporation undistributed earnings) have been distributed. Deemed dividends issued proportionately to all shareholders are not subject to one-class-of-stock issues and do not require payments of principal or interest.
A 20 percent tax rate applies for qualified dividends if AGI is greater than $450,000 (MFJ), $400,000 (single), $425,000 (HOH) and $225,000 (MFS). In addition, the 3.8 percent Medicare surtax on net investment income (NIIT) applies to qualified dividends if AGI exceeds $250,000 (MFJ) and $200,000 (single/HoH). However, if accumulated C corporate earnings and profits can be distributed while minimizing shareholder tax rates (keeping total AGI below the net investment income tax (NIIT) thresholds and avoiding AMT) qualified dividend distributions may be a good strategy.
The deemed dividend election can be for all or part of earnings and profits. Furthermore, the deemed dividend election automatically constitutes an election to distribute earnings and profits first as discussed above. The corporation may therefore be able to distribute sufficient cash dividends to the shareholders for them to pay the tax and to treat the balance as the deemed dividend portion. This can make it more affordable to eliminate or significantly reduce the corporation’s earnings and profits.
Modification of rental arrangements. Rents do not constitute passive investment income if the S corporation provides significant services or incurs substantial costs in conjunction with rental activities. Whether significant services are performed or substantial costs are incurred is a facts and circumstances determination. Treas. Reg. §1.1362-2(c)(5)(ii)(B)(2). The significant services test can be met by entering into a lease format that requires significant management involvement by the corporate officers.
For farm C corporations that switch to S corporate status, consideration should be given to entering into a net crop share lease (while retaining significant management decision-making authority) upon making the S election, as an alternative to a cash rent lease or a 50/50 crop share lease. Some form of bonus bushel clause is usually added to a net crop share lease in case a bumper crop is experienced or high crop sale prices result within a particular crop year. Net crop leases in the Midwest, for example, normally provide the landlord with approximately 30-33 percent of the corn and 38-40 percent of the beans grown on the real estate.
Since crop share income is generally not considered "passive" (if the significant management involvement test can be met), a net crop share lease should allow the corporation to limit involvement in the farming operation and avoid passive investment income traps unless the corporation has significant passive investment income from other sources (interest, dividends, etc.) such that passive investment income still exceeds 25 percent of gross receipts.
Other strategies. Gifts of stock to children or grandchildren could be considered so that dividends paid are taxed to those in lower tax brackets. However, tax benefits may be negated for children and grandchildren up to the age of 18–23 if they receive sufficient dividends to cause the "kiddie" tax rules to be invoked. In addition, a corporation may redeem a portion of the stock held by a deceased shareholder and treat such redemption as a capital gain redemption to the extent that the amount of the redemption does not exceed the sum of estate taxes, inheritance taxes and the amount of administration expenses of the estate. IRC §303. The capital gain reported is usually small or nonexistent due to step up in basis of a shareholder’s stock at date of death.
The TCJA may change the equation for the appropriate entity structure for a farm or ranch (or other business). If an existing C corporation elects S status, passive income may be an issue to watch out for.
Wednesday, May 9, 2018
Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications.
But, what happens if the CRP land is sold even though several years remain on the contract? This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production.
The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post.
Consequences of Early Termination
When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived). That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). That would be the case, for instance, when a lessee terminates a lease by buying the leased property. I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. Thus, allocations to lease contracts by real estate purchasers of real estate are not effective. The taxpayer must allocate the entire adjusted basis to the underlying capital asset.
Sale Price Allocation To CRP Contract
The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).
The acquiring farmer may pay the early termination costs. In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).
Early Termination Payments
Generally. A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease.
If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term. Rev. Rul. 71-283. However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale.
As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.
The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax. It’s important to understand what might happen if early termination is a possibility.
Monday, May 7, 2018
The popularity of e-filing taxes has now increased to the extent that more than 90 percent of all individual income tax returns are filed electronically. The vast majority of taxpayers that e-file find the process a simple and convenient way to file and, if a refund is due, a faster way to obtain it. But, is there any downside to e-filing? A recent federal case from California indicates that if a taxpayer isn’t diligent a big problem could arise.
The potential peril of e-filing – that’s the topic of today’s post.
In Spottiswood v. United States, No. 17-cv-00209-MEJ, 2018 U.S. Dist. LEXIS 69064 (N.D. Cal. Apr 24, 2018), the plaintiff electronically filed a joint return for the 2012 tax year via TurboTax software on April 12, 2013. The return contained an erroneous Social Security number for a dependent. The same day, the IRS rejected the return because the Social Security number and last name did not match IRS records. Later that same day, TurboTax sent the plaintiff an email notifying him that the return had been rejected due to the mismatch of the name and Social Security number for the dependent.
The email notification of the rejected return is exactly how the system is supposed to work. However, the plaintiff failed to check his email account and, hence, did not learn of the e-file status of the return until about 18 months later. Consequently, the IRS assessed late payment and late filing penalties.
The plaintiff filed the 2012 return on January 7, 2015 and paid the $395,619 tax liability in full. On February 16, 2015, the IRS assessed a late filing penalty of $89,014.27 and a late payment penalty of $41,539.99 plus interest of $26,216.81 on the late payment. The plaintiff paid the interest, but not the penalties. On April 27, 2015, the plaintiff submitted a statement to the IRS noting that had he realized that the return had not been accepted he could have paper filed the return on a timely basis. The plaintiff also conceded that he didn’t read the “fine print” of the tax software agreement that “may have” notified him that he needed to log back in to ensure that the return was accepted. The plaintiff, in August of 2016, filed a request via Form 843 for abatement of the penalties for late filing and late payment, and lied that the 2012 return had been electronically filed via TurboTax without issue. The plaintiff filed suit challenging the assessment of the penalties.
At trial, the plaintiff conceded the late payment penalty (and associated interest) but challenged the other penalties and interest assessed. The plaintiff claimed that the document filed should have been accepted as a “return” and should not have been rejected. The plaintiff claimed that the return met all of the requirements of Beard v. Comr., 82 T.C. 766 (1984) because it was sufficient to calculate the tax liability; purported to be a return; was an honest and reasonable attempt to satisfy the requirements of the tax law; and was executed under the penalty of perjury. The plaintiff also pointed out that the IRS would have accepted the return had it been paper-filed, citing the Internal Revenue Manual (IRM).
Unfortunately for the plaintiff, the trial court determined that the plaintiff had not properly established a foundation for the IRM, and did not create a triable issue of fact as to whether the same mistake on a paper-filed return would have been accepted by the IRS. Accordingly, the court held that the return, as filed, did not allow the IRS to compute the plaintiff’s tax liability (without providing any explanation of how a Social Security number mismatch had anything to do with computing tax liability) and granted the government’s motion for summary judgment.
While e-filing a return can be a desirable method for filing a return it is imperative to ensure that the IRS has accepted the return. Any type of communication that doesn’t involve direct, face-to-face communication has its drawbacks. When a return is e-filed, it’s a must to make sure that the return has been accepted. Diligently checking for an email verification is absolutely essential. Not doing so could be quite costly.
Friday, April 27, 2018
When a farmer sells an harvested crop, the tax rules surrounding the reporting of the income from the sale are fairly well understood. But, what happens when a farmer dies during the growing season? The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord. If the decedent was a landlord, the type of lease matters.
The tax rules involving the post-death sale of crops and livestock – that’s the focus of today’s post.
For income tax purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death. I.R.C. §1014(a)(1). But, there is an exception to this general rule. Income in respect of decedent (IRD) property does not receive any step-up in basis. I.R.C. §691. IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.
In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.
- The decedent entered into a legal agreement regarding the subject matter of the sale.
- The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).
- No economically material contingencies that might have disrupted the sale existed at the time of death.
- The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.
The case involved the sale of calves by a decedent’s estate. Two-thirds of the calves were deliverable on the date of the decedent’s death. The other third were too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered. The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death. In addition, the estate’s activities with respect to the calves were substantial and essential. The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied.
Farmer or Landlord?
Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.
- Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters.
- If the decedent was a farm landlord, was the decedent a materially participating landlord or a non-materially participating landlord?
For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366. See also Estate of Burnett v. Comm’r, 2 TC 897 (1943). The rule is the same if the decedent was a landlord under a material participation lease. These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014. No allocation is made between the decedent’s estate and the decedent’s final income tax return. Treas. Reg. §20.2031-1(b).
From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.
If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964). That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death. If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final return. No prorations would have been required. If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula.
IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.
Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction. Rev. Rul. 75-11, 1975-1 CB 27.
Character of Gain
Sale of grain. Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes. I.R.C. §§61(a)(2), 63(b). However, when a farmer dies and the estate sells grain inventory within six months after death, the income from the sale is treated as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule. I.R.C. §1223(9). However, ordinary income treatment occurs in the crop was raised on land that is leased to a tenant. See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959).
If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business. Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.
The sale of crops and livestock post-death are governed by specific tax rules. Because death often occurs during a growing period, it’s important to know these unique rules.
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.