Thursday, June 14, 2018

Farmers, Self-Employment Tax and Personal Property Leases

Overview

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.

General Rule

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.     

Conclusion

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. 

June 14, 2018 in Income Tax | Permalink | Comments (0)

Friday, May 25, 2018

The TCJA and I.R.C. 529 Plans

Overview

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.

Background

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.

Tax Treatment

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.

Eligible Student

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.”

Funding Ceiling

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.

Qualified Expenses

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.

Non-Qualified Expenses

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.

Conclusion

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.

May 25, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, May 23, 2018

The Impact of the TCJA on Estates and Trusts

Overview

The Tax Cuts and Jobs Act (TCJA) that was signed into law on December 22, 2017, represents a major change to many provisions of the tax Code that impact individuals and business entities. I have discussed of the major changes impacting farm and ranch taxpayers and businesses in prior posts. But, the TCJA also makes substantial changes with respect to the income taxation of trusts and estates. Those changes could have an impact on the use of trusts as an estate planning/wealth transfer device. Likewise, the TCJA changes that impact decedent’s estate must also be noted.

The TCJA’s changes that impact trusts and estates – that’s the focus of today’s post.

In General

While the media has largely focused on the TCJA’s rate reductions for individuals and C corporations, the rates and bracket amounts were also modified for trusts and estates. The new rate structure for trusts and estates are located in I.R.C. §1(j)(2)(E) and are as follows: 10%: $0: $2,550; 24%: $2,551-$9,150; 35%: $9,151-$12,500; 37% - over $12,500. As can be noted, the bracket structure for trusts and estates remains very compressed. Thus, the pre-TCJA planning approach of not trapping income or gains inside a trust or an estate remains the standard advice. That’s because the TCJA did not change the tax rates for qualified dividends and long-term capital gains, although the bracket cut-offs are modified slightly as follows: 0%: $0-$2,600; 15%: $2,601-$12,700; 20%: Over $12,700. Those rates and brackets remain advantageous compared to having the income or gain taxed at the trust or estate level.

Other Aspects of Trust/Estate Taxation

Post-TCJA, it remains true that an estate or trust’s taxable income is computed in the same manner as is income for an individual. I.R.C. §641(b). However, the TCJA amends I.R.C. §164(b) to limit the aggregate deduction for state and local real property taxes and income taxes to a $10,000 maximum annually. But, this limit does not apply to any real estate taxes or personal property taxes that a trust or an estate incurs in the conduct of a trade or business (or an activity that is defined under I.R.C. §212). Thus, an active farm business conducted by a trust or an estate will not be subject to the limitation.

The TCJA also suspends miscellaneous itemized deductions for a trust or an estate. That means, for example, that investment fees and expenses as well as unreimbursed business expenses are not deductible. This will generally cause an increased tax liability at the trust or estate level as compared to prior law. Why? With fewer deductions, the adjusted taxable income (ATI) of a trust or an estate will be higher. For simple trusts, this is also a function of distributable net income (DNI) which, in turn, is a function of the income distribution deduction (IDD). I.R.C. §651(b) allows a simple trust to claim an IDD limited to the lesser of fiduciary accounting income (FAI) or DNI. Under prior law, all trust expenses could be claimed when determining DNI, but only some of those expenses were allocated to principal for purposes of calculating FAI. Now, post-TCJA, ATI for a trust or an estate will be higher due to the loss of various miscellaneous itemized deductions (such as investment management fees). As ATI rises, DNI will decline but FAI won’t change (the allocation of expenses is determined by the trust language or state law). The more common result is likely to be that FAI will be the actual limitation on the IDD, and more income will be trapped inside the estate or the trust. That’s what will cause the trust or the estate to pay more tax post-TCJA compared to prior years.

But, guidance is needed concerning the deductibility of administrative expenses such as trustee fees. It’s not clear whether the TCJA impacts I.R.C. §67. That Code section does not apply the two percent limitation to administrative expenses that are incurred solely because the property is held inside a trust or an estate. There is some support for continuing to deduct these amounts. I.R.C. §67(g) applies to miscellaneous itemized deductions, but trustee fees and similar expenses are above-the-line deductions for a trust or an estate that impact the trust or estate’s AGI. Thus, I.R.C. §67 may not apply. I am told that guidance will be forthcoming on that issue during the summer of 2018. We shall see.

A trust as well as an estate can still claim a $600 personal exemption (with the amount unchanged) under I.R.C. §642. Don’t confuse that with the TCJA’s suspension of the personal exemption for individuals. Also, don’t confuse the removal of the alternative minimum tax (AMT) for corporations or the increased exemption and phaseout range for individuals with the application of the AMT to trusts and estates. No change was made concerning how the AMT applies to a trust or an estate. See I.R.C. §55.(d)(3). The exemption stays at $24,600 with a phaseout threshold of $82,050. Those amounts apply for 2018 and they will be subsequently adjusted for inflation (in accordance with the “chained” CPI).

Other TCJA Impacts on Trusts and Estates

The new 20 percent deduction for pass-through entities under I.R.C. §199A can be claimed by an estate or a trust with non-C corporate business income. The deduction is claimed at the trust or the estate level, with the $157,500 threshold that applies to a taxpayer filing as a single person applying to a trust or an estate. The rules under the now-repealed I.R.C. §199 apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital. There is no separate computation required for alternative minimum tax purposes.

The eligibility of a trust or an estate for the I.R.C. §199A deduction may provide some planning opportunities to route pass-through income from a business that is otherwise limited or barred from claiming the deduction through a non-grantor trust so that the deduction can be claimed or claimed to a greater extent. For example, assume that a sole proprietorship farming operation nets $1,000,000 annually, but pays no qualified wages and has no qualifying property (both factors that result in an elimination of the deduction for the business). If business income is routed through a trust (or multiple truss) with the amount of trust income not exceeding the $157,500 threshold, then an I.R.C. §199A deduction can be generated. However, before this strategy is utilized, there are numerous factors to consider including overall family estate planning/succession planning goals and the economics of the business activity at issue.

Clarification is needed with respect to a charitable remainder trust (CRT) that has unrelated business taxable income (UBIT). UBIT is income of the CRT that comes from an unrelated trade or business less deductions “allowed by Chapter 1 of the Code” that are “directly connected” with the conduct of a trade or business. Treas. Reg. §1.512(a)-1(a). Is the new I.R.C. §199A deduction a directly connected deduction? It would seem to me that it is because it is tied to business activity conducted by the trust. If that construction is correct, I.R.C. §199A would reduce the impact of the UBIT on a CRT. Certainly, guidance is needed from the Treasury on this point.

Related to the CRT issue, the TCJA would appear to allow an electing small business trust (ESBT) to claim the I.R.C. §199A deduction on S corporate income. But, again, guidance is needed. An ESBT calculates the tax on S corporate income separately from all other trust income via a separate schedule. The result is then added to the total tax calculated for the trust’s non-S corporate income. Thus, the ESBT pays tax on all S corporate income. It makes no difference whether the income has been distributed to the ESBT beneficiaries. Also, in computing its tax, the deductions that an ESBT can claim are set forth in I.R.C. §641(c)(2). However, the TCJA does not include the I.R.C. §199A deduction in that list. Was that intentional? Was that an oversight? Your guess is as good as mine.

Another limiting factor for an ESBT is that an ESBT can no longer (post-2017 and on a permanent basis) deduct 100 percent of charitable contributions made from the S corporation’s gross income. Instead, the same limitations that apply to individuals apply to an ESBT – at least as to the “S portion” of the ESBT. But, the charitable contribution need not be made from the gross income of the ESBT. In addition, the charitable contribution must be made by the S corporation for the ESBT to claim the deduction. If the ESBT makes the contribution, it is reported on the non-ESBT portion of the return. It is not allocated to the ESBT portion.

Under the TCJA, an ESBT can have a nonresident alien as a potential current beneficiary.

If a trust or an estate incurs a business-related loss, the TCJA caps the loss at $250,000 for 2018 (inflation-adjust for future years). The $250,000 amount is in the aggregate – it applies at the trust or estate level rather than the entity level (if the trust or estate is a partner of a partnership or an S corporation shareholder). I.R.C. §461(l)(2). Amounts over the threshold can be carried over and used in a future year.

Conclusion

The TCJA impacts a broad array of taxpayers. Its impacts are not limited to individuals and corporate taxpayers. Trusts and estates are also affected. For those with trusts or involved with an estate, make sure to consult tax counsel to make sure the changes are being dealt with appropriately.

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

Tuesday, May 15, 2018

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

Overview

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

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

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

S Corporation Passive Income

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

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

How Can Passive Income Be Avoided?

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Wednesday, May 9, 2018

Purchase and Sale Allocations to CRP Contracts

In General

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.

Conclusion

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.

May 9, 2018 in Income Tax, Real Property | Permalink | Comments (0)

Monday, May 7, 2018

Is There a Downside Risk to E-Filing Your Taxes?

Overview

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.

California Case

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. 

Conclusion

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.

May 7, 2018 in Income Tax | Permalink | Comments (1)

Friday, April 27, 2018

Post-Death Sale of Crops and Livestock

Overview

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.

General Rule

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.

  1. The decedent entered into a legal agreement regarding the subject matter of the sale.
  2. 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).
  3. No economically material contingencies that might have disrupted the sale existed at the time of death.
  4. 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.

  1. 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. 
  2. 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.  

Conclusion

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.

April 27, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, April 25, 2018

Gifts of Ag Commodities To Children and the New Tax Law

Overview

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.      

Conclusion

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. 

April 25, 2018 in Income Tax | Permalink | Comments (0)

Monday, April 23, 2018

Divorce and the New Tax Law – IRS Grants Some Relief

Overview

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.

Pre-TCJA Law

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). 

TCJA Modification

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.

Conclusion

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.

April 23, 2018 in Income Tax | Permalink | Comments (0)

Thursday, April 19, 2018

Passive Activities and Grouping

Overview

It is not uncommon for a farmer or a higher-income taxpayer to invest in various activities in which they do not materially participate (as determined by a seven-factor test under Treas. Reg. §1.469-5T(a).  Examples of passive investments for farmers include rental activities, “condominium” grain storage LLCs and interests in ethanol and bio-diesel plants.  These investments generate either passive income or passive losses.  Passive income is subject to ordinary income tax and may also be subject to an additional 3.8 percent passive tax.  I.R.C. §1411.  When a passive activity generates losses, however, the passive activity rules limit the ability to deduct the losses to the extent the taxpayer has passive income in the current year.  Otherwise, they are deducted in the taxpayer’s final year of the investment.   

When a farmer (or other taxpayer) has investments in which they don’t materially participate and, hence, potentially face the impact of the passive activity rules can those investment activities be combined with an activity in which the taxpayer materially participates so that the limitation on deducting losses can be avoided?  There might be.  It might be possible to group activities.  A recent case shows how the grouping rules work.

That’s the topic of today’s post – grouping activities under the passive loss rules.

Grouping Activities 

An election can be made on the tax return to group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. Treas. Reg. §1.469-4.  Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.”  But, how is an appropriate economic unit determined?  The Treasury Regulations state that a taxpayer may use any reasonable method to make the grouping determination, although the following factors set forth in Treas. Reg. 1.469‑4(c)(2) are given the greatest weight:

  • Similarities and differences in types of business;
  • The extent of common control;
  • The extent of common ownership;
  • Geographical location; and
  • Interdependence between the activities

Grouping disclosure.  The IRS has issued final guidance on the disclosure reporting requirements of groupings (and regroupings). Rev. Proc. 2010-13, 2010-1 C.B. 329.  A grouping statement is to be filed with the tax return stating that the taxpayer is electing to group the listed activities together so that they are treated as a single activity for the tax year, and all years thereafter.  The taxpayer should also represent in the grouping statement that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.

A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, since 2013, a 3.8 percent net investment income tax applies to net rental income and other passive business income of upper income taxpayers.

Under the guidance, a written tax return statement is required for:

  • New groupings, such as in the first year of grouping two activities;
  • The addition of a new activity to an existing grouping; and
  • Regroupings, such as for an error or change in facts.

However, no written statement is required for:

  • Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
  • The disposition of an activity from a grouping; and
  • Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.

If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity.

Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer.  However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure.

Special Grouping Rules

A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity. Treas. Reg. §1.469-4(d)(1).

An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business. Treas. Reg. §1.469-4(d)(5)(ii).

An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. Treas. Reg. §1.469-4(d)(2).

Recent Case

A recent case illustrates the how the factors for grouping are applied.  In Brumbaugh v. Comr. T.C. Memo. 2018-40, the petitioner owned 60 percent of a C corporation that was engaged in developing real estate. The balance of the stock was owned by two others. The business had its headquarters in southern California and the plaintiff participated in the business for more than 500 hours in 2007, the year in issue. The business had a development project in 2007 in northern California several hundred miles away. The shareholders discussed buying an airplane for the trips to the project and back to southern California.

Ultimately, instead of the corporation buying the plane, the plaintiff bought it personally through his LLC. In 2006, the plaintiff had formed and LLC (taxed as a partnership) in which he owned 51 percent and his wife owned 49 percent. The LLC entered into a management agreement with an aviation company that provided that the aviation company was responsible for all managerial duties related to the plane and had the exclusive right to charter the plane for commercial flights by third parties whenever the petitioner did not need to use the plane. The plaintiff was also given access to other planes when his was being chartered. In 2007, the plaintiff used the plane on only one occasion. On four other occasions he used a different plane because his was being chartered. On petitioner’s 2007 return, he reported a $683,000 loss. Upon audit, the IRS recharacterized the loss as a passive loss on the basis that the plaintiff had not materially participated in the LLC’s activities.

The Tax Court agreed with the IRS and also concluded that the petitioner could not group the airplane activity with the real estate development activity because none of the Treas. Reg. §1.469-4(c)(2) factors favored grouping the two activities together. There was no functional similarity between the two activities and the plane was not integrated into the real estate activity in any way. While the factors for extent of common ownership and common control were neutral (the petitioner held controlling interests in both entities, but the interests were very different), there was no interdependence between the two businesses. In addition, the court noted that the petitioner did not materially participate in the aviation activity because there was no evidence to support the petitioner’s contention that he participated for at least 100 hours including no contemporaneous logs, appointment books, calendars or narrative summaries. In any event, the petitioner did not devote 500 or more hours in the aggregate to “significant participation activities.”  In addition, the real estate development activity did not qualify as a significant participation activity (another issue not discussed in this post). 

Conclusion

Farmers, ranchers and other taxpayers often engage (invest) in passive activities in addition to their business activity in which they materially participate.  While it is possible to group the investment activities with a farming business, for example, the factors set forth in the regulations for grouping must be satisfied.  The recent Tax Court case illustrates that it can be rather difficult to satisfying those factors.

April 19, 2018 in Income Tax | Permalink | Comments (0)

Friday, April 13, 2018

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

Overview

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

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

Calendar of Events

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

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

May 9 – CoBank, Wichita KS

May 10 – Kansas Society of CPAs, Salina, KS

May 14 - Lorman, Co. Webinar

May 16 – Quincy Estate Planning Council, Quincy, IL

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

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

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

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

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

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

June 27 – Kansas Society of CPAs, Topeka, KS

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

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

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

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

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

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

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

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

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

September 21 – University of Illinois, Moline, IL

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

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

October 3 – CoBank, Wichita, KS

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

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

Special Attention – Summer Seminar

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

Conclusion

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

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

Wednesday, April 11, 2018

Distinguishing Between a Capital Lease and an Operating Lease

Overview

Economic conditions in much of agriculture have deteriorated in recent years. Prices for many crops have dropped, livestock prices have come down from recent highs, and cash rents and land values have leveled off or fallen. In some instances, agricultural producers leveraged to expand their operations during the good times, only to find that the tougher farm economy has made things financially difficult.

In the downturn, legal and tax issues become critically important for many farmers and ranchers. One of those involves the distinction between a capital lease and an operating lease.  That distinction and why it matters is the topic of today’s post.

The Basics

A capital lease is a lease in which the only thing that the lessor does is finance the “leased” asset, and all other rights of ownership transfer to the lessee. Conversely, with an operating lease the asset owner (lessor) transfers only the right to use the property to the lessee. Ownership is not transferred as it is with a capital lease, and possession of the property reverts to the lessor at the end of the lease term. As a result, if the transaction is a capital lease, the asset is the lessee’s property and, for accounting purposes, is recorded as such in the lessee’s general ledger as a fixed asset. For tax purposes, the lessee deducts the interest portion of the capital lease payment as an expense, rather than the amount of the entire lease payment (which can be done with an operating lease).

Distinguishing Characteristics

So, what distinguishes a capital lease from an operating lease and why is the distinction important? There are at least a couple of reasons for properly characterizing capital and operating leases. One reason involves the fact that leases can be kept off a lessee’s financial statements, which could provide a misleading picture of the lessee’s finances. Another reason involves the proper tax characterization of the transaction. With an operating lease, the lessee deducts the lease payment as an operating expense and there is no impact on the lessee’s balance sheet. With a capital lease, however, the lessee recognizes the lease as an asset and the lease payment as a liability on the balance sheet. Also, with a capital lease, the lessee claims an annual amount of depreciation and deducts the interest expense associated with the lease. Based on these distinctions, many businesses prefer to treat lease transactions as operating leases, sometimes when the structure of the transaction indicates that they should not.

For a capital lease, the present value of all lease payments is considered to be the asset’s cost which, as noted above, the lessee records as a fixed asset, with an offsetting credit to a capital lease liability account. For accounting purposes, as each lease payment is made, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lessor has revenue equal to the present value of the future cash flows from the lease, and records the expenses associated with the lease. For the lessor, a lease receivable is recorded on the lessor’s balance sheet and recognizes the interest income as it is paid.

FASB Standards

A transaction that is a capital lease has any one of the following features (according to the Financial Accounting Standards Board (FASB)):

  • Ownership of the asset shifted from the lessee by the end of the lease period; or
  • The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
  • The lease term is at least 75 percent of the estimated economic life of the asset (and the lease cannot be cancelled during that time); or
  • The value of the minimum lease payments (discounted to present value) required under the lease equals or exceeds 90 percent of the fair value of the asset at the time the lease is entered into.

If none of the above factors can be satisfied, the transaction is an operating lease. In that event, the lessee is able to deduct the lease payment as a business expense and the leased asset is not treated as an asset of the lessee.

In the typical example, a farmer “trades in” equipment in return for not having to pay any of the operating lease payments or make a large down payment on the lease. If the trade is for a capital lease, with the IRS treating the transaction as a financing arrangement (i.e., a loan), then no gain is triggered on the trade if no cash is received. But there also is no deduction for the lease payments (although interest may be deductible). If the trade constitutes an operating lease, the farmer has gain equal to the amount of “trade-in” value that is credited to the operating lease minus the farmer’s tax cost in the equipment. The gain can be offset (partially or fully) with the lease expense (lease cost amortized for the year of sale).

Example:

On June 1, 2016, a farmer trades in a used, fully depreciated, tractor worth $120,000 for a new tractor under an operating lease over four years. The farmer will have ordinary income of $120,000 in 2016 and can deduct the lease payments made in 2016 and later years as a business expense. Had the trade occurred late in 2016, it is possible that no lease expense could be claimed in 2016, but that $30,000 could be claimed as a lease expense deduction in each year of 2017- 2020.

TCJA Modification to Like-Kind Exchanges

While the above discussion focuses on a trade-in of equipment in return for a lease, it is useful to remember that the recently enacted tax bill modifies the like-kind exchange rules.  Under a provision include the “Tax Cut and Jobs Act,” for exchanges completed after December 31, 2017, I.R.C. §1031 is inapplicable to personal property exchanges.  Thus, for example, on the trade of an item of farm equipment, the transaction will be treated as a sale with gain recognition on the sale of the item “traded.”  The trade-in value is reported as the sales price (Form 4797), with no tax deferral for any I.R.C. §1231 gain or I.R.C. §1245 recapture. The typical result will be that gain will result because most farm equipment has been fully depreciated via expense method or bonus depreciation.    The taxpayer’s income tax basis in the new item of farm equipment acquired in the “trade” will be the new item’s purchase price.  That amount will then be eligible for a 100 percent deduction (“bonus” depreciation) through 2022.  The “bonus” percentage is reduced 20 percentage points annually through 2026.  In 2027, a taxpayer would have to report 100 percent of the gain realized on a “trade” of personal property, but could deduct the cost of the item acquired in the “trade” under the expense method depreciation provision of I.R.C. §179 (presently capped at $1 million).  The gain on the “trade” is not subject to self-employment tax, and the depreciation deduction on the item acquired in the trade reduces self-employment tax. A further complication, beginning in 2018, is that net operating losses can only offset 80 percent of taxable income.  Thus, a taxpayer may want to elect out of bonus depreciation on the newly acquired asset and use just enough expense method depreciation to get taxable income to the desired level.

Conclusion

Understanding the difference between a capital lease and an operating lease, is helpful to avoiding bad tax and legal results in agricultural transactions.  The proper classification is very important.  It’s a big deal particularly when the agricultural economy turns south.

April 11, 2018 in Income Tax | Permalink | Comments (0)

Tuesday, April 3, 2018

Refundable Fuel Credits - Following the Rules Matters

Overview

The Congress, through numerous tax and other legislative bills that have been enacted since the 1970s, has provided numerous subsidies designed to stimulate the production, sale and use of alternative fuels.  In addition to the production-related subsidies, alternative fuel infrastructure subsidies also exist.  In addition to the tax subsidies, Title IX of the 2014 Farm Bill included $694 million of mandatory funding and $765 million of discretionary funding for biofuels.    In addition to tax subsidies and other funding mechanisms, the Renewable Fuel Standard provides preferential treatment for corn and soybean production.  Many farmers, particularly in the Midwest, view the credits as important to their businesses (by removing supply and creating demand) and as an investment opportunity (“fueled” as it is, by government mandates).

The Internal Revenue Code (Code) provisions concerning the tax credits for alternative fuels are complex and must be precisely followed.  The fact that many of these credits are refundable (can reduce the tax liability below zero and allow a tax refund to be obtained) increases the likelihood of fraud with respect to their usage.  As a consequence, the IRS can levy huge penalties for the misuse of the credits.  A recent federal case from Iowa illustrates how the alternative fuel credit can be misused, and the penalties that can apply for such misuse.

The alternative fuel credit – that’s the topic of today’s post.

The Alternative Fuel Credit

Section 6426 of the Code provides for several alternative fuel credits.  Subsection (d) specifies the details for the alternative fuel credit.  The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004.  That initial version provided credits for alcohol and biodiesel fuel mixtures.  In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures.  The credits proved popular with taxpayers.  During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.”  That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy).  The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy.  C.C.M. AM2010-001 (Mar. 12, 2010).  However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit.

As modified, I.R.C. §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used.  In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business. 

For purposes of I.R.C. §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3).  I.R.C. §6426(d)(2)(G).  “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.”  An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel.  See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b).  An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer.  Id.  In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS.  I.R.C. 6426(a)(2). 

Recent Case

In Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018), the plaintiff was a Pella, IA firm that produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business.  Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the I.R.C. §6426 refundable credit for alternative fuel production.

To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries.  In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day.

The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction.  The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code.  The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.”  A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit.  C.C.A. 201133010 (Jul. 12, 2011).  The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”

The plaintiff claimed a refundable alternative fuel mixture credit in accordance with I.R.C. §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014.  The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (I.R.C. §6675); civil fraud penalty (I.R.C. §6663) and failure-to-file and failure-to-pay penalties (I.R.C. 6651).

The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied.

In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits.

The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice.  In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon.  Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon.

The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786.  A large part of the other penalties had already been abated.  The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff. 

Conclusion

Initially, the refundable credits were presented to Congress as incubators. As the business and demand grew, there would be less need for the subsidy. The initial tax subsidies are critical for these business models to succeed. Unknown is whether any of the business models wean themselves off of the credit to be successful without taxpayer subsidy.

Each year, the IRS releases a list of the “Dirty Dozen” tax scams.  On the current list are “excessive claims for business credits.”  That includes alternative fuel tax credits.  The fact that the alternative fuel credit is refundable makes it even more enticing to those that are seeking to scam the system.  While alternative fuel credits may have their place, extreme care must be taken to ensure that appropriate business models and transactions are utilized to properly claim them. In the recent case, a local municipality (the WRA) was brought in to help make the scam look legitimate.

April 3, 2018 in Income Tax | Permalink | Comments (0)

Friday, March 30, 2018

Tax Issues Associated With Oil and Gas Production

Overview

The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies. It is important to understand the various types of payments that a landowner might receive and the tax consequences that may apply due to the nature of the income received.

Sorting through the various types of payments associated with an oil and gas lease and their tax implications is the topic of today’s post.

Relationship of the Parties

The income from the oil and gas property is commonly divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In the typical lease arrangement, the royalty owner retains one-eighth (12.5 percent) and the working interest owner holds the other 87.5 percent (the balance of the portion of production or income that remains after the royalty interest owner’s share is satisfied).

The working interest owner bears the entire cost of exploration for minerals, as well as the development and production costs. The royalty owner bears none of the exploration, development, or operational costs. The funding necessary for the working interest owner to develop the oil and gas property is provided by investors who receive an interest in the activity in exchange for their capital investment. The costs of the activity borne by the working interest owner are allocated to the investors. These include geological survey costs, tangible costs (the drilling equipment and well), and intangible drilling costs (IDC).  These costs can be currently deducted rather than capitalized.

This relationship between the working interest owner and the investors is typically a joint venture that is classified as a partnership for tax purposes. Thus, the partnership passes through the costs separately to the investors on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. In the early years of the activity, the partnership typically passes through large losses to the partners. Because the partners are merely investors in the activity, the losses in their hands are passive losses. These losses are limited under the passive loss rules (I.R.C. §1411) such that they are only deductible to the extent the investor has passive income.

The working interest owner (who owns the interest either directly or through an entity that does not limit liability for the interest), however, is treated as being engaged in a non-passive activity regardless of the participation of the working interest owner. Temp. Treas. Reg. §1.469-1T(e)(4)(i).   Likewise, for an investor who holds both a general and limited partnership interest, the investor’s entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity regardless of whether the investor is materially participating.

Note:  Investors in the working interest activity, given the broad definition of “partnership” contained in the Code, will likely have income from the activity that is subject to self-employment tax even though they are not materially participating in the activity.  See, e.g., Methvin v. Comm’r, T.C. Memo 2015-81, aff’d., 653 Fed. Appx. 616 (10th Cir. 2016). 

Types of Payments

Bonus payment.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014). 

For the lessee, a bonus payment is not deductible even if it is paid in installments. It must be capitalized as a leasehold acquisition cost. However, the bonus payment may be subject to cost depletion.

Installment bonus payments. A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.

A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Delay rentals.  A delay rental is paid for the privilege of deferring development of the property by extending the primary term to allow additional time for drilling operations to begin. It can be avoided either by abandonment of the lease or by starting development operations (i.e., drilling for oil or obtaining production). A delay rental payment is “pure rent.” It is simply a payment to defer development rather than a payment for oil.

Delay rentals are ordinary income regardless of whether they are based on production. However, if they are not based on production, they are not depletable gross income to the lessor.  Treas. Reg. §1.612-3(c)(2).    Depletable gross income for the lessor is the royalty income received. Royalty income is based on production.  If the delay rentals paid are not based on production, they do not reduce the lessee’s depletable gross income.  Treas. Reg. §1.613-2(c)(5).

Delay rental payments are reported in the same manner as bonus payments. They are reported to the lessor in box 1 of Form 1099-MISC and constitute NII potentially subject to the additional 3.8 percent NIIT. The lessor reports the payments on Schedule E, with the amount flowing to line 17 of Form 1040, and are potentially subject to the NIIT.

Under Treas. Reg. §1.612-3(c), delay rentals are in the nature of rent that the lessee can deduct as a current expense.  However, the IRS maintains that I.R.C. §263A applies to delay rentals, which requires that the payments be capitalized.  The only exception to capitalization applies if the taxpayer has credible evidence establishing that the leasehold was acquired for some reason other than development.

Royalty income.  A landowner royalty is the right to the oil, gas, or minerals “in place” that entitles the owner to a specified percentage of gross production (if and when production occurs) free of the expenses of development and operations. A royalty interest is a continuing non-operating interest in oil and gas. Thus, a royalty payment is a payment for oil and gas.

Royalty payments are payments received for the extraction of minerals from the property that the landowner, as lessor, owns.   Royalties are paid as an agreed-upon percentage of the resource extracted (i.e., based on production).

Royalty payments are ordinary income that is reported to the lessor in box 2 of Form 1099-MISC. Royalty payments may be reduced by percentage or cost depletion. The lessor reports the royalty income on Schedule E, are they are included in NII and are subject to the additional 3.8 percent NIIT if the taxpayer’s gross income is above the applicable threshold ($200,000 single; $250,000 MFJ).

The lessee can deduct royalty payments as a trade or business expense. In addition, if the lessee pays the ad valorem taxes (taxes based on the property’s value) on mineral property, the payment constitutes an additional royalty to the lessor to the extent that income from production covers the tax payment.

Advance royalties. Although it is not commonly included in oil and gas leases, the lease may contain a provision providing the mineral owner with an advance royalty of the operating interest. Thus, an advance royalty is paid before the production of minerals occurs, and can be paid to the lessor either in a lump sum or periodically until production begins. The lessee deducts the advance royalty payments in the year in which the mineral production (on account of which it was paid) is sold.

Advance royalties are ordinary income to the lessor, and the lessor is not entitled to percentage depletion on the payments. However, the lessor is entitled to cost depletion in the year the payments are made to the extent they exceed production.

Advance minimum royalties. Advance minimum royalties meet the same conditions as an advanced royalty, but there is also a minimum royalty provision in the contract. This provision requires that a substantially uniform amount of royalties be paid at least annually over the life of the lease or for a period of at least 20 years.

The tax treatment to the lessor for advance minimum royalties is the same as with advanced royalties.  The lessee can deduct the advance royalties from gross income in the year the oil or gas is sold or recovered. The lessee also has the option to deduct the payments in the year they are paid or accrued.

Shut-in royalties. The lease may provide for payments to be made to the lessor when a well is shut- in (turned off because of lack of market or marketing facilities) but the well is still capable of producing in commercial quantities. The lessee is entitled to deduct the shut-in royalty payment and the lessor must report the payment as income.

Damage payments.  When a well is drilled, the nearby surface area can suffer damages that may entitle the landowner to compensation. To determine the income tax consequences of any payment for surface damages, the governing instrument (lease, etc.) may provide guidance.

Compensatory damages associated with lost profit (e.g., crop damage payments) are taxable as ordinary income (treated as a sale of the crop). To the extent the damage payment represents damages for destruction of business goodwill, the payment is nontaxable up to the taxpayer’s basis in the affected property. The amount of the damage payment that exceeds the taxpayer’s basis is taxable as I.R.C. §1231 gain. Payments for anticipated damages (but when no actual damage occurs) are reported as ordinary income.  See, e.g., Gilbertz v. U.S., 808 F.2d 1374 (10th Cir. 1987), rev’g 574 F. Supp. 177 (Wyo. 1983).

Production payments.  Most landowners retain only a royalty interest in minerals. However, landowners who have a working (operating) interest in the production may also receive a “production payment.” A production payment arises from a transaction in which the owner of an oil and gas interest sells a specific volume of production from an identifiable property until a specified amount of money or minerals has been received. A production payment is payable only out of the working interests’ share of production.

There are two types of production payments.  Retained production payments result when the mineral interest owner assigns the interest and retains a production payment. The payment is payable out of future production from the assigned property interest.  A carved-out production payment is created when an owner of a mineral interest assigns a production payment to another person but retains the interest in the property from which the production payment is assigned.

Generally, a carved-out production payment is treated under I.R.C. §636 as a mortgage (nonrecourse) loan on the property. As such, it does not qualify as an economic interest in the property. The lessee treats the payments as principal repayment and interest expense, and the lessor treats the payments received as principal and interest income. Thus, the producer does not recognize taxable income at the time the transaction is entered into. The lessor continues to be treated as the owner of the burdened properties. As the production occurs and is delivered to the holder of the production payment, the lessor is treated as having sold the production for its FMV and having applied the proceeds to repay the principal and interest due to the holder.

However, if the consideration given for the production payment is pledged for development of the property or if the production payment is retained when the property is leased, the payment qualifies as an economic interest. In this situation, the payments that the lessor receives via the production payment agreement are ordinary income that are subject to cost or percentage depletion.  The lessee capitalizes the payments.  The transaction may be treated as the sale of an overriding royalty interest in some instances, however.

Treas. Reg. §1.636-3 requires that the life of the production payment be shorter than the life of the property. Thus, for an unexplored property, if no minerals are discovered or the reserves are in such small quantities that they will never pay off the production payment, the production payment’s life will exist until the lease is abandoned.  Once the lease is abandoned, the transaction is treated by the lessee as a purchase of an overriding royalty interest. It is capitalized by the lessee and treated as capital gain by the lessor.

Payments for “shooting rights.”  In some situations, an operator may not want to incur the costs of entering into a lease on the property (to avoid lease bonuses, for example). Consequently, the operator may enter into a contract with the landowner to pay a smaller amount under a contract that gives the operator a right to enter onto the property to conduct exploration activities. The contract does not grant any drilling or production rights. The payments that the landowner receives under this type of arrangement are reportable as ordinary income.

Conclusion

Sorting out the proper tax treatment of various payments associated with an oil and gas lease is important and can be somewhat complex.  For those receiving (or paying) such amounts, competent tax counsel should be consulted to ensure proper reporting.  Today's post was just a quick summary of some of the tax issues associated with oil and gas production.  

March 30, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, March 28, 2018

IRS Collections – The Basics

Overview

An issue that I sometimes get into when dealing with practitioner questions concerns the IRS collections process.  What can the IRS reach?  What’s the process for establishing an IRS lien?  What’s the levy process?  What planning steps should a taxpayer take to protect assets within the limits of applicable law?  These, and similar questions are important when a taxpayer finds themselves on the wrong end of an IRS audit.

The basics of the IRS collection process and related issues – that’s the topic of today’s post.  This is not intended as a comprehensive review of the IRS procedures.  Instead, today’s post is merely a primer dealing with some of the more common questions.  Also, not discussed is a taxpayer’s option of contesting an IRS determination in Tax Court.

Basics

IRS notices.  When the IRS, upon audit, determines that a tax liability exists for any individual or taxpaying entity, the IRS collection process begins.  The process is basically the same for an individual taxpayer as it is for any taxpaying entity.  The IRS will send at least two notices requesting payment.  The verbiage becomes increasingly urgent with each notice.  The last notice sent before any action can be taken will be labeled “Final” and will sent via certified mail.  It is important to note that the IRS cannot take any action or file a notice of federal tax lien until 30 days have expired from that final notice. 

The IRS automated collection system.  After the final notice goes out and the 30-day period elapses, regardless of whether a lien is filed, the initial IRS contact will be by IRS collection personnel in what is known as the Automated Collection System (ACS).  The ACS will provide notice and make demand for payment and try to get as much financial information from the taxpayer as possible to document possible sources for future collection actions.  Depending on personnel resources and workload priorities, if ACS cannot resolve the delinquency, it would be assigned to a “queue” of collection cases that would then be assigned to field collection personnel for face-to-face contact.  Cases are assigned to the field based on workload priorities.  There are maximum caseload inventories for collection personnel, so the case could conceivably sit dormant for a period of time before being assigned to the field.  Of course, the collection statute of limitations (10 years from the date of assessment) continues to toll even though the case is not being actively pursued.

Tax lien.  Subsequent to the final IRS notice and the expiration of the 30-day period, if the delinquent taxes remain unpaid, the IRS will provide notice of an intent to levy and notice of a Collection Due Process hearing.  Typically, the IRS provides taxpayers with notice of each of these steps by sending multiple letters as part of the ACS.  Once the last notice is received (it will signify that it is the last) and the unpaid tax balance isn’t paid (or other arrangements aren’t made to pay the balance), the IRS can levy the taxpayer’s income or other assets.  This levy power also includes the ability to garnish wages as well as self-employment income and the seizure of bank accounts.

A federal tax lien can be filed with the appropriate office determined by the taxpayer’s residence.  Where that lien is filed is determined by state law.  In general, filing will be in the office of the County Recorder for the county of the taxpayer’s residence.  Once the asserted tax liability reaches a certain point, the filing of the lien is a foregone conclusion and it will likely be an automated process.  Where that point is at is discretionary with the IRS, but certainly if the asserted tax liability is $50,000 and greater, a federal tax lien will be filed.   

The lien is a general lien and attaches to all property, both personal and real.  The lien must be filed in the jurisdiction where the real property is located.   Thee lien is good for 10 years from the date of assessment and will not be extended, although exceptions do exist in the event of bankruptcy or mutual agreement between the taxpayer and IRS. 

What about a lien on the taxpayer’s personal residence?  The likelihood of IRS seizing a personal residence and offering it for sale is extremely small unless, of course, the taxpayer is living an opulent lifestyle.  But, unless there are exigent circumstances, there is a virtually no chance that the IRS would take enforcement action against the taxpayer’s personal residence.  That’s because there are several layers of authorization that an IRS Revenue Officer must receive to get approval to proceed to enforce a tax lien on a taxpayer’s personal residence by virtue of a tax sale.  The IRS simply doesn’t operate like a county does for nonpayment of real estate taxes. The IRS will collect on the lien, however, if the taxpayer sells the residence.

Offers in Compromise

Offer in Compromise (OIC) acceptances, contrary to all the media advertisements, are generally not accepted unless it works to the government’s best interests for collection.  When determining whether to compromise a tax debt, the IRS takes into consideration numerous factors.  The taxpayer’s age is one of those as it relates to the likelihood that the taxpayer will outlive the collection statute and make payment.  In general, the IRS will always determine to what extent the taxpayer has equity in their assets. In general, if the taxpayer has equity in the property that gave rise to the tax liability, that property could be subject to enforcement actions.  But, not only must the taxpayer have equity in the property, there must be a market for the property. 

The IRS will also see whether the taxpayer has income in excess of necessary living expenses.  Those are all factors that the IRS will use to determine an acceptable amount to compromise a tax debt.  All of the factors are tied to the likelihood of the ability of the IRS to collect on the tax debt. 

Note:  The IRS Collection Financial Standards should can be reviewed to help determine what goes into the IRS calculation of the collectability of a tax debt:  https://www.irs.gov/businesses/small-businesses-self-employed/collection-financial-standards.

Other Points

Social Security benefits are subject to levy actions on a monthly basis, but are limited to 15 percent of the individual taxpayer’s Social Security benefit.  Disability payments under Social Security are not subject to levy.  If the taxpayer has only social security and pension benefits, then it is probably in the taxpayer’s best interest to complete a Collection Information Statement to determine if there is any monthly income after allowable living expenses.  If there is, it may be possible for the taxpayer to enter into an installment agreement to pay-off the tax debt.  If there is no excess income or assets, the IRS will report the account as “currently not collectible” and the taxpayer’s case would be designated as having a “dormant” status (with the collection statute still running).  At the end of 10 years, the lien would be automatically released.

 The IRS can also levy pension benefits, but they are limited to allow for necessary living expenses.  The amounts of the limitation are generally revised annually to take into account cost of living variations. 

Note:  The IRS chart for the income exemption from levies can be found at the following link: https://www.irs.gov/pub/irs-pdf/p1494.pdf.

Tax overpayments will almost always be utilized to offset a tax delinquency.

Conclusion

A taxpayer, in general, doesn’t ever want communication from the IRS.  That’s especially the case for communication asserting a tax deficiency.  But, if it occurs, knowledge of the basics of the IRS collection process is important in order to determine the best course of action to take in getting the alleged tax debt eliminated.

March 28, 2018 in Income Tax | Permalink | Comments (1)

Monday, March 26, 2018

Congress Modifies the Qualified Business Income Deduction

Overview

Late last week, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625.  This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017.  I.R.C. §199A , known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses.  However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives.  Before the technical correction, those sales generated a tax deduction from gross sales for the seller.  But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income.  That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected. 

The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaces it with the former (pre-2018) I.R.C. §199 for cooperatives.  In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated.  Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains. The Joint Committee on Taxation estimates that the provision modifying I.R.C. §199A will raise $108 million over the next decade.

Today’s blog post examines the modification to I.R.C. §199A. 

The Domestic Production Activities Deduction

In general.  I.R.C. §199, the Domestic Production Activities Deduction (DPAD) was enacted as part of the American Jobs Creation Act of 2004 effective for tax years beginning after 2004.  While often referred to as a “manufacturing” deduction, the DPAD was available to many businesses including those engaged in agricultural activities.   Except for domestic oil-related production activities (for which the deduction is limited to six percent), for tax years beginning after 2009 and before 2018, the DPAD is equal to the lesser of 9 percent of the taxpayer’s qualified production activities income for the year; 9 percent of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI); and 50 percent of the Form W-2 (FICA) wages of the taxpayer for the taxable year.  Former I.R.C. §§199(a)(1) and (b)(1).  The deduction was from taxable income, subject to an overall limit of 50 percent of current year Form W-2 wages that were associated with qualifying activity employment.  The DPAD was allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, it was not allowed in computing SE income, and it could not create a loss.

Pass-Through Entities.  In general, the DPAD was not claimed by pass-through entities (such as S corporations, partnerships, estates or trusts) when computing taxable income.  Instead, the DPAD was applied at the shareholder, partner or beneficiary level.  The pass-through entity would provide the necessary information required to compute the DPAD as a footnote on Schedule K-1.  A taxable income limitation applied at the shareholder/partner level with each shareholder/partner separately computing the DPAD on its individual income tax return.

Note:  While the DPAD was not claimed by a pass-through entity, estates and trusts were eligible for the DPAD if the income was not passed through to the beneficiaries.

Agricultural Cooperatives.  Agricultural cooperatives could also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that were allocable to qualified production activities were deductible from the member’s gross income.

Members of agricultural cooperatives included the DPAD for their distributions from the cooperative. The rules for cooperatives provided in §199(d)(3) and Treas. Reg. §1.199-6 applied to any portion of the DPAD that is not passed through to the cooperative’s patrons. In addition, a cooperative’s qualified production activities income was computed without taking into account any deduction allowable under IRC §1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions. 

The TCJA Provision As Applied to Agricultural Cooperatives

For tax years beginning after 2017, the DPAD is repealed.  In it place, for taxable years beginning after December 31, 2017, and before January 1, 2026, the TCJA creates (as applied to an agricultural or horticultural cooperative) a deduction equal to the lesser of (a) 20 percent of the excess (if any) of the cooperative’s gross income over the qualified cooperative dividends paid during the taxable year for the taxable year, or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. I.R.C. §199A(g).  The cooperative’s section 199A(g) deduction may not exceed its taxable income (computed without regard to the cooperative’s deduction under I.R.C. §199A(g)) for the taxable year.

As for the impact of I.R.C. §199A on patrons of ag cooperatives, effective for tax years beginning after 2017, there is no longer a DPAD that a cooperative can pass through to a patron.  However, as noted above, the deduction is 20 percent of the total of payments received from the cooperative (including non-cash qualified patronage dividends).  The only limit is 100 percent of net taxable income less capital gains.  For sales to a non-cooperative, the deduction is 20 percent of net farm income. 

The Modification     

Impact on cooperatives.  The provision in the Omnibus bill removes the QBI deduction for agricultural or horticultural cooperatives.  In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives.  Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts.  A cooperative’s DPAD is reduced by any amount passed through to patrons. 

Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative. 

Note:  As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.

Impact on patrons.  Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d).

Note:  The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.

The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)). What is a qualified payment?  It’s any amount that meets three tests:  1) the payment must be either a patronage dividend or a per-unit retain allocations; 2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and 3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative.

An eligible patron cannot be a corporation and cannot be another ag cooperative.   In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g).  Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons.

Transition rule.  A transition rule applies such that the repeal of the DPAD does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018.  That type of qualified payment is subject to the pre-2018 DPAD provision, and any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules.  In that event, no post-2017 QBI deduction is allowed for those type of qualified payments.

Conclusion

With the technical correction to I.R.C. §199A, where do things now stand for farmers? 

  • The overall QBI deduction cannot exceed 20 percent of taxable income. That restriction applies to all taxpayers regardless of income.  If business income exceeds $315,000 (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation test is phased-in.
  • The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses.  For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced. 
  • While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase only for those corporations that would have otherwise triggered a 15 percent rate under prior law.
  • For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.
  • For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source.  Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation ($315,000 MFJ; $157,000 all others).
  • For farmers selling to ag cooperatives that also pay W-2 wages, the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the $315,000 threshold (MFJ; $157,500 all others), the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent).  If the farmer is above the $315,000 amount (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation.  This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income.  To this amount is added any pass-through DPAD from the cooperative to produce the total deductible amount.   
  • For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains.  If net farm income exceeds $315,000 (MFJ; $157,500 single), the deduction may be reduced on a phased-in basis.
  • The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.

March 26, 2018 in Income Tax | Permalink | Comments (0)

Thursday, March 22, 2018

The Tax Treatment of Farming Net Operating Losses

Overview

In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result.  Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income.  A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040. 

Special rules apply to farm NOLs.  Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA). 

Farm NOLs – The Basics

Carryback rule.  Until the changes contained in legislation enacted in late 2017, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years.  Those were the rules in place through 2017.   A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up.  Whether a loss is carried back two years instead of five depends on the farmer’s level of income in those carryback years and the applicable tax bracket.  

Another beneficial rule can apply when an NOL is carried back to a prior year.  Because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election.  By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made.  That will allow the taxpayer to claim future depreciation deductions.  This is the case, at least, on the taxpayer’s federal return.  Some states don’t “couple” with the federal I.R.C. §179 provision.

Taxpayers may elect to forego an NOL carryback in favor of a carryforward (for 20 years).  However, if a taxpayer elects not to carry a net operating loss back to offset income in prior years, the taxpayer will be limited to a carryforward of the NOL. 

The TCJA and The Impact on Farm NOLs

For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.

An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount.  The NOL carried over from other years may not be used in calculating the NOL for the year in question.  In addition, capital losses may not exceed capital gains.  Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses.  In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.

The TCJA made changes to how farmers can treat NOLs.  For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year.  For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC.  In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form). 

Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset).  In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). This effective date provision has an immediate impact on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years.  Instead, the NOL can only be carried back two years.  All other corporate taxpayers can only carry an NOL forward.

Instead, under the TCJA, farmer NOLs can only be carried back two years and all others must be carried forward.  NOLs that are carried back can only offset 80 percent of taxable income.   However, NOLs that are carried forward will not expire after 20 years (as they did under prior law).  Similar to the carryback rule, NOLs that are carried forward can only offset

In the case of a partnership or S corporation, the TCJA applies the NOL rules at the partner or shareholder level.  Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. 

Marital Status Changes

There are additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward.  In that case, only the spouse who had the loss can claim the NOL deduction.  On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss.  Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return.  The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.

Change in Filing Status

Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years.

NOLs and Death

A NOL that has been carried forward is deductible on a decedent’s final income tax return.  It cannot be carried over to a decedent’s estate.  Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.

Conclusion

Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow.  That's where the NOL rules come into play.  

March 22, 2018 in Income Tax | Permalink | Comments (0)

Thursday, March 8, 2018

Deductible Repairs Versus Capitalization

Overview

The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled.  The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a).  I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs.  Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property.

The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with.  A recent court decision involving a Colorado grape-growing operation illustrates the difficulty in determining the correct tax classification of expenses.

Basic Principles

In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income.  Depreciation is required if an asset has a useful life of more than one year.  Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible.  Instead, those items must be depreciated or amortized over the period of benefit or use.  Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.

A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs.  Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003).  Under these court opinions, engines and transmissions are generally treated as part of the larger machine.  This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine).  Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction.

Recent Case

In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm.  She had lived there off-and-on since 1965, but continuously from 1983 forward.  Before the petitioner came into ownership of the property, her father owned it.  She cultivated about 700 white French hybrid rind grapevines on a part of the property.  In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton.  The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers.  She grazed animals on other parts of the farm.  Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011.  Many of those claimed deductible expenses were associated with her grape growing activity.  Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized. 

Underground water line.  In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes.  Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure.  The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009.  More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired.  The court determined that the entire water line was replaced at least one time during 2009 and 2010. 

The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased.  Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010.  She claimed to not have the funds in prior years to make repairs in those earlier years. 

The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed.  The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline.  The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe).  It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option.  The court noted that an analogous situation was present in Hunter v. Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding.   

The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses.  However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible.

Storage yard.  The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard.  The storage yard did not previously exist.  The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized.  The court agreed.  It was new construction on top of previously unimproved land and, as such, was an improvement.  The associated costs were not currently deductible. 

Burn area.  In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals.  After the fire, it was determined that the fire had made the burned area unable to absorb water.  As a result, the petitioner, paid to have burned tree stumps removed along with boulders.  The soil of the burned area was cultivated so that the tract could be used for forage.  The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return.  The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.” 

The court agreed with the IRS.  The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value.  In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business.  After the fire, the court noted that the petitioner testified that the entire area would be used as forage.  Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized. 

Conclusion

The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized.  The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.         

March 8, 2018 in Income Tax | Permalink | Comments (0)

Monday, February 26, 2018

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

Overview

The “Tax Cuts and Jobs Act” (TCJA) enacted in late 2017, cuts the corporate tax rate to 21 percent.  That’s 16 percentage points lower than the highest individual tax rate of 37 percent.  On the surface, that would seem to be a rather significant incentive to form a C corporation for conducting a business rather than some form of pass-through entity where the business income flows through to the owners and is taxed at the individual income tax rates.  In addition, a corporation can deduct state income taxes without the limitations that apply to owners of pass-through entities or sole proprietors. 

Are these two features enough to clearly say that a C corporation is the entity of choice under the TCJA?  That’s the focus of today’s post – is forming a C corporation the way to go?

Tax Comparisons

The fact that corporations are now subject to a corporate tax at a flat rate of 21 percent is not the end of the story.  There are other factors.  For instance, the TCJA continues the multiple tax bracket system for individual income taxation, and also creates a new 20 percent deduction for pass-through income (the qualified business income (QBI) deduction).  In addition, the TCJA doesn’t change or otherwise eliminate the taxation on income distributed (or funds withdrawn) from a C corporation – the double-tax effect of C-corporate distributions.  These factors mute somewhat the apparent advantage of the lower corporate rate. 

Under the new individual income tax rate structure, the top bracket is reached at $600,000 for a taxpayer filing as married filing joint (MFJ).  For those filing as single taxpayers or as head-of household, the top bracket is reached at $500,000.  Of course, not every business structured as a sole-proprietorship or a pass-through entity generates taxable income in an amount that would trigger the top rate.  The lower individual rate brackets under the TCJA are 10, 12, 22, 24, 32 and 35 percent.  Basically, up to about $75,000 of taxable income (depending on filing status), the individual rates are lower than the 21 percent corporate rate.  So, just looking at tax rates, businesses with relatively lower levels of income will likely be taxed at a lower rate if they are not structured as a C corporation.

As noted, under the TCJA, for tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of business taxable income.  However, the deduction comes with a limitation. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.  I.R.C. §199A.  Architects and engineers can claim the QBI deduction, but other services business are limited in their ability to claim it.  For them, the QBI deduction starts to disappear once taxable income exceeds $315,000 (MFJ).    

Clearly, the amount of income a business generates and the type of business impacts the choice of entity.    

Another factor influencing the choice between a C corporation or a flow-through entity is whether the C corporation distributes income, either as a dividend or when share of stock are sold.  The TCJA, generally speaking, doesn’t change the tax rules impacting qualified dividends and long-term capital gains.  Preferential tax rates apply at either a 15 percent or 20 percent rate, with a possible “tack-on” of 3.8 percent (the net investment income tax) as added by Obamacare.  I.R.C. §1411.  So, if the corporate “double tax” applies, the pass-through effective rate will always be lower than the combined rates applied to the corporation and its shareholders.  That’s true without even factoring in the QBI deduction for pass-through entities.  But, for service businesses that have higher levels of income that are subject to the phase-out (and possible elimination) of the QBI deduction, the effective tax rate is almost the same as the rate applying to a corporation that distributes income to its shareholders, particularly given that a corporation can deduct state taxes in any of the 44 states that impose a corporate tax (Iowa’s stated corporate rate is the highest). 

Other Considerations

C corporations that have taxable income are also potentially subject to penalty taxes.    The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531.  The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments.  I.R.C. §535.  There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment.  Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders.  This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions.  Consequently, this leads to a build-up of earnings and profits within the corporation.

The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year.  Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business.  So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax.  To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax.  I.R.C. §535(c)(2)(A).  However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway.  I.R.C. §535(c)(2)(B).  But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax.  That’s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business. 

The other penalty tax applicable to C corporations is the PHC tax.  I.R.C. §§541-547.  This tax is imposed when the corporation is used as a personal investor.  The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).

To be a PHC, two tests must be met.  The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year.  Most farming and ranching operations automatically meet this test.  The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources.  See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991). 

What if the Business Will Be Sold?

If the business will be sold, the tax impact of the sale should be considered.  Again, the answer to whether a corporation or pass-through entity is better from a tax standpoint when the business is sold is that it “depends.”  What it depends upon is whether the sale will consist of the business equity or the business assets.  If the sale involves equity (corporate stock), then the sale of the C corporate stock will likely be taxed at a preferential capital gain rate. Also, for a qualified small business (a specially defined term), if the stock has been held for at least five years at the time it is sold, a portion of the gain (or in some cases, all of the gain) can be excluded from federal tax.   Any gain that doesn’t qualify to be excluded from tax is taxed at a 28% rate (if the taxpayer is in the 15% or 20% bracket for regular long-term capital gains).   Also, instead of a sale, a corporation can be reorganized tax-free if technical rules are followed. 

If the sale of the business is of the corporate assets, then flow-through entities have an advantage.  A C corporation would trigger a “double” tax.  The corporation would recognize gain taxed at 21 percent, and then a second layer of tax would apply to the net funds distributed to the shareholders.  Compare this result to the sale of assets of a pass-through entity which would generally be taxed at long-term capital gain rates. 

Other Considerations

Use of the C corporation may provide the owner with more funds to invest in the business.  Also, a C corporation can be used to fund the owner’s retirement plan in an efficient manner.  In addition, fringe benefits are generally more advantageous with a C corporation as compared to a pass-through entity (although the TCJA changes this a bit).  A C corporation is also not subject to the alternative minimum tax (thanks to the TCJA).  There are also other minor miscellaneous advantages. 

Conclusion

So, what’s the best entity choice for you and your business?  It depends!  Of course, there are other factors in addition to tax that will shape the ultimate entity choice.  See your tax/legal advisor for an evaluation of your specific facts.

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

Tuesday, February 20, 2018

Summer Farm Income Tax/Estate and Business Planning Conference

Overview

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

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

Agenda

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

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

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

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

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

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

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

Location

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

Attend In-Person or Via the Web

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

More Information

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

Conclusion

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

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