Thursday, September 20, 2018
Land ownership includes two separate estates in land – the surface estate and the mineral estate. The mineral estate can be severed from the surface estate with the result that ownership of the separate estates is in different parties. In some states, the mineral estate is dominant. That means that the mineral estate owner can freely use the surface estate to the extent reasonably necessary for the exploration, development and production of the minerals beneath the surface.
The “accommodation doctrine” is a court-made doctrine relating to the mineral owner's right to use the surface estate to drill for and produce minerals. ... The doctrine requires a balancing of the interests of the surface and mineral owner. How that balancing works was at issue in a recent case.
The accommodation doctrine – that’s the topic of today’s post.
The Accommodation Doctrine
If the owner of the mineral estate has only a single method for developing the minerals, many courts will allow that method to be utilized without consideration of its impact on the activities of the surface estate owner. See., e.g., Merriman v. XTO Energy, Inc., 407 S.W.3d 244 (Tex. 2013). But, under the accommodation doctrine, if alternative means of development are reasonably available that would not disrupt existing activities on the surface those alternative means must be utilized. For example, in Getty Oil co. v. Jones, 470 S.W.2d 618 (Tex. 1971), a surface estate owner claimed that the mineral estate owner did not accommodate existing surface use.
To prevail on that claim, the Texas Supreme Court, determined that the surface owner must prove that the mineral estate owner’s use precluded or substantially impaired the existing surface use, that the surface estate owner had no reasonable alternative method for continuing the existing surface use, and that the mineral estate owner has reasonable development alternatives that would not disrupt the surface use. A question left unanswered in the 1971 decision was whether the accommodation doctrine applied beyond subsurface mineral use to the exercise of groundwater rights. But, in 2016, the court said that the doctrine said the doctrine applied to groundwater. Coyote Lake Ranch, LLC v. City of Lubbock, No. 14-0572, 2016 Tex. LEXIS 415 (Tex. Sup. Ct. May 27, 2016).
Harrison v. Rosetta Res. Operating, LP, No. 08-15-00318-CV 2018 Tex. App. LEXIS 6208 (Tex Ct. App. Aug. 8, 2018), involved a water-use dispute between an oil and gas lessee and the surface owner. The plaintiff owned the surface of a 320-acre tract. The surface estate had been severed from the mineral estate, with the minerals being owned by the State of Texas. In October 2009, the plaintiff executed an oil and gas lease on behalf of the State with Eagle Oil & Gas Co. Eagle began its drilling operations, but before completing its first well it assigned the lease to Comstock Oil & Gas, L.P., subject to an agreement to indemnify Eagle against claims arising from its operations to that point. Within a few months, the plaintiff and several other plaintiffs sued Eagle for negligently destroying the plaintiff’s irrigation ditch as well as damage resulting from road construction, among other claims. Comstock defended Eagle in the lawsuit and settled a few months later. According to the settlement agreement, Comstock would make repairs to a water well on the plaintiff’s land and purchase 120,000 barrels of water from the plaintiff at a rate of fifty cents per barrel. A plastic-lined “frac pit” was also built on the property to store water produced from the well, although the pit was not a requirement of the settlement agreement. Comstock complied with the agreement and purchased the required amounts of water from the plaintiff at the agreed price. Comstock completed two oil wells on the property that year and began constructing a third well the following year. Before completing the third well, however, Comstock assigned the least to Rosetta Resources Operating, LP, the defendant in this case, who continued construction of the third well and began construction of several more. Unlike Comstock, the defendant did not purchase its water from the plaintiff, choosing instead to pump in water from an adjacent property, a neighbor of the plaintiff.
After learning that the defendant was importing his neighbor’s water, the plaintiff filed suit in his individual capacity and as trustee against the defendant for breach of contract, claiming an employee of the defendant had orally agreed to continue the same arrangement the plaintiff had enjoyed with Comstock. He also sought to permanently enjoin the defendant from using his neighbor’s water and sought cancellation of the State’s oil and gas lease. The defendant filed three motions for summary judgment that collectively challenged all of the plaintiff’s claims. In response, the plaintiff filed an amended petition asserting that the defendant had violated the “accommodation doctrine” by not purchasing his water, thus rendering his well and frac pit useless and unnecessarily causing damage to his property. The trial court granted the defendant’s motions for summary judgment in their entirety. The plaintiff appealed.
The appellate court determined that the plaintiff’s accommodation doctrine arguments appeared to rest on his proposition that because a frac pit was built on his land for use by the former lessee, it unified the use of the land with the oil and gas operations, and when the defendant chose not buy his water it substantially interfered with his existing use of the land as a source of water for drilling operations. Thus, the substantial interference complained of was that the frac pit was no longer profitable because the defendant is not using it to supply water for its operations. The appellate court held that categorizing a refusal to buy goods produced from the land as interference with the land for purposes of the accommodation doctrine would stretch the doctrine beyond recognition. Therefore, because the defendant’s use did not impair the plaintiff’s existing surface use in any way, except in the sense that not buying the water had precluded the plaintiff from realizing potential revenue from selling its water to the defendant, the inconvenience to the surface estate was not evidence that the owner had no reasonable alternative to maintain the existing use. Lastly, the court determined that if it were to hold for the plaintiff on these facts they would, in effect, be holding that all mineral lessees must use and purchase water from the surface owner under the accommodation doctrine if his water is available for use. Accordingly, the appellate court affirmed.
The accommodation doctrine is not designed to substitute for common sense reasonableness when the dominant estate owner has two clear options for doing something that involve the same cost. If one option is more disruptive to the surface owner, inherent limits of reasonable use dictate use of the less disruptive option. The recent Texas case is just another illustration of how courts wrestle with the application of the doctrine.
Thursday, July 26, 2018
Financial distress in the farm sector continues to be a real problem. Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years. As an example, the level of working capital in the farm sector has fallen sharply since 2012. Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak. In the past year alone, working capital dropped by 18 percent. It has also declined precipitously as a percentage of gross revenue. This means that many farmers have a diminished ability to reinvest in their farming operations. It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate. When that happens, the sellers of the assets that repossess have tax consequences to worry about.
Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains. Other times, farmland might be repossessed.
Tax issues upon repossession of farmland – that’s the topic of today’s post.
Repossession of Farmland
Special exception. A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt. It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale. However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved. See I.R.C. §453B(f)(2). In addition, for the special rules to apply, the debt must be secured by the real property.
When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition.
Handling interest. Amounts of interest received, stated or unstated, are excluded from the computation of gain. Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt. However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income. I.R.C. §453B(f)(2). But, a question exists as to whether that provision applies in financial distress situations.
The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts.
Debt secured by the real property. The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property. Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules.
Character of gain. The character of the gain from reacquisition is determined by the character of the gain from the original sale. For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation. If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income. If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain.
Basis issues. Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property. The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs.
The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition. However, the holding period does not include the time between the original sale and the date of reacquisition.
Is the personal residence involved? The provisions on reacquisition of property generally apply to residences or the residence part of the transaction. However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale. An adjustment is made to the sales price of the old residence and the basis of the new residence. If not resold within one year, gain is recognized under the rules for repossession of real property. An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election. The exclusion can, therefore, be made after reacquisition. An election can be made at any time within three years after the due date of the return.
No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero. Losses are not deductible on sale or repossession of a personal residence. When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property. Adjustment is made to the income tax basis of the reacquired residence.
Special situations. In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69-83, 1969-1 C.B. 202. A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent. However, the Installment Sales Revision Act of 1980 changed that result. The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980. Presumably, that means acquisitions by the estate or beneficiary. Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been. The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable.
The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.
Tax planning is important for farmers that are in financial distress and for creditors of those farmers. As usual, having good tax counsel at the ready is critical. Tax issues can become complex quickly.
Wednesday, July 18, 2018
Next month, Washburn Law School and Kansas State University (KSU) will team up for its annual symposium on agricultural law and the business of agriculture. The event will be held in Manhattan at the Kansas Farm Bureau headquarters. The symposium will be the first day of three days of continuing education on matters involving agricultural law and economics. The other two days will be the annual Risk and Profit Conference conducted by the KSU Department of Agricultural Economics. That event will be on the KSU campus in Manhattan. The three days provide an excellent opportunity for lawyers, CPAs, farmers and ranchers, agribusiness professionals and rural landowners to obtain continuing education on matters regarding agricultural law and economics.
This year’s symposium on August 15 will feature discussion and analysis of the new tax law, the Tax Cuts and Jobs Act, and its impact on individuals and businesses engaged in agriculture; farm and ranch financial distress legal issues and the procedures involved in resolving debtor/creditor disputes, including the use of mediation and Chapter 12 bankruptcy; farm policy issues at the state and federal level (including a discussion of the status of the 2018 Farm Bill); the leasing of water rights; an update on significant legal (and tax) developments in agricultural law (both federal and state); and an hour of ethics that will test participant’s negotiation skills.
The symposium can also be attended online. For a complete description of the sessions and how to register for either in-person or online attendance, click here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
Risk and Profit Conference
On August 16 and 17, the KSU Department of Agricultural Economics will conduct its annual Risk and Profit campus. The event will be held at the alumni center on the KSU campus, and will involve a day and a half of discussion of various topics related to the economics of the business of agriculture. One of the keynote speakers at the conference will be Ambassador Richard T. Crowder, an ag negotiator on a worldwide basis. The conference includes 22 breakout sessions on a wide range of topics, including two separate breakout sessions that I will be doing with Mark Dikeman of the KSU Farm Management Association on the new tax law. For a complete run down of the conference, click here: https://www.agmanager.info/risk-and-profit-conference
The two and one-half days of instruction is an opportunity is a great chance to gain insight into making your ag-related business more profitable from various aspects – legal, tax and economic. If you are a producer, agribusiness professional, or a professional in a service business (lawyer; tax professional; financial planner; or other related service business) you won’t want to miss these events in Manhattan. See you there, or online for Day 1.
July 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Wednesday, May 9, 2018
Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications.
But, what happens if the CRP land is sold even though several years remain on the contract? This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production.
The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post.
Consequences of Early Termination
When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived). That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). That would be the case, for instance, when a lessee terminates a lease by buying the leased property. I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. Thus, allocations to lease contracts by real estate purchasers of real estate are not effective. The taxpayer must allocate the entire adjusted basis to the underlying capital asset.
Sale Price Allocation To CRP Contract
The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).
The acquiring farmer may pay the early termination costs. In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).
Early Termination Payments
Generally. A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease.
If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term. Rev. Rul. 71-283. However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale.
As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.
The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax. It’s important to understand what might happen if early termination is a possibility.
Tuesday, March 20, 2018
Normally land is acquired in a transaction where a buyer pays a sum to buy the property and obtain legal title to it. However, if a person without legal title to a tract can claim legal ownership by showing that the person has possessed it for a certain amount of time without the permission of the tract’s true owner. This is known as “adverse possession” and it has been recognized for several centuries, dating back to early English common law.
A concept similar to adverse possession is that of a prescriptive easement. A prescriptive easement is an implied easement for usage of another person’s tract of land where the use occurs without the true owner’s permission, and has lasted for a time period set by statute in the particular jurisdiction. A prescriptive easement can result in title ownership over the area subject to the easement resting in the party (or parties) using the easement.
Adverse possession and prescriptive easements are important to rural landowners. Many cases are brought every year concerning boundary disputes that involve these concepts. Once title is successfully obtained by adverse possession (or by prescription), the party obtaining title can bring a court action to quiet title. A quiet title action ensures that the land records properly reflect the true owner of the property.
Obtaining title to land by adverse possession or by a prescriptive easement. That’s the topic of today’s post.
Obtaining title to property either by adverse possession or easement by prescription has some common requirements. The possession must be “open and notorious” which means the possession is obvious to anyone. In addition, the possession must be actual and continuous. This means that the usage of the property must be uninterrupted for the applicable statutory timeframe (generally from 5 to 20 years, depending on state law). The possession must also be adverse to the rights of the true property owner. Also, in many states, the possession must be hostile – in opposition to the claim of someone else. Also, adverse possession commonly requires that the possession be exclusive, but a prescriptive easement typically only requires that the prescriptive user use the easement in a way that differs from the general public.
There are other points to both adverse possession and easement by prescription such as whether title can be obtained adverse to the government (it generally cannot) or a railroad (again, the answer is generally negative). In addition, a negative easement cannot be created by prescription.
Prescription may also be used to end an existing legal easement. For example, if a servient tenement (estate) holder were to erect a fence blocking a legally deeded right-of-way easement, the dominant tenement holder would have to act to defend their easement rights during the statutory period or the easement might cease to have legal force, even though it would remain a deeded document. Failure to use an easement leading to loss of the easement is sometimes referred to as "non-user."
The adverse possession/prescriptive easement issue came up recently in an Idaho case. In Lemhi County v. Moulton, No. 24 2018, Ida. LEXIS 60 (Idaho Sup Ct. Mar. 13, 2018), the plaintiff, a county, sought declaratory relief to prevent flooding on the Lemhi County Backroad. The Backroad runs generally north-to-south, dividing two ranches - the Skinner Ranch (uphill property) and the Hartvigson Ranch (downhill property). The downhill property spans approximately 200 acres and is situated on the Lemhi Valley floor near the Lemhi River. Most of the downhill property is on the west side of the Backroad, but a small portion extends into a steep draw on the east side (the "Hartvigson Draw"). The water flowing through the draw runs under the Lemhi County Backroad through one of two culverts, across the downhill property, and into a draw that feeds into the Lemhi River. The uphill property is on higher ground on the east side of the Backroad. The uphill property has three drainages, one of which feeds into the Hartvigson draw.
In its declaratory judgment action, the plaintiff claimed that in November 2010, the downhill property obstructed the flow of water from the Hartvigson Draw through the culverts, which caused flooding along that area of the Backroad. The plaintiff noted in its complaint that the failure to allow the water to pass unobstructed was based at least in part on the allegation that the uphill property sent too much water down the draw, which caused damage to the downhill property.
The trial court entered a judgment that the downhill property allow drainage of natural surface water in the amount of 3.25 cubic feet per second (CFS) through the culverts and across its lands. However, that judgment left unresolved how much water, if any, the uphill property could legally send down the Hartvigson Draw. After a three-day bench trial, the court found that the channel through the basin, down the Hartvigson Draw, across the downhill property, and eventually into the Lemhi River was a natural waterway. Additionally, the trial court found that this water flow met the requirements for the uphill property to establish a prescriptive easement. The court entered a judgment permitting the uphill property to send water in the amount of 3.25 CFS down the basin drainage that flowed through the Hartvigson Draw under both an easement and natural servitude theory.
The downhill property owners timely appealed. They claimed that the trial court erred in its prescriptive easement determination on two fronts: (1) the uphill property's water use was not adverse to them; and (2) the plaintiff failed to prove the scope of the easement. They claimed that the use was not adverse because they had a wastewater right for water out of the Hartvigson draw. However, the state Supreme Court determined that the trial court’s factual findings established that the uphill landowners had been sending water down the draw for decades, before and after the established wastewater right. Thus, the Court held that the practice of the uphill landowners of sending water down the draw was under a claim of right and adverse to the downhill property owners. In addition, downhill owners claimed that no witness at trial could testify as to the exact amount of water that had regularly been sent down the Hartvigson Draw, and absent that testimony the trial court lacked clear and convincing evidence to support an easement for 3.25 CFS. However, the Court pointed to testimony by the owner of uphill property that the approximate quantity sent down the draw was between 3 and 3.5 CFS. Thus, the Court held that the trial court did not err in limiting the easement to 3.24 CFS.
The Supreme Court also determined that the trial court’s judgment was not sufficiently clear with respect to the location of the drainage. Therefore, Court remanded the case to the trial court in order to clear up the judgment with regards to the location of the drainage.
Property usage and boundary disputes are, unfortunately, too common in rural settings. Many times, the problem stems from a fundamental lack of communication. But, that’s not always the case. Sometimes, issues can arise through the fault of no one. It is those times that its good to have an experienced ag lawyer in tow.
Thursday, February 22, 2018
Leasing is of primary importance to agriculture. Leasing permits farmers and ranchers to operate larger farm businesses with the same amount of capital, and it can assist beginning farmers and ranchers in establishing a farming or ranching business.
Today’s post takes a brief look at some of the issues surrounding farmland leases – economic; estate planning; and federal farm program payment limitation planning.
Common Types of Leases
Different types of agricultural land leasing arrangements exist. The differences are generally best understood from a risk/return standpoint. Cash leases involve the periodic payment of a rental amount that is either a fixed number of dollars per acre, or a fixed amount for the entire farm. Typically, such amounts are payable in installments or in a lump sum. A flexible cash lease specifies that the amount of cash rent fluctuates with production conditions and/or crop or livestock prices. A hybrid cash lease contains elements similar to those found in crop-share leases. For example, a hybrid cash lease usually specifies that the rental amount is to be determined by multiplying a set number of bushels by a price determined according to terms of the lease, but at a later date. The tenant will market the entire crop. The landlord benefits from price increases, while requiring no management or selling decisions or capital outlay. However, the rental amount is adversely affected by a decline in price. The tenant, conversely, will not bear the entire risk of low commodity prices, as would be the case if a straight-cash lease were used, but does bear all of the production risk and must pay all of the production costs.
Under a hybrid-cash lease, known as the guaranteed bushel lease, the tenant delivers a set amount of a certain type of grain to a buyer by a specified date. The landlord determines when to sell the grain, and is given an opportunity to take advantage of price rises and to make his or her own marketing decisions. However, the landlord must make marketing decisions, and also is subject to price decreases and the risk of crop failure. For tenants, the required capital outlay will likely be less, and the tenant should have greater flexibility as to cropping patterns. While the rental amount may be less than under a straight-cash lease, the tenant will continue to bear the risk of crop failure.
Another form of the hybrid-cash lease, referred to as the minimum cash or crop share lease, involves a guaranteed cash minimum. However, the landlord has the opportunity to share in crop production from a good year (high price or high yield) without incurring out-of-pocket costs. For a tenant, the minimum cash payment likely will be less than under a straight-cash lease because the landlord will receive a share of production in good years. The tenant, however, still retains much of the production risk. In addition, the tenant typically does not know until harvest whether the tenant will receive all or only part of the crop. This may make forward cash contracting more difficult.
Under a crop-share leasing arrangement, the rent is paid on the basis of a specified proportion of the crops. The landlord may or may not agree to pay part of certain expenses. There are several variations to the traditional crop-share arrangement. For example, with a crop share/cash lease, rent is paid with a certain proportion of the crops, but a fixed sum is charged for selected acreage such as pasture or buildings, or both. Under a livestock-share leasing arrangement, specified shares of livestock, livestock products and crops are paid as rent, with the landlord normally sharing in the expenses. For irrigation crop-share leases, rent is a certain proportion of the crops produced, but the landlord shares part of the irrigation expenses. Under labor-share leases, family members are typically involved and the family member owning the assets has most of the managerial responsibility and bears most of the expenses and receives most of the crops. The other family members receive a share of yield proportionate to their respective labor and management inputs.
Estate Planning Implications
Leasing is also important in terms of its relation to a particular farm or ranch family's estate plan. For example, with respect to Social Security benefits for retired farm-landlords, pre-death material participation under a lease can cause problems. A retired farm-landlord who has not reached full retirement age (66 in 2018) may be unable to receive full Social Security benefits if the landlord and tenant have an agreement that the landlord shall have “material participation” in the production of, or the managing of, agricultural products.
While material participation can cause problems with respect to Social Security benefits, material participation is required for five of the last eight years before the earlier of retirement, disability or death if a special use valuation election is going to be made for the agricultural real estate included in the decedent-to-be's estate. I.R.C. §2032A. A special use valuation election permits the agricultural real estate contained in a decedent's estate to be valued for federal estate tax purposes at its value for agricultural purposes rather than at fair market value. The solution, if a family member is present, may be to have a nonretired landlord not materially participate, but rent the elected land to a materially participating family member or to hire a family member as a farm manager. Cash leasing of elected land to family members is permitted before death, but generally not after death. The solution, if a family member is not present, is to have the landlord retire at age 65 or older, materially participate during five of the eight years immediately preceding retirement, and then during retirement rent out the farm on a nonmaterial participation crop-share or livestock-share lease.
Farm Program Payments
Leases can also have an impact on a producer's eligibility for farm program payments. In general, to qualify for farm program payments, an individual must be “actively engaged in farming.” For example, each “person” who is actively engaged in farming is eligible for up to $125,000 in federal farm program payments each crop year. A tenant qualifies as actively engaged in farming through the contribution of capital, equipment, active personal labor, or active personal management. Likewise, a landlord qualifies as actively engaged in farming by the contribution of the owned land if the rent or income for the operation's use of the land is based on the land's production or the operation's operating results (not cash rent or rent based on a guaranteed share of the crop). In addition, the landlord's contribution must be “significant,” must be “at risk,” and must be commensurate with the landlord's share of the profits and losses from the farming operation.
A landowner who cash leases land is considered a landlord under the payment limitation rules and may not be considered actively engaged in farming. In this situation, only the tenant is considered eligible. Under the payment limitation rules, there are technical requirements that restrict the cash-rent tenant's eligibility to receive payments to situations in which the tenant makes a “significant contribution” of (1) active personal labor and capital, land or equipment; or (2) active personal management and equipment. Leases in which the rental amount fluctuates with price and/or production (so-called “flex” leases) can raise a question as to whether or not the lease is really a crop-share lease which thereby entitles the landlord to a proportionate share of the government payments attributable to the leased land.
Under Farm Service Agency (FSA) regulations (7 C.F.R. §1412.504(a)(2)), a lease is a “cash lease” if it provides for only a guaranteed sum certain cash payment, or a fixed quantity of the crop (for example, cash, pounds, or bushels per acre).” All other types of leases are share leases. In April 2007, FSA issued a Notice stating that if any portion of the rental payment is based on gross revenue, the lease is a share lease. Notice DCP-172 (April 2, 2007). However, according to FSA, if a flex or variable lease pegs rental payments to a set amount of production based on future market value that is not associated with the farm’s specific production, it’s a cash lease. Id. That was the FSA’s position through the 2008 crop year. Beginning, with the 2009 crop year, FSA has taken the position that a tenant and landlord may reach any agreement they wish concerning “flexing” the cash rent payment and the agreement will not convert the cash lease into a share-rent arrangement.
There are many issues that surround farmland leasing. Today’s post just scratches the surface with a few. Of course, many detailed tax rules also come into play when farmland is leased. The bottom line is that the type of lease matters, for many reasons. Give your leasing arrangement careful consideration and get it in writing.
Tuesday, January 23, 2018
Farmers, ranchers and rural landowners frequently deal with many types of legal issues. Two of those sometimes involve the rules surrounding partition of farmland and adverse possession. These are two issues that heavily depend on state law and, as a result, the same set of facts can produce a different depending on the particular state.
In today’s post I take a look at a couple of recent cases that have again highlighted the importance of these issues.
Unfortunately, an all too common problem in estate planning for farm families is that farmland is left to multiple children equally as co-owners at the death of the surviving parent. That can create problems, particularly if there is at least one child that wants to continue farming the land and siblings that don’t. The sibling (or siblings) that don’t want to farm will often want to “cash out” their inheritance. Can the farmland be split-out between the siblings? That’s often difficult to accomplish, as a recent case illustrates.
In Wihlm v. Campbell, No. 15-0011 (Iowa Sup. Ct. Jan. 12, 2018), vac’g., 886 N.W.2d 617 (Iowa Ct. App. 2016), three siblings inherited approximately 300 acres of farmland as tenants in common when their father died. The land was divided into several parcels and two of the siblings brought partition actions seeking to have the properties sold and the proceeds divided. The other sibling (the defendant) wanted an in-kind division with respect to her share of about 79 acres and the homestead. The trial court ordered the entire property sold with the proceeds divided equally. The defendant appealed. An appraiser had testified at trial that if the property were sold at auction he would recommend selling it in separate parcels to bring a higher total selling price. The appraiser also testified that the tract that the defendant sought would be worth approximately one-third of the total value of the 300-acre tract. He also testified that an in-kind division would be fair and equitable. Another appraiser testified that it would be better to sell the entire tract together, but still another appraiser testified that more money could be realized on sale if separate tracts were sold.
The appellate court noted that the trial court had concluded that the defendant had failed to prove that the division of the properties in kind was equitable and practicable based on the testimony of two of the appraisers. But, the appellate court disagreed, noting that an appraisal is much more certain than speculation and that, in this case, the appraiser’s opinion was well supported. Accordingly, the court held that the defendant had proved that the division of the property was equitable and practicable. The court remanded the case for an in-kind partition of the property that the defendant requested, and for partition by sale of the balance with the proceeds split by the other siblings.
On further review, the Iowa Supreme Court vacated the court of appeals’ opinion on the basis that the defendant failed to meet her burden to prove that the partition in-kind was equitable and practicable. The Supreme Court gave no analysis for its opinion other than noting a 1968 Iowa Supreme Court opinion that stated the rule pertaining to partition of real estate “is unequivocal in favoring partition by sale and in placing upon the objecting party the burden to show why this should not be done in the particular case.” The Court followed that view in Newhall v. Roll, 888 N.W.2d 636 (Iowa 2016). Apparently, the conflicting testimony of the appraisers was insufficient to allow the defendant to prove that the division of the properties in-kind would be equitable and practicable.
Another topic that often arises in rural settings involves adverse possession. Adverse possession can involve boundary issues as well as access to property. But, again, the rules surrounding this issue are highly dependent on state law concerning the elements that must be establish to prove adverse possession. A recent case illustrates how the adverse possession rules work in Texas. Adverse possession gets particularly “messy” when mineral rights are also involved.
The facts of Hardaway v. Lou Eda Korth Stubbs Nixon, No. 04-16-00252-CV, 2017 Tex. App. LEXIS 10957 (Tex. Ct. App. Nov. 22, 2017) date back over 100 years. In the late 1800s, the Eckford’s owned, among other property, a 147.5-acre tract in Karnes County, Texas as community property. Mrs. Eckford was appointed as guardian of the community estate in 1893. Mr. Eckford died intestate on November 10, 1896. Under the laws of intestacy, one-half of the real property, which was community property, passed to Mrs. Eckford, and the other half of the real property passed to the couple’s nine surviving children. Mrs. Eckford conveyed portions of the property throughout her life, including a conveyance to the defendant’s predecessor in interest. When Mrs. Eckford died in 1928, her court appointed administrator advised the trial court that “all of the real estate” belonging to the estate should be sold to pay claims and expenses. Ultimately, in 1939, the administrator purported to sell all of the property once owed by the Eckfords as community property, including the 147.5 acres to the defendant’s predecessors.
The defendant’s parents entered into a mineral lease with Texas Oil & Gas Corp. in 1978 leasing the mineral rights in the entire 147.5 acres. At some point before 2012, Burlington Resources Oil & Gas Company and East 17th Resources, LLC (BRO&G) discovered information that led them to believe that the heirs of the Eckford’s owned an unleased one-half interest in the 147.5-acre tract that the defendant possessed. BRO&G believed that the defendant and the Eckford’s heirs were cotenants with regard to the 147.5 acres. As a result, BRO&G sought out and entered into mineral leases with numerous Eckford heirs. In 2012, because some of the numerous Eckford heirs could not be located, BRO&G instigated a receivership proceeding. The defendant intervened in the receivership action alleging sole ownership of the entire 147.5-acre tract. Ultimately, the defendant filed a motion for partial summary judgment in which he alleged full ownership of the property as a matter of law.
The trial court granted summary judgment in the defendant’s favor with regard to ownership of the property based only on constructive ouster and subsequent adverse possession. The Eckford heirs appealed. The appellate court held that a party claiming adverse possession as to a cotenant must not only prove his possession was adverse, but must also prove some sort of ouster. In addition, Texas law requires a summary judgment movant to do more than assert and prove “long-continued” possession under a claim of ownership and nonassertion of a claim by the titleholder to prove constructive ousters as a matter of law.
The appellate court determined that the only ground for summary judgment as to constructive ouster set forth in the defendant’s motion is long-continued possession coupled with absence of a claim by the Eckford heirs. The court determined that this neither asserted or established that they took “unequivocal, unmistakable, and hostile acts.” Therefore, the defendant failed to prove constructive ouster as a matter of law on the sole ground asserted in their motion. Accordingly, the appellate court reversed the trial court’s grant of summary judgment and remanded the matter to the trial court.
There are many cases involving these two issues, and the cases mentioned above are just a very small sample that illustrate an aspect of the real estate-related issues that rural landowners face. The cases also point out that a good lawyer well versed in these type of issues is good to have in tow.
Friday, December 8, 2017
Rural landowners can have various opportunities to earn income from their land that is in addition to income from crop and/or livestock production. For some landowners, that might include the possibility of leasing some of the property for oil and gas production. But, what should be considered before entering into a lease? This past May, David Pierce, Burke Griggs, Shawn Leisinger and I took our Rural Law Program to Dodge City, KS for a presentation. David Pierce made a presentation on oil and gas leases, and I took some notes of his discussion for future use on the blog.
Today’s post takes a brief look at what Prof. Pierce highlighted as some of the basic issues to be think about before entering into an oil and gas lease. Any lack of clarity in the commentary below is mine.
Doing nothing. It’s important to remember that when a landowner is approached about entering into an oil and gas lease that an acceptable strategy is to do nothing. There is no obligation to lease in a state (such as Kansas) that doesn’t have a compulsory “pooling” statute. But, while there is no obligation to lease, if the land is not owned outright by one person any cotenant has the power to develop, and authorize others to develop, without the consent of other cotenants. If that happens, there is then a duty to account to other cotenants for their share of the net proceeds (production revenue minus all reasonable costs of drilling, completing, and operating the well). Similarly, if one cotenant seeks to develop the minerals, that could give rise to another cotenant seeking a partition.
Similarly, when parents leave a tract of land to multiple children, and the parents don’t hold the leasing rights for the benefit of others that may create a duty to lease. The children end up with undivided interests in the entire tract. This means that the children receive all of the surface rights associated with the tract plus an undivided percentage interest in the oil and gas rights, plus the right to execute oil and gas leases for all of the undivided interests in their tract. That last point is key. Each child will end up with the right to enter into any lease covering the oil and gas rights held collectively by all of the siblings.
A related issue to that of a cotenant developing the property without the consent of other cotenants is that, for a proposed horizontal well, a lessee might seek to use another provision in state law to consolidate nonconsenting parties. This can happen if a state has a compulsory unitization statute. Kansas has such a statute, but it has never been tested in court. On the other hand, Ohio has used its compulsory unitization statute to combine the acreage necessary to conduct horizontal drilling into a shale formation.
Doing nothing presently. Another viable strategy is that the landowner may simply not enter into an oil and gas lease at the present time. Perhaps the up-front bonus money is not enough to allow the landowner to hire an attorney that is well-versed in oil and gas law for representation in the negotiation process. In any event, with this approach the landowner could gain strength in any future negotiation process.
Other Questions to Ask
Its also important for a landowner to understand who they are dealing with. Is it the developer or an intermediary? If the landowner is dealing with an intermediary, the intermediary will be looking to sell the lease and probably receive an overriding royalty in the lease. That’s an important point. The profit the intermediary retains upon selling the lease could have been the landowner’s if the deal is struck directly with the developer.
Also, it’s a good idea for a landowner to determine what the party seeking the oil and gas lease is planning for the landowner’s property and the nearby area. When is drilling to begin? Is there a formation that they are trying to develop? Have wells already been drilled in that area? Have wells been drilled elsewhere? Have other local landowners already executed leases and, if so, how many acres are under lease? What is being paid to other landowners in terms of a bonus and royalty rate? Can the landowner get the best deal that is offered? Will the developer match the best deal another developer offers? What can be learned about the company that is investing in the development of the land that will be leased?
Standard Lease Form?
One basic principle of oil and gas development is that there is not standard form for an oil and gas lease. See, e.g., Kansas Natural Gas Co. v. Board of Commissioners of Neosho County, 89 P.750, 751 (Kan. 1907). Thus, all of the terms of an oil and gas lease are negotiable. But, an oil and gas lease should address three general topics: 1) the rights granted by the lease; 2) the duration of those granted rights; and 3) the amount of compensation that the lessor will receive during the lease term.
While the terms of an oil and gas lease are negotiable, a party to the lease will not be satisfied with the contractual arrangement unless certain key points are achieved. The lessee (developer) wants exclusive development rights and associated use rights that are broad enough to allow the lessee to develop. In addition, the lessee must have adequate time to conduct the operations required to extend the lease. Also, the lessee must ensure that the leased land can be developed under existing law regulating oil and gas operations. From an economic standpoint, once the lessee commits funds to develop the lease, the lessee needs to be able to maintain the lease in effect as necessary to fully enjoy the benefits of its investment. In that same vein, the anticipated economic returns must be adequate to justify the risks involved.
From the lessor’s standpoint, it is important to receive an adequate financial incentive to part with the oil and gas and related surface rights. The lessee also wants continuing control over the surface estate prior before electing to make use of the surface to develop the leased land. Likewise, the lesssor wants continuing control over all other mineral and related rights not encompassed by the rights granted to the lessee. The lessor wants the ability to easily determine when the lease terminates in whole or in part, and the ability to easily determine the royalty due. It’s also important the lessor gets an assurance that as development progresses the impacted surface will be timely and properly reclaimed so it can be devoted to other uses. Similarly, the lessor wants the assurance that any disputes will be determined locally where the land is located, and that the lessor is able to access local courts to address disputes.
The Bonus and Obligation to Lease
Some of the most important details of the oil and gas lease transaction are not reflected anywhere in the oil and gas lease. Usually the lease contains a recitation similar to the following:
“Lessor, in consideration of one Dollars ($ 1.00 ) in hand paid, receipt of which is here acknowledged . . . .”. As that recitation indicates, the lease is presented as a unilateral grant by the lessor, and the lease is typically signed only by the lessor.
As for what makes the agreement binding on the parties, a conveyancing analysis is used to bind the lessee applying the requirements of delivery and acceptance. Likewise, some lessees still use a sight draft to create a situation where the parties may, or may not, be bound pending the lessee’s review and approval of the lessor’s title. The sight draft can create problems if it is not clear whether a contract to lease, with performance conditions, has been created or whether no obligation exists because the lessee is not bound in any way. This creates opportunities for the lessor in a rising leasing market and opportunities for the lessee in a declining leasing market. Thus, it is best to avoid the situation by nailing down the moment when the parties become bound. Perhaps the best approach is for a landowner to remain unbound, and free to deal with anyone, up until the landowner has the bonus money in hand. This places the urgency on the lessee to close the deal quickly.
These are some basic initial considerations for a landowner to work through before entering into an oil and gas lease so that the best negotiated deal can be struck. Useful information for those thinking about getting into an oil and gas lease.
Tuesday, August 22, 2017
On September 18, Washburn School of Law will be having its second annual CLE conference in conjunction with the Agricultural Economics Department at Kansas St. University. The conference, hosted by the Kansas Farm Bureau (KFB) in Manhattan, KS, will explore the legal, economic, tax and regulatory issue confronting agriculture. This year, the conference will also be simulcast over the web.
That’s my focus today – the September 18 conference in Manhattan, for practitioners, agribusiness professionals, agricultural producers, students and others.
Financial situation. Midwest agriculture has faced another difficult year financially. After greetings by Kansas Farm Bureau General Counsel Terry Holdren, Dr. Allen Featherstone, the chair of the ag econ department at KSU will lead off the day with a thorough discussion on the farm financial situation. While his focus will largely be on Kansas, he will also take a look at nationwide trends. What are the numbers for 2017? Where is the sector headed for 2018?
Regulation and the environment. Ryan Flickner, Senior Director, Advocacy Division, at the KFB will then follow up with a discussion on Kansas regulations and environmental laws of key importance to Kansas producers and agribusinesses.
Tax – part one. I will have a session on the tax and legal issues associated with the wildfire in southwest Kansas earlier this year – handling and reporting losses, government payments, gifts and related issues. I will also delve into the big problem in certain parts of Kansas this year with wheat streak mosaic and dicamba spray drift.
Weather. Mary Knapp, the state climatologist for Kansas, will provide her insights on how weather can be understood as an aid to manage on-farm risks. Mary’s discussions are always informative and interesting.
Crop Insurance. Dr. Art Barnaby, with KSU’s ag econ department, certainly one of the nation’s leading experts on crop insurance, will address the specific situations where crop insurance does not cover crop loss. Does that include losses caused by wheat streak mosaic? What about losses from dicamba drift?
Washburn’s Rural Law Program. Prof. Shawn Leisinger, the Executive Director of the Centers for Excellence at the law school (among his other titles) will tell attendees and viewers what the law school is doing (and planning to do) with respect to repopulating rural Kansas with well-trained lawyers to represent the families and businesses of agriculture. He will also explain the law school’s vision concerning agricultural law and the keen focus that the law school has on agricultural legal issues.
Succession Planning. Dr. Gregg Hadley with the KSU ag econ department will discuss the interpersonal issues associated with transitioning the farm business from one generation to the next. While the technical tax and legal issues are important, so are the personal family relationships and how the members of the family interact with each other.
Tax – part two. I will return with a second session on tax issues. This time my focus will be on hot-button issues at both the state and national level. What are the big tax issues for agriculture at the present time? There’s always a lot to talk about for this session.
Water. Prof. Burke Griggs, another member of our “ag law team” at the law school, will share his expertise on water law with a discussion on interstate water disputes, the role of government in managing scarce water supplies, and what the relationship is between the two. What are the implications for Kansas and beyond?
Producer panel. We will close out the day with a panel consisting of ag producers from across the state. They will discuss how they use tax and legal professionals as well as agribusiness professionals in the conduct of their day-to-day business transactions.
The Symposium is a collaborative effort of Washburn law, the ag econ department at KSU and the KFB. For lawyers, CPAs and other tax professionals, application has been sought for continuing education credit. The symposium promises to be a great day to interact with others involved in agriculture, build relationships and connections and learn a bit in the process.
We hope to see you either in-person or online. For more information on the symposium and how to register, check out the following link: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
August 22, 2017 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Wednesday, August 16, 2017
Easements are common in agriculture. An easement does not give the holder of the easement a right of possession, but a right to use or to take something from someone else's land. To the holder of the easement, the easement is a right or interest in land, but to the owner of the real estate subject to the easement, the easement is an encumbrance upon that person's estate. Easements may take several forms and are common in agricultural settings. Sometimes, the terminology used to describe an easement can be confusing.
In today’s post, I take a look at the various types of easements that are common in agriculture and some of the common issues that they present.
Easements in Gross and Appurtenant Easements
An easement may be either an easement in gross or an appurtenant easement. An easement “in gross” serves the holder only personally instead of in connection with such person's ownership or use of any specific parcel of land. An easement in gross is a non-assignable personal right that terminates upon the death, liquidation or bankruptcy of its holder.
An easement that is “appurtenant” is one whose benefits serve a particular parcel of land. An appurtenant easement becomes a right in that particular parcel of land and passes with title to that land upon a subsequent conveyance. Examples of appurtenant easements include walkways, driveways and utility lines that cross a particular parcel and lead to an adjoining or nearby tract.
Determining whether an easement is one in gross or is appurtenant depends upon the circumstances of each particular situation. Courts generally prefer appurtenant easements. The particular classification matters when the question is whether the easement in question is assignable or whether it passes with the title to the land to which it may be appurtenant.
Affirmative and Negative Easements
An easement is either an affirmative easement or a negative easement. Most easements are affirmative and entitle the holder to do certain things upon the land subject to the easement. A negative easement gives its holder a right to require the owner of the land subject to the easement to do or not to do specified things with respect to that land. Thus, negative easements are synonymous with covenantal land restrictions and are similar to certain “natural rights” that are incidents of land ownership. These include riparian rights, lateral and subjacent support rights, and the right to be free from nuisances. However, most American courts reject the English “ancient lights” doctrine and refuse to recognize a negative easement for light, air and view. See, e.g., Fontainebleau Hotel Corp. v. Forty-Five Twenty-Five, Inc. 114 So.2d 357 (Fla. App. 1959). However, if a property owner's interference with a neighboring owner's light, air or view is done maliciously, the court may enjoin such activity as a nuisance. See, e.g., Coty v. Ramsey Associates, Inc., 149 Vt. 451, 546 A.2d 196 (1988).
Profits and licenses. A concept related to an easement is that of a profit. For example, O, owner of Blackacre, could grant to A a right to enter Blackacre to cut and remove timber. A is said to have a profit in Blackacre - a right of severance which will result in A's acquiring possession to the severed thing. Easement and profit rights generally include the right to improve the burdened land, perhaps only to a gravel road, but perhaps to erect and maintain more substantial structures, such as bridges, pipelines, and even buildings that facilitate use of the easement or profit. Sometimes a question arises as to whether a point is reached at which structures become so substantial that the rights become those of occupation and possession instead of just use. In answering this question, courts look at the circumstances as a whole instead of the labels the parties use. In general, the existence of permanent, substantial structures is viewed as an estate rather than an easement or profit.
A license is a term that covers a wide range of permissive land uses which, unless permitted, would be trespasses. For example, a hunter who is on the premises with permission is a licensee. The distinction between a license and an easement or profit is that a license can be terminated at any time by the person who created the license. For example, permission to hunt may be denied. Conversely, easements and profits exist for a fixed period of time or perpetually and are rights in land. A license is only a privilege. Likewise, easements and profits are interests in land while licenses are not, and licenses may be granted orally, but because easements and profits are interests in land, they are subject to the statute of frauds and must be in writing.
An easement may also be implied from prior use or necessity, or arise by prescription. An implied easement may arise from prior use if there has been a conveyance of a physical part of the grantor's land (hence, the grantor retains part, usually adjoining the part conveyed), and before the conveyance there was a usage on the land that, had the two parts then been severed, could have been the subject of an easement appurtenant to one and servient upon the other, and this usage is, more or less, “necessary” to the use of the part to which it would be appurtenant, and “apparent.” An easement implied from necessity involves a conveyance of a physical part only of the grantor's land, and after severance of the tract into two parcels, it is “necessary” to pass over one of them to reach any public street or road from the other. No pre-existing use needs to be present. Instead, the severance creates a land-locked parcel unless its owner is given implied access over the other parcel.
Prescriptive Easements (Adverse Possession)
Acquiring an easement by prescription is analogous to acquiring property by adverse possession. If an individual possesses someone else's land in an open and notorious fashion with an intent to take it away from them, such person (known as an adverse possessor) becomes the true property owner after the statutory time period (anywhere from 10 to 21 years) has expired. For an easement by prescription to arise, the use of the land subject to the easement must be open and notorious, adverse, under a claim of right, continuous and uninterrupted for the statutory period.
For example, assume that A owns Blackacre, and that B owns adjacent Whiteacre. A drives across a portion of Whiteacre to reach A's garage on Blackacre. A does this five days a week for 22 years. B then puts up a barbed wire fence in A's path. If A can show an adverse use of Whiteacre and that A's use was continuous for the full statutory period, and that A's use was visible and notorious or was made with B's acquiescence, A will have a prescriptive easement over Whiteacre. However, acquiescence does not mean permission. If A receives permission from B to cross Whiteacre, the prescriptive period never begins to run and no prescriptive easement will arise. See, e.g., Rafanelli v. Dale, 924 P.2d 242 (Mont. 1996)
Adverse possession (prescriptive easement) statutes vary by jurisdiction in terms of the requirements a person claiming title by adverse possession must satisfy and the length of time property must be adversely possessed. Once title is successfully obtained by adverse possession, the party obtaining title can bring a court action to quiet title. A quiet title action ensures that the land records properly reflect the true owner of the property.
Termination of Easements
An easement may be terminated in several ways.
Merger. Merger, also referred to as unity of ownership, terminates an existing easement. For example, assume that A owns Blackacre and B owns adjoining Whiteacre. B grants A an easement across Whiteacre so that A can acquire access to Blackacre. Two years later, A buys Whiteacre in fee simple. Because A now owns both tracts of real estate, the easement is terminated.
Release. An easement may also be terminated by a release. If the easement was for a duration of more than one year, the release must be in writing to be effective and comply with all of the formalities of a deed.
Abandonment. An easement may also be terminated by abandonment. Mere intent to abandon is not effective to terminate the easement. Instead, abandonment can only occur if the holder of the easement demonstrates by physical action an intent to permanently abandon the easement. Mere words are insufficient to cause an abandonment of the easement. For example, assume that an easement holder builds a barn in such a manner that access to the easement is blocked. This action would be sufficient to constitute abandonment of the easement.
Estoppel. An easement may also be terminated by estoppel where there is reasonable reliance by the owner of the servient tenement who changes position based on assertions or conduct of the easement holder. For example, assume that A tells B that A is releasing the easement over B's property. As a result, A doesn't use the easement for a long time. B then builds a machine shed over A's easement. In this situation, the easement would be terminated by estoppel and A could not reassert the existence of the easement after the machine shed has been built.
Prescription. An easement may also be terminated by prescription where the owner of the servient tenement possesses and enjoys the servient tenement in a way that would indicate to the public that no easement right existed.
Easements are common in agriculture and can arise in numerous ways. An understanding of what they are, how they can arise, how they can be terminated, and the associated legal issues can be useful.
Monday, July 31, 2017
Today's post is a deviation from my normal posting on an aspect of agricultural law and tax that you can use in your practice or business. That’s because I have a new book that is now available that you might find useful as a handbook or desk reference. Thanks to West Academic Publishing, my new book “Agricultural Law in a Nutshell,” is now available. Today’s post promotes the new book and provides you with the link to get more information on how to obtain you copy.
The Nutshell is taken from my larger textbook/casebook on agricultural law that is used in classrooms across the country. Ten of those 15 chapters are contained in the Nutshell, including some of the most requested chapters from my larger book – contracts, civil liabilities and real property. Also included are chapters on environmental law, water law and cooperatives. Bankruptcy, secured transactions, and regulatory law round out the content, along with an introductory chapter. Not included in this Nutshell are the income tax, as well as the estate and business planning topics. Those remain in my larger book, and are updated twice annually along with the other chapters found there.
The Nutshell is designed as a concise summary of the most important issues facing agricultural producers, agribusinesses and their professional advisors. Farmers, ranchers, agribusinesses, legal advisors and students will find it helpful. It’s soft cover and easy to carry.
Rural Law Program
The Nutshell is another aspect of Washburn Law School’s Rural Law Program. This summer, the Program placed numerous students as interns with law firms in western Kansas. The feedback has been tremendous and some lawyers have already requested to be on the list to get a student for next summer. Students at Washburn Law can take numerous classes dealing with agricultural issues. We are also looking forward to our upcoming Symposium with Kansas State University examining the business of agriculture and the legal and economic issues that are the major ones at this time. That conference is set for Sept. 18, and a future post will address the aspects of that upcoming event.
You can find out more information about the Nutshell by clicking here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/agriculturallawnutshell/index.html
Monday, June 5, 2017
Generally, an exchange of property for other property is treated as a sale. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment. I.R.C. §1031. The new property is treated as a continuation of the original property. That means that neither gain nor loss is recognized until (if ever) the replacement property is sold. Gain, however, is recognized to the extent of any boot or unlike property received in the exchange.
Like-kind exchanges are very popular in agriculture. Whether the transaction involves a trade of real estate or equipment, ag producers find tax-deferred exchanges to be a useful tax planning tool. Today’s post looks at just a few of the aspects of like-kind exchanges.
What is “Like-Kind”?
Personal property. With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class. Also, property is of a like-kind to property that is of the same nature or character. Like-kind property does not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis. Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
Real estate. With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment. Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange.
A leasehold interest can be exchanged for fee interests if the leasehold interest has at least 30 years to run at the time the exchange is entered into. Treas. Reg. §1.1031(a)-1(c). Case law also indicates that, at the time the transaction is entered into, the lease must have at least 30 years remaining. See, e.g., VIP Industries Inc. & Subsidiaries v. Comm’r, T.C. Memo. 2013-357.
Water rights that are limited in duration are not considered like-kind to a fee interest in land, (Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002)), but if the water rights are limited only as to annual use the IRS has ruled that they are of sufficient like-kind to a fee interest in land to qualify the transaction for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).
The “Holding” Requirement
The statute is silent about how long the relinquished and replacement properties must be held. Thus, the key is the taxpayer’s intent in holding the exchange properties. However, the IRS has ruled that if the taxpayer acquires the relinquished property immediately before the exchange, or disposes of the replacement property immediately after the exchange, the holding requirement of I.R.C. §1031(a) is not met. See, e.g., Rev. Rul. 75-291, 1975-2 C.B. 332; Rev. Rul. 77-297, 1977-2 C.B. 304; Rev. Rul. 84-121, 1984-2 C.B. 168.
The courts tend to consider whether the relinquished property was held for investment or for use in a business, and whether the replacement property was held for investment or for use in a business. See, e.g., Bolker v. Comr., 760 F.2d 1039 (9th Cir. 1985). Clearly, acquiring property in an exchange which is then immediately fixed-up and sold, does not meet the test of having been held for investment or for use in a trade or business. Similarly, based on the facts of the case, IRS may argue that the transaction really involved the intent to make a gift and that the property was not held for investment or for use in a trade or business. See, e.g., Wagensen v. Comr., 74 T.C. 653 (1980); Click v. Comr., 78 T.C. 225 (1982). In any event, the taxpayer bears the burden to prove the requisite intent. See, e.g., Land Dynamics v. Comr., T.C. Memo. 1978-259.
For exchanges between related parties, if property that was part of the exchange is disposed of within two years of the last transfer that was part of the exchange, the tax deferral is eliminated. In addition, I.R.C. §1031(f)(4) provides that the like-kind exchange rules do not apply to any exchange that is part of a transaction or series of transactions structured to avoid the related party prohibition. The IRS has ruled that taxpayer who transfers relinquished property to a qualified intermediary in an I.R.C. §1031 exchange for replacement property formerly owned by a related party does not qualify for non-recognition treatment. Rev. Rul. 2002-83, IRB No. 2002-49 (intermediary used to circumvent the related party prohibition). The IRS has also disallowed tax-deferred treatment where a taxpayer attempted several related party exchanges, moving low basis property in exchange for the high basis property of a related party, before the sale of the low basis property. Priv. Ltr. Rul. 200126007 (Mar. 22, 2001). However, the IRS has allowed tax-deferred treatment where the related party exchange preceded the sale to a third party by more than the two-year statutory minimum. Field Service Advice 200137003 (Sept. 17, 2001).
What About Debt?
The IRS has prescribed rules that govern the handling of debt in a like-kind exchange. Treas. Reg. §1.1031(d)-(2). Gain recognized on a like-kind exchange with debt is the greater of the excess value of the relinquished property over the value of the acquired property, or the excess of the equity in the relinquished property over the equity in the acquired property (this excess equal to the cash received in the exchange). Thus, if the value of the acquired property equals or exceeds the value of the relinquished property and the equity in the acquired property equals or exceeds the equity in the relinquished property, no gain is recognized on the exchange.
These are just a few of the points concerning like-kind exchanges that seem to generate a lot of questions. These transactions are popular in agriculture. But, anytime a tax-deferred exchange is desired, competent tax and legal advice is a must.
Friday, May 12, 2017
Generally, an exchange of property for other property is treated as a sale with gain or loss being recognized on the transaction. I.R.C. §§61(a)(3); 1001. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment. I.R.C. §1031. Federal and state income tax is not avoided, it is simply deferred until the replacement property is sold (except that gain is immediately recognized to the extent of any boot or unlike property received in the exchange). The rationale is that the replacement property is viewed as causing no material change in the taxpayer’s economic position. It’s just a continuation of the original property.
Like-kind exchanges are popular in agriculture for various reasons. Those reasons can include the facilitation of an estate or business plan, Medicaid asset preservation planning, or simply for tax deferral reasons. Sometimes an exchange is straightforward as a direct, two-party exchange. Other times it is a “deferred” exchange or a “reverse” exchange. When an exchange is other than a direct, two-party exchange, special rules must be followed. Several years ago, the IRS established a “safe harbor” for such exchanges, but recently the U.S. Tax Court said that a transaction that wasn’t within the confines of the safe harbor still qualified for tax deferral.
The implications of the Tax Court decision on deferred or like-kind exchanges is our focus today.
Like-Kind Exchange Details
With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class. Also, property is of a like-kind to property that is of the same nature or character. Like-kind property does not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis. Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment. Even water rights, if they are not limited in duration, can be like-kind to a fee interest in land. See, e.g., Priv. Ltr. Rul. 200404044 (Oct. 23, 2003). Thus, agricultural real estate may be traded for residential real estate. See also Treas. Reg. §1.1031(a)-(1)(c). However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are I.R.C. §1245 property. For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange.
Deferred exchanges. An exchange may qualify for the like-kind exchange treatment even if the replacement property is received after the relinquished property has been given up. I.R.C. §1031(a)(3) and Treas. Reg. §1.1031(k)-1. This is known as a deferred exchange, and a qualified intermediary (Q.I.) is to be used to facilitate the exchange. The Q.I. is a party unrelated to the taxpayer that, pursuant to a written agreement with the taxpayer, holds the proceeds from the sale of the relinquished property in trust or an escrow account. The Q.I. takes title to the property that is sold (the relinquished property) and receives the sales proceeds. This is done to ensure that the taxpayer is not in constructive receipt of the sale proceeds.
After the relinquished property is transferred, replacement property must be identified within 45 days after the date of the transfer of the relinquished property, and the replacement property must be received before the earlier of 180 days or the due date of the income tax return, including extensions, for the tax year in which the relinquished property is transferred. Treas. Reg. §1.1031(k)-1(b).
Reverse exchanges. With a reverse exchange, the taxpayer receives the replacement property before the transfer of the relinquished property. Often, a reverse exchange is facilitated by a “parking” transaction or a “build-to-suit” transaction where the replacement property is “parked” with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed.
Safe Harbor. While the Code doesn’t address reverse exchanges and regulations haven’t been developed to provide guidance, the IRS did issue a safe harbor in 2000 for such transactions. Rev. Proc. 2000-37, 2000-2, C.B. 308. Under the safe harbor, the Q.I. must hold the property for the taxpayer’s benefit and be treated as the beneficial owner for federal tax purposes. In addition, for the safe harbor to apply, the IRS said that the 45-day and 180-day requirements must be met. The IRS made no comment on the tax treatment of “parking” transactions that don’t satisfy the safe harbor. But, a major difference between the safe harbor and the Treasury Regulations governing deferred exchanges is that, under the safe harbor, the Q.I. must take title and beneficial ownership of the replacement property. In a deferred exchange, the Q.I. only need “facilitate” the exchange. That doesn’t require taking legal title. Later, in 2004, the IRS tightened the safe harbor so that it didn’t apply to taxpayers who acquire replacement property that the taxpayer or a related party owned before the exchange. Rev. Proc. 2004-51, 2004-2, C.B. 294.
Clearly, with Rev. Proc. 2004-51, the IRS didn’t want taxpayers to use reverse exchanges to reinvest proceeds from the sale of one property into improvements to other real estate that the taxpayer had previously owned. For example, assume that a farmer owns a tract of land that is not in close proximity to his primary farming operation and has become inconvenient to operate. Thus, the farmer wants to sell the tract and use the proceeds to build a livestock facility on other land that he owns that is adjacent to his farming operation. In an attempt to structure the transaction in a manner to qualify as a tax-deferred exchange, the farmer transfers title to the land where the livestock facility will be built to a Q.I. The farmer provides the financing and the Q.I. has the livestock facility built. The farmer then transfers the tract that he desires to dispose of to the Q.I. and the Q.I. sells it and uses the sale proceeds to retire the debt on the livestock facility. Because the farmer owned the land on which the livestock facility was built before the exchange occurred, Rev. Proc. 2004-51 would operate to bar the transaction from tax-deferred treatment.
In Estate of Bartell v. Comr., 147 T.C. No. 5 (2016), a taxpayer (a drugstore chain) sought a new drugstore while it was still operating an existing drugstore that it owned. The taxpayer identified the location where the new store was to be built, and assigned its rights to the purchase contract in the property to a Q.I. in April of 2000. The taxpayer then entered into a second agreement with the Q.I. that provided that the Q.I. would buy the property, with the taxpayer having the right to buy the property from the Q.I. for a stated period and price. The taxpayer, in June of 2001, leased the tract from the Q.I. until it disposed of the existing drugstore in September of 2001. The taxpayer then used the proceeds of the existing drugstore to buy the new store from the intermediary, with the transaction closing in December of 2001. Because the new store was acquired before the existing store was disposed of, it met the definition of a reverse exchange. However, the safe harbor did not apply because the exchange was undertaken before the safe harbor became effective. If the safe harbor had applied, the transaction would not have been within it because the Q.I. held title for much longer than 180 days. Despite that, the IRS nixed the tax deferral of the exchange because it viewed the taxpayer as having, in substance, already acquired the replacement property. In other words, it was the taxpayer rather than the Q.I. that held the burdens and benefits of ownership before the transfer which negated income tax deferral. An exchange with oneself is not permissible. As a result, eliminated was the deferral of about $2.8 million of gain realized on the transaction in 2001.
The Tax Court noted that existing caselaw did not require the Q.I. to acquire the benefits and burdens of ownership as long as the Q.I. took title to the replacement property before the exchange. The Tax Court noted that it was important that the third-party facilitator was used from the outset. While the safe harbor didn’t apply to the transaction, the Tax Court noted that 45 and 180-day periods begin to run on “the date on which the taxpayer transfers the property relinquished in the exchange,” and that the taxpayer satisfied them. The Tax Court also noted that caselaw does not impose any specific time limits, and supported a taxpayer’s pre-exchange control and financing of the construction of improvements on the replacement property during the time a Q.I. holds title to it. The taxpayer’s temporary possession of the replacement property via the lease, the court reasoned, should produce the same result.
What impact does the court’s decision have on the safe harbor? For starters, even though the safe harbor didn’t apply in the case, the court’s decision certainly illustrates that the safe harbor only applies with respect to reverse exchanges. Another point is that because the facts of the case involved pre-2004 years, the Tax Court did not need to address Rev. Proc. 2004-51 and how the IRS tightened the screws on the safe harbor at that time. That means that Estate of Bartell probably shouldn’t be relied too heavily upon and a reverse exchange transaction should be structured to come within the safe harbor, as modified by Rev. Proc. 2004-51. But, the safe harbor is just that – a safe harbor.
Wednesday, February 15, 2017
A question that I sometimes get involves an interesting aspect of farm lease law (although it’s probably not unique to agriculture) when the land is co-owned. The question is whether, when co-owned farmland is leased, must all of the co-owners agree to lease the property? On the flip side, must all of them agree to a termination of the lease? Those are interesting and important questions.
A few years ago, I discussed these issues with the former Dean of the University of Iowa College of Law who had written a bit on the matter in the 1960s. Today’s blog post is loosely based on that conversation (and an initial article that my staff attorney Erica Eckley, and myself authored in 2013 – the original article is available at www.calt.iastate.edu).
While most of the caselaw on the issue is relatively dated, there is a recent case from Ohio on point. In H & H Farms, Inc. v. Huddle, No. 3:13 CV 371, 2013 U.S. Dist. LEXIS 72501 (N.D. Ohio May 22, 2013), a married couple owned a tract of farmland. Over a period of time, they transferred undivided fractional interests in the farmland to a son – the defendant in the case. The wife eventually died, with the husband remaining in the farm home. At the time the case was filed, the son owned an undivided 94 percent interest in the farmland and his father owned 6 percent. The plaintiff had been the tenant on the property for a number of years and was the father’s grandson and nephew of the son. The father entered into an 11-year lease with the plaintiff for $150/year. However, the son did not consent to the lease and claimed that it was unenforceable and that the plaintiff would be trespassing if he attempted to farm the land. The plaintiff sought a declaratory judgment regarding the legal sufficiency of the lease, and the son filed a motion to dismiss. There was only one issue before the court - whether a legally plausible claim had been alleged.
The court addressed the legal standard for possession when tenants in common lease real estate. In Ohio, tenants in common each have a distinct title and right to enter upon the entire tract of real estate and take possession of it even if the ownership share is less than other tenants in common. If a tenant in common is not in possession of the real estate (i.e., an absentee landlord), that co-tenant is entitled to receive the reasonable rental value of the property from the co-tenant in possession consistent with the (absentee) co-tenant’s ownership interest. The court also noted that, under Ohio law, when an owner conveys property via a lease, the owner retains the fee simple interest in the property. Ohio courts have held that the possession of the tenant is synonymous with the lessor’s possession. Thus, tenants in common have a present possessory interest in the property. So, the father’s possession under the facts of the case was also the co-tenant’s possession.
The son’s motion to dismiss was based on the argument that a tenant in common cannot convey, encumber, or divest the rights of a co-tenant. The court disagreed because of the principle that a lease does not divest the possession of the land from the co-tenant. The court held that because the son’s possessory rights were not divested, there would be no need for him to approve the lease. Thus, the court declared that the plaintiff had stated a claim for which relief could be granted, and the motion to dismiss would not be granted.
The court, however, went on to state that it believed that when a six percent owner leases a farm to a third party for 11 years, it would be inequitable for the lease to remain with the land following a partition sale. But, that statement was merely dicta because it was not germane to the issue before the court and the motion to dismiss.
So, the tenant’s possessory interest is strong and cannot be disturbed. That also can mean that, absent a provision in a written lease, the landowner doesn’t have the right to hunt the leased ground absent the tenant’s permission. Of course, not allowing the tenant to hunt the ground will likely result in the tenant being terminated as soon as possible under state law.
Accounting for rents. Some states, such as Iowa have a statutory provision on this issue. Iowa Code § 557.16 explicitly states that a co-tenant in possession is liable for the reasonable rent to the co-tenant not in possession. See, e.g., Meier v. Johannsen, 47 N.W.2d 793, 242 Iowa 665 (1951).
Partition action. Because the tenant’s right of possession during the term of the lease is strong and cannot be interfered with, that can mean that once there is a valid lease, the tenant’s rights probably cannot be dislodged by a partition action. Similarly, property that is subject to a life estate cannot be partitioned. Redding v. Redding, 284 N.W. 167, 226 Iowa 327 (1939).
Termination of lease. In Dethlefs v. Carrier, 64 N.W.2d 272, 245 Iowa 786 (1954), a tenant had a written lease on 40 acres of farmland. The land was owned by a brother and sister as tenants in common and the lease was entered into between the tenant and the sister. The brother did not sign the lease. Upon the sister’s death, the brother became the sole owner, but did not follow state law to terminate the lease. The brother claimed that the sister’s death terminated not only her interest in the land, but also terminated the lease and eliminated the requirement that he give notice to terminate the lease. The court disagreed on the basis that, in such a situation, a presumption arises that the lease was made with the knowledge and consent of each co-tenant. There was no evidence to overcome the presumption
Similarly, the tenant’s possessory interest also is an issue when the landlord dies during the term of the lease and a growing crop exists. Entitlement to the crop is fairly clear when the landlord owns a fee simple interest in the leased land — the landlord’s heirs succeed to the landlord’s share of the crop. However, if the landlord owns less than a fee simple interest in the leased land (such as a life estate), the outcome may be different. The question is whether the deceased landlord’s estate or the holder of the remainder interest is entitled to the landlord’s share. In two 1977 Kansas cases, Finley v. McClure, 222 Kan. 637, 567 P.2d 851 (1977) and Rewerts v. Whittington, 1 Kan. App. 2d 557, 571 P.2d 58 (1977), the landlord owned only a life estate interest in certain farm ground and leased it on shares to a tenant. The landlord died before the growing wheat crop was harvested, and the court held that the landlord’s crop share was a personal asset of the landlord, entitling the landlord’s estate to the landlord’s crop share on the basis that growing crops are personal property. The remainderman takes nothing. The Nebraska Supreme Court has reached a similar conclusion. Heinold v. Siecke, 257 Neb. 413, 598 N.W.2d 58 (1999). However, the Colorado Supreme Court has held that the remainderman was entitled to the landlord’s share on the basis that the language in the deed creating the reserved life estate in the decedent had divested the estate of any rights to profits from the crops. Williams v. Stander, 143 Colo. 469, 354 P.2d 492 (1960).
Whenever farmland is owned by multiple parties or the ownership interests include a life estate, a partition action is likely not possible, but an absentee co-tenant may not be required to consent to a lease. It may be that a presumption arises that the lease was made with each co-tenant’s knowledge and consent. An issue also arises if the landlord owns less than a full fee simple interest. If you encounter these issues, consulting legal counsel would be a good idea.
Monday, January 30, 2017
Agricultural law is often “law by the exception.” Numerous situations exist where being a “farmer” or being engaged in “agriculture” results in different, and more favorable, treatment under the law. One of those areas of favorability has to do with the tax treatment of property that is used for agricultural purposes.
One might think that it is easy to determine if a tract of land is used for an agricultural purpose. Often it is. The property is either cropped or grazed. But, other situations are not as easy. Today, we take a look at those blurry situations.
Mechanics of Real Property Taxation
In many states, real property is listed and valued every two years. In each year in which real property is not regularly assessed, the assessor lists and assesses any real property not included in the previous assessment and any improvements made since the previous assessment. Normal and necessary repairs up to a threshold amount per building per year do not increase the taxable value. The tax rate, typically expressed in dollars per $1,000 of actual value, is applied against actual value or a percentage of actual value. Actual value is usually the “fair and reasonable market value” of the property. “Market value” is defined as the result of a “fair and reasonable exchange in the year in which the property is listed and valued between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and each being familiar with all the facts relating to the particular property.”
In general, the actual value of agricultural property is to be determined on the basis of productivity and net earning capacity on the basis of use for agricultural purposes. This typically results in lower valuation for real property tax purposes for agricultural property than nonagricultural property. Thus, to obtain favorable tax treatment, the parcel in question must be used as farm or ranch land for agricultural purposes in accordance with the particular state statute. While agricultural dwellings are typically valued as rural residential property and are assessed at the same percentage of actual value as other residential property, the lower “use” valuation of agricultural real estate when compared with nonagricultural real estate has spawned numerous cases construing the boundary of the definition of “agricultural land” and “agricultural activities.”
The following is a listing of some of the more illustrative cases that provide a flavor of the issues that can arise and how the courts deal with them:
- In Drost v. Mahaska County Board of Review, et al., 840 N.W.2d 726 (Iowa Ct. App. 2013), the court held that the assessment of $410,480 was correct instead of the plaintiffs’ claimed $75,000. Even though the plaintiffs had sold a wetland easement on 283 acres to the federal government, the ag land still had “net earning capacity,” encompassing potential productivity.
- Under Colorado law (Colo. Rev. Stat. § 39-1-102(3.5)), agricultural products must originate from the land’s productivity. There have been numerous cases involving the application of the statute. For example, in Welby Gardens Co. v. Colorado Bd. of Assessment Appeals, 56 P.3d 1121 (Colo. Ct. App. 2002), even though greenhouses produced horticultural products, and the statute defined agriculture as including horticulture, the products did not originate from the land’s productivity and the property was not eligible to be taxed as farm property.
- In Bond County Board of Review v. Property Tax Appeal Board, 796 N.E.2d 628 (Ill. Ct. App. 2003), subdivided lots used for raising and storing of hay and storing of logs were properly valued as agricultural land. The statute did not require subdivided lots to be assessed as residential property.
- In Schmeig v. County of Chisago, 740 N.W.2d 770 (Minn. 2007), Minnesota law, “agricultural land” defined as “all land used during the preceding year for agricultural purposes,” and the statute contemplated that a particular tract may be subject to more than one classification. The classification of the entire tract as commercial was not appropriate where bees were raised on part of the tract.
- In Hanneken v. Missouri State Tax Commission, No. 96-73000 (Dec. 19, 1996), a portion of lake front property was accepted into a governmental conservation program for timber improvement. The tract qualified for agricultural classification even though it was not part of an ongoing farming operation and there would be a long-time period before trees would be harvestable.
- In Mollica v. Divison of Property Valuation and Review, 2008 Vt. 60 (2008), a “Christmas Cottage” on a Christmas tree farm used as sales office and warming hut for customers during Christmas season and rented guest house during off-season remained eligible for enrollment in a tax abatement program as farm property. The property was used as “rental property” only during the “non-farm” season and still remained actively used in a farming operation during Christmas tree harvesting season.
- In In re Goddard, 39 Kan. App.2d 325 (2008), a sawmill operation was not “farming” for purpose of state ad valorem property tax exemption, but a yarding tractor used to harvest trees was exempt farm equipment.
- In another Colorado case, Douglas County Board of Equalization v. Clarke, 921 P.2d 717 (Colo. 1996), the taxpayer was required to prove that actual grazing of the parcel at issue occurred during the tax year unless there was a conservation practice being utilized that prevented grazing.
- Also in Colorado, C.P. Bedrock, LLC v. Denver County Board of Equalization, 259 P.3d 514 (Colo. Ct. App. Apr. 14, 2011), writ of cert. dismissed, 2011 Colo. LEXIS 569 (Colo. Sup. Ct. Jun. 20, 2011), the property at issue did not qualify as “agricultural” property for tax purposes. There was no grazing of livestock or crop growing activities present, and the property was not sufficiently connected by use with other land so as to be classified as agricultural land. The property was also not used for conservation purposes.
- In Elmstad v. Lane County Assessor, No. TC-MD 101235D, 2011 Ore. Tax LEXIS 226 (Or. Tax Ct. Jun. 6, 2011), the taxpayer was not entitled to ad valorem real property tax assessment as farm because the property was not used primarily for making profit. The taxpayer’s testimony was that he intended to start vineyard and grow hay and blueberries and filberts on 9.27 acres. The statute focused on the current use of the land, and the land had been laying fallow for more than one year. The sales of a few pounds of honey was insufficient to show a profit motive.
- In Terry v. Sperry, et al., 130 Ohio St. 3d 125, 956 N.E.2d 276 (2011), involved a situation where, under the applicable state statute, township zoning commissions, boards of township trustees or boards of zoning appeals were barred from prohibiting agricultural uses on land or the use of buildings or structures incident to “agricultural uses.” Under the statute, a township could not regulate the zoning of buildings used primarily for venting and selling wine, and no requirement existed that venting and selling of wine be a secondary or subordinate use of the property or that viticulture be the primary use of the property. Thus, the township could not prohibit use of property for venting and selling wine if any part of property used for viticulture.
- In McLendon v. Nikolits, No. 4D15-4003, 2017 Fla. App. LEXIS 765 (Fla. Ct. App. Jan. 25, 2017),the defendant, county property appraiser, denied the plaintiff’s request for an ag tax classification on all of the plaintiff’s property. The plaintiff owned a five-acre tract and used the land to raise wild birds for sale as pets – aviculture. The plaintiff spent about $50,000 to buy cages, sheds, fences, feeders and structures for storage. From 2006-2012, the defendant classified the property as agriculture because of its dual use for aviculture and cattle. In 2012, the defendant denied an ag tax classification for the requested 4.5 acres, instead issuing it for 2.25 acres. The plaintiff appealed to the Value Adjustment Board (VAB) which held that the entire 4.5 acres should have ag classification. In 2013, the defendant denied ag classification to the portion of the property used for aviculture, which decision was reversed by the VAB. The defendant appealed the VAB’s decision and also denied ag classification for tax year 2014. Both parties motioned for summary judgment. The trial court ruled for the defendant on the basis that only poultry qualified as ag under the applicable statute and entered summary judgment for the defendant. On further review, the appellate court reversed. The appellate court held that if, on remand, the plaintiff could establish that aviculture is useful to humans, then agricultural classification should apply. The court reached that conclusion because the applicable statute defined “farm product” as “any…animal…useful to humans.”
The cases illustrate that in situations that don’t involve traditional crop or livestock usage of real estate can lead to interesting property tax questions. Niche farming activities are an example. A new one recently involves marijuana growing activities in those states where it is legal under state law. In any event, it is a good idea to be familiar with the particularities of state law. Each state defines “agriculture” and “agricultural activity” differently and the court constructions of those statutes also vary. Determining what state law is and bringing an activity within the definition of “agriculture” can save tax dollars.
Friday, January 6, 2017
Today we continue our look this week at the biggest developments in agricultural law and taxation during 2016. Out of all of the court rulings, IRS developments and regulatory issues, we are down to the top five developments in terms of their impact on ag producers, rural landowners and agribusinesses.
So, here are the top five (as I see them) in reverse order:
(5) Pasture Chiseling Activity Constituted Discharge of “Pollutant” That Violated the CWA. The plaintiff bought approximately 2,000 acres in northern California in 2012. Of that 2,000 acres, the plaintiff sold approximately 1,500 acres. The plaintiff retained an environmental consulting firm to provide a report and delineation map for the remaining acres and requested that appropriate buffers be mapped around all wetlands. The firm suggested that the plaintiff have the U.S. Army Corps of Engineers (COE) verify the delineations before conducting any grading activities. Before buying the 2,000 acres, the consulting firm had provided a delineation of the entire tract, noting that there were approximately 40 acres of pre-jurisdictional wetlands. The delineation on the remaining 450 acres of pasture after the sale noted the presence of intact vernal and seasonal swales on the property along with several intermittent and ephemeral drainages. A total of just over 16 acres of pre-jurisdictional waters of the United States were on the 450 acres – having the presence of hydric soils, hydrophytic vegetation and hydrology (1.07 acres of vernal pools; 4.02 acres of vernal swales; .82 acres of seasonal wetlands; 2.86 acres of seasonal swales and 7.40 acres of other waters of the United States). In preparation to plant wheat on the tract, the property was tilled at a depth of 4-6 inches to loosen the soil for plowing with care taken to avoid the areas delineated as wetlands. However, an officer with the (COE) drove past the tract and thought he saw ripping activity that required a permit. The COE sent a cease and desist letter and the plaintiff responded through legal counsel requesting documentation supporting the COE’s allegation and seeking clarification as to whether the COE’s letter was an enforcement action and pointing out that agricultural activities were exempted from the CWA permit requirement. The COE then provided a copy of a 1994 delineation and requested responses to numerous questions. The plaintiff did not respond. The COE then referred the matter to EPA for enforcement. The plaintiff sued the COE claiming a violation of his Fifth Amendment right to due process and his First Amendment right against retaliatory prosecution. The EPA refused the referral due to the pending lawsuit so the COE referred the matter to the U.S. Department of Justice (DOJ). The DOJ filed a counterclaim against the plaintiff for CWA violations.
The court granted the government’s motion on the due process claim because the cease and desist letter did not initiate any enforcement that triggered due process rights. The court also dismissed the plaintiff’s retaliatory prosecution claim. On the CWA claim brought by the defendant, the court determined that the plaintiff’s owner could be held liable as a responsible party. The court noted that the CWA is a strict liability statute and that the intent of the plaintiff’s owner was immaterial. The court then determined that the tillage of the soil causes it to be “redeposited” into delineated wetlands. The redeposit of soil, the court determined, constituted the discharge of a “pollutant” requiring a national pollution discharge elimination system (NPDES) permit. The court reached that conclusion because it found that the “waters” on the property were navigable waters under the CWA due to a hydrological connection to a creek that was a tributary of Sacramento River and also supported the federally listed vernal pool fairy shrimp and tadpole shrimp. Thus, a significant nexus with the Sacramento River was present. The court also determined that the farming equipment, a tractor with a ripper attachment constituted a point source pollutant under the CWA. The discharge was not exempt under the “established farming operation” exemption of 33 U.S.C. §1344(f)(1) because farming activities on the tract had not been established and ongoing, but had been grazed since 1988. Thus, the planting of wheat could not be considered a continuation of established and ongoing farming activities. Duarte Nursery, Inc. v. United States Army Corps of Engineers, No. 2:13-cv-02095-KJM-AC, 2016 U.S. Dist. LEXIS 76037 (E.D. Cal. Jun. 10, 2016).
(4) Prison Sentences Upheld For Egg Company Executives Even Though Government Conceded They Had No Knowledge of Salmonella Contamination. The defendant, an executive of a large-scale egg production company (trustee of the trust that owned the company), and his son (the Chief Operating Officer of the company) pled guilty as “responsible corporate officers” to misdemeanor violations of 21 U.S.C. §331(a) for introducing eggs that had been adulterated with salmonella into interstate commerce from the beginning of 2010 until approximately August of 2010. They each were fined $100,000 and sentenced to three months in prison. They appealed their sentences as unconstitutional on the basis that they had no knowledge that the eggs at issue were contaminated at the time they were shipped. They also claimed that their sentences violated Due Process and the Eighth Amendment insomuch as the sentences were not proportional to their “crimes.” They also claimed that incarceration for a misdemeanor offense would violate substantive due process.
The trial court determined that the poultry facilities were in poor condition, had not been appropriately cleaned, had the presence of rats and other rodents and frogs and, as a result, the defendant and his son either “knew or should have known” that additional salmonella testing was needed and that remedial and preventative measures were necessary to reduce the presence of salmonella. The appellate court agreed, finding that the evidence showed that the defendant and son were liable for negligently failing to prevent the salmonella outbreak and that 21 U.S.C. §331(a) did not have a knowledge requirement. The appellate court also did not find a due process violation. The defendant and son claimed that because they did not personally commit wrongful acts, and that due process is violated when prison terms are imposed for vicarious liability felonies where the sentence of imprisonment is only for misdemeanors. However, the court held that vicarious liability was not involved, and that 21 U.S.C. §331(a) holds a corporate officer accountable for failure to prevent or remedy “the conditions which gave rise to the charges against him.” Thus, the appellate court determined, the defendant and son were liable for negligently failing to prevent the salmonella outbreak. The court determined that the lack of criminal intent does not violate the Due Process Clause for a “public welfare offense” where the penalty is relatively small (the court believed it was), the defendant’s reputation was not “gravely” damaged (the court believed that it was not) and congressional intent supported the penalty (the court believed it did). The court also determined that there was no Eighth Amendment violation because “helpless” consumers of eggs were involved. The court also found no procedural or substantive due process violation with respect to the sentences because the court believed that the facts showed that the defendant and son “had reason to suspect contamination” and should have taken action to address the problem at that time (even though law didn’t require it).
The dissent pointed out that the government stipulated at trial that its investigation did not identify any corporate personnel (including the defendant and son) who had any knowledge that eggs sold during the relevant timeframe were contaminated with salmonella. The dissent also noted that the government conceded that there was no legal requirement for the defendant or corporation to comply with stricter regulations during the timeframe in issue. As such, the convictions imposed and related sentences were based on wholly nonculpable conduct and there was no legal precedent supporting imprisonment in such a situation. The dissent noted that the corporation “immediately, and at great expense, voluntarily recalled hundreds of millions of shell eggs produced” at its facilities when first alerted to the problem. As such, according to the dissent, due process was violated and the sentences were unconstitutional. United States v. Decoster, 828 F.3d 626 (8th Cir. 2016).
(3) The IRS and Self-Employment Tax. Two self-employment tax issues affecting farmers and ranchers have been in the forefront in recent years – the self-employment tax treatment of Conservation Reserve Program (CRP) payments and the self-employment tax implications of purchased livestock that had their purchase price deducted under the de minimis safe harbor of the capitalization and repair regulations. On the CRP issue, in 2014 the U.S. Court of Appeals ruled that CRP payments in the hands of a non-farmer are not subject to self-employment tax. The court, in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g, 140 T.C. 350 (2013), held the IRS to its historic position staked out in Rev. Rul. 60-32 that government payments attributable to idling farmland are not subject to self-employment tax when received by a person who is not a farmer. The court refused to give deference to an IRS announcement of proposed rulemaking involving the creation of a new Rev. Rul. that would obsolete the 1960 revenue ruling. The IRS never wrote the new rule, but continued to assert their new position on audit. The court essentially told the IRS to follow appropriate procedure and write a new rule reflecting their change of mind. In addition, the court determined that CRP payments are “rental payments” statutorily excluded from self-employment tax under I.R.C. §1402(a). Instead of following the court’s invitation to write a new rule, the IRS issued a non-acquiescence with the Eighth Circuit’s opinion. O.D. 2015-02, IRB 2015-41. IRS said that it would continue audits asserting their judicially rejected position, even inside the Eighth Circuit (AR, IA, MN, MO, NE, ND and SD).
In 2016, the IRS had the opportunity to show just how strong its opposition to the Morehouse decision is. A Nebraska non-farmer investor in real estate received a CP2000 Notice from the IRS, indicating CRP income had been omitted from their 2014 return. The CP2000 Notice assessed the income tax and SE Tax on the alleged omitted income. The CRP rental income was in fact included on the return, but it was included on Schedule E along with cash rents, where it was not subject to self-employment tax. The practitioner responded to the IRS Notice by explaining that the CRP rents were properly reported on Schedule E because the taxpayer was not a farmer. This put the matter squarely before the IRS to reject the taxpayer’s position based on the non-acquiescence. But, the IRS replied to the taxpayer’s response with a letter informing the taxpayer that the IRS inquiry was being closed with no change from the taxpayer’s initial position that reported the CRP rents for the non-farmer on Schedule E.
On the capitalization and repair issue, taxpayers can make a de minimis safe harbor election that allows amounts otherwise required to be capitalized to be claimed as an I.R.C. §162 ordinary and necessary business expense. This de minimis expensing election has a limit of $5,000 for taxpayers with an Applicable Financial Statement (AFS) and $2,500 for those without an AFS. Farmers will fall in the latter category. In both cases, the limit is applied either per the total on the invoice, or per item as substantiated by the invoice. One big issue for farmers and ranchers is how to report the income from the sale of purchased livestock that are held for productive use, such as breeding or dairy animals for which the de minimis safe harbor election was made allowing the full cost of the livestock to be deducted. It had been believed that because the repair regulations specify when the safe harbor is used, the sale amount is reported fully as ordinary income that is reported on Schedule F where it is subject to self-employment tax for a taxpayer who is sole proprietor farmer or a member of a farm partnership. In that event, the use of the safe harbor election would produce a worse tax result that would claiming I.R.C. §179 on the livestock.
An alternative interpretation of the repair regulations is that the self-employment tax treatment of the gain or loss on sale of assets for which the purchase price was deducted under the de minimis safe harbor is governed by Treas. Reg. §1.1402(a)-6(a). That regulation states that the sale of property is not subject to selfemployment tax unless at least one of two conditions are satisfied: (1) the property is stock in trade or other property of a kind which would properly be includible in inventory if on-hand at the close of the tax year; or (2) the property is held primarily for sale to customers in the ordinary course of a trade or business. Because purchased livestock held for dairy or breeding purposes do not satisfy the first condition, the question comes down to whether condition two is satisfied – are the livestock held primarily for sale to customers in the ordinary course of a trade or business? The answer to that question is highly fact-dependent. If the livestock whose purchase costs have been deducted under the de minimis rule are not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the effect of the regulation is to report the gain on sale on Part II of Form 4797. This follows Treas. Reg. §1.1402(a)-6(a) which bars Sec. 1231 treatment (which would result in the sale being reported on Part I of Form 4797). In that event, the income received on sale would not be subject to self-employment tax.
In 2016, the IRS, in an unofficial communication, said that the alternative interpretation is the correct approach. However, the IRS was careful to point out that the alternative approach is based on the assumptions that the livestock were neither inventoriable nor held for sale, and that those assumptions are highly fact dependent on a case-by case basis. The IRS is considering adding clarifying language to the Farmers’ Tax Guide (IRS Pub. 225) and/or the Schedule F Instructions.
(2) TMDLs and the Regulation of Ag Runoff. Diffused surface runoff of agricultural fertilizer and other chemicals into water sources as well as irrigation return flows are classic examples of nonpoint source pollution that isn’t discharged from a particular, identifiable source. A primary source of nonpoint source pollution is agricultural runoff. As nonpoint source pollution, the Clean Water Act (CWA) leaves regulation of it up to the states rather than the federal government. The CWA sets-up a “states-first” approach to regulating water quality when it comes to nonpoint source pollution. Two key court opinions were issued in 2016 where the courts denied attempts by environmental groups to force the EPA to create additional federal regulations involving Total Maximum Daily Loads (TMDLs). The states are to establish total maximum daily TMDLs for watercourses that fail to meet water quality standards after the application of controls on point sources. A TMDL establishes the maximum amount of a pollutant that can be discharged or “loaded” into the water at issue from all combined sources on a daily basis and still permit that water to meet water quality standards. A TMDL must be set “at a level necessary to implement water quality standards.” The purpose of a TMDL is to limit the amount of pollutants in a watercourse on any particular date. Two federal court opinions in 2016 reaffirmed the principle that regulation of nonpoint source pollution is left to the states and not the federal government.
In Conservation Law Foundation v. United States Environmental Protection Agency, No. 15-165-ML, 2016 U.S. Dist. LEXIS 172117 (D. R.I. Dec. 13, 2016), the plaintiff claimed that the EPA’s approval of the state TMDL for a waterbody constituted a determination that particular stormwater discharges were contributing to the TMDL being exceeded and that federal permits were thus necessary. The court, however, determined that the EPA’s approval of the TMDL did not mean that EPA had concluded that stormwater discharges required permits. The court noted that there was nothing in the EPA’s approval of the TMDL indicating that the EPA had done its own fact finding or that EPA had independently determined that stormwater discharges contributed to a violation of state water quality standards. The regulations simply do not require an NPDES permit for stormwater discharges to waters of the United States for which a TMDL has been established. A permit is only required when, after a TMDL is established, the EPA makes a determination that further controls on stormwater are needed.
In the other case, Gulf Restoration Network v. Jackson, No. 12-677 Section: “A” (3), 2016 U.S. Dist. LEXIS 173459 (E.D. La. Dec. 15, 2016), numerous environmental groups sued the EPA to force them to impose limits on fertilizer runoff from farm fields. The groups claimed that many states hadn’t done enough to control nitrogen and phosphorous pollution from agricultural runoff, and that the EPA was required to mandate federal limits under the Administrative Procedure Act – in particular, 5 U.S.C. §553(e) via §303(c)(4) of the CWA. Initially, the groups told the EPA that they would sue if the EPA did not write the rules setting the limits as requested. The EPA essentially ignored the groups’ petition by declining to make a “necessity determination. The groups sued and the trial court determined that the EPA had to make the determination based on a 2007 U.S. Supreme Court decision involving the Clean Air Act (CAA). That decision was reversed on appeal on the basis that the EPA has discretion under §303(c)(4)(B) of the CWA to decide not to make a necessity determination as long as the EPA gave a “reasonable explanation” based on the statute why it chose not to make any determination. The appellate court noted that the CWA differed from the CAA on this point. On remand, the trial court noted upheld the EPA’s decision not to make a necessity determination. The court noted that the CWA gives the EPA “great discretion” when it comes to regulating nutrients, and that the Congressional policy was to leave regulation of diffused surface runoff up to the states. The court gave deference to the EPA’s “comprehensive strategy of bringing the states along without the use of federal rule making…”.
Also, in 2016 the U.S. Supreme Court declined to review a decision of the U.S. Court of Appeals for the Third Circuit which had determined in 2015 that the EPA had acted within its authority under 33 U.S.C. §1251(d) in developing a TMDL for the discharge of nonpoint sources pollutants into the Chesapeake Bay watershed. American Farm Bureau, et al. v. United States Environmental Protection Agency, et al., 792 F.3d 281 (3d Cir. 2015), cert. den., 136 S. Ct. 1246 (2016).
(1) The Election of Donald Trump as President and the Potential Impact on Agricultural and Tax Policy. Rural America voted overwhelmingly for President-elect Trump, and he will be the President largely because of the sea of red all across the country in the non-urban areas. So, what can farmers, ranchers and agribusinesses anticipate the big issues to be in the coming months and next few years and the policy responses? It’s probably reasonable to expect that same approach will be applied to regulations impacting agriculture. Those with minimal benefit and high cost could be eliminated or retooled such that they are cost effective. Overall, the pace of the generation of additional regulation will be slowed. Indeed, the President-elect has stated that for every new regulation, two existing regulations have to be eliminated.
Ag policy. As for trade, it is likely that trade agreements will be negotiated on a much more bi-lateral basis – the U.S. negotiating with one other country at a time rather than numerous countries. The President-elect is largely against government hand-outs and is big on economic efficiency. That bodes well for the oil and gas industry (and perhaps nuclear energy). But, what about less efficient forms of energy that are heavily reliant on taxpayer support? Numerous agricultural states are heavily into subsidized forms of energy with their state budgets littered with numerous tax “goodies” for “renewable” energy.” However, the President-elect won those states. So, does that mean that the federal subsidies for ethanol and biodiesel will continue. Probably. The Renewable Fuels Standard will be debated in 2017, but will anything significant happen? Doubtful. It will continue to be supported, but I expect it to be reviewed to make sure that it fits the market. Indeed, one of the reasons that bio-mass ethanol was reduced so dramatically in the EPA rules was that it couldn’t be produced in adequate supplies. What about the wind energy production tax credit? What about the various energy credits in the tax code? Time will tell, but agricultural interests should pay close attention.
The head of the Senate Ag Committee will be Sen. Roberts from Kansas. As chair, he will influence the tone of the debate of the next farm bill. I suspect that means that the farm bill will have provisions dealing with livestock disease and biosecurity issues. Also, I suspect that it will contain significant provisions crop insurance programs and reforms of existing programs. The House Ag Committee head will be Rep. Conaway from Texas. That could mean that cottonseed will become an eligible commodity for Agricultural Risk Coverage (ARC) and Price Loss Coverage (PLC). It may also be safe to assume that for the significant Midwest crops (and maybe some additional crops) their reference prices will go up. Also, it now looks as if the I.R.C. §179 issue involving the income limitation for qualification for farm program payments (i.e., the discrepancy of the treatment between S corporations and C corporations) will be straightened out. Other federal agencies that impact agriculture (EPA, Interior, FDA, Energy, OSHA) can be expected to be more friendly to agriculture in a Trump Administration.
Tax policy. As for income taxes, it looks at this time that the Alternative Minimum Tax might be eliminated, as will the net investment income tax that is contained in Obamacare. Individual tax rates will likely drop, and it might be possible that depreciable assets will be fully deductible in the year of their purchase. Also, it looks like the corporate tax rate will be cut as will the rate applicable to pass-through income. As for transfer taxes, President-elect Trump has proposed a full repeal of the federal estate tax as well as the federal gift tax. Perhaps repeal will be effective January 1, 2017, or perhaps it will be put off until the beginning of 2018. Or, it could be phased-in over a certain period of time. Also, while it appears at the present time that any repeal would be “permanent,” that’s not necessarily a certainty. Similarly, it’s not known whether the current basis “step-up” rule would be retained if the estate tax is repealed. That’s particularly a big issue for farmers and ranchers. It will probably come down to a cost analysis as to whether step-up basis is allowed. The President-elect has already proposed a capital gains tax at death applicable to transfers that exceed $10 million (with certain exemptions for farms and other family businesses). Repeal of gift tax along with repeal of estate tax has important planning implications. There are numerous scenarios that could play out. Stay tuned, and be ready to modify existing plans based on what happens. Any repeal bill would require 60 votes in the Senate to avoid a filibuster unless repeal is done as part of a reconciliation bill. Also, without being part of a reconciliation bill, any repeal of the federal estate tax would have to “sunset” in ten years.
January 6, 2017 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Wednesday, January 4, 2017
This week we are looking at the biggest developments in agricultural law and taxation for 2016. On Monday, we highlighted the important developments that just missed being in the top ten. Today we take a look at developments 10 through six. On Friday, we will look at the top five.
- Court Obscures Rational Basis Test To Eliminate Ag Exemption From Workers' Compensation Law. While this is a state Supreme Court decision, its implications are significant. Most, if not all, states have a statutory exemption from workers’ compensation for employers that are engaged in agriculture. The statutory exemption varies in scope from state to state and, of course, an employer that is otherwise exempt can choose to be covered by the statute and offer workers’ compensation benefits to employees. In this case, the plaintiffs claimed that their on-the-job injuries should be covered under the state (NM) workers' compensation law. One plaintiff tripped while picking chile and fractured her left wrist. The other plaintiff was injured while working in a dairy when he was head-butted by a cow and pushed up against a metal door causing him to fall face-first into a concrete floor and sustain neurological damage. The plaintiffs' claims for workers' compensation benefits were dismissed via the exclusion from the workers' compensation system for employers. On appeal, the appellate court reversed. Using rational basis review (the standard most deferential to the constitutionality of the provision at issue), the court interpreted Sec. 52-1-6(A) of the New Mexico Code as applying to the primary job duties of the employees (as opposed to the business of the employer and the predominant type of employees hired), and concluded the distinction was irrational and lacked any rational purpose. The appellate court noted that the purpose of the law was to provide "quick and efficient delivery" of medical benefits to injured and disabled workers. Thus, the court determined that the exclusion violated the constitutional equal protection guarantee. The court further believed that the exclusion for workers that cultivate and harvest (pick) crops, but the inclusion of workers that perform tasks associated with the processing of crops was a distinction without a difference. The appellate court made no mention that the highest court in numerous other states had upheld a similar exclusion for agriculture from an equal protection constitutional challenge. On further review, the state Supreme Court affirmed. The Court determined that there was nothing to distinguish farm and ranch laborers from other ag employees and that the government interest of cost savings, administrative convenience and similar interests unique to agriculture were not rationally related to a legitimate government interest. The court determined that the exclusion that it construed as applying to ag laborers was arbitrary discrimination. A dissenting judge pointed out that the legislature’s decision to allow employers of farm and ranch laborers to decide for themselves whether to be subject to workers’ compensation or opt out and face tort liability did not violate any constitutionally-protected right. The dissent noted that such ability to opt out was a legitimate statutory scheme that rationally controlled costs for New Mexico farms and ranches, and that 29 percent of state farms and ranches had elected to be covered by workers’ compensation. The dissent also noted that the majority’s opinion would have a detrimental economic impact on small, economically fragile farms in New Mexico by imposing an additional economic cost of $10.5 million annually (as projected by the state Workers’ Compensation Administration). On this point, the dissent further pointed out that the average cost of a claim was $16,876 while the average net farm income for the same year studied was $19,373. The dissent further concluded that the exemption for farming operations was legitimately related to insulating New Mexico farm and ranches from additional costs. In addition, the dissent reasoned that the majority misapplied the rational basis analysis to hold the act unconstitutional as many other state courts and the U.S. Supreme Court had held comparable state statutes to satisfy the rational basis test. The dissent pointed out forcefully that the exclusion applied to employers and that the choice to be covered or not resided with employers who predominately hired ag employees. As such there was no disparate treatment between ag laborers and other agricultural workers. Rodriguez, et al. v. Brand West Dairy, et al., 378 P.3d 13 (N.M. Sup. Ct. 2016), aff’g., 356 P.3d 546 (N.M. Ct. App. 2015).
- 9. COE Jurisdictional Determination Subject to Court Review. The plaintiff, a peat moss mining company, sought the approval of the Corps of Engineers (COE) to harvest a swamp (wetland) for peat moss to use in landscaping projects. The COE issued a jurisdictional determination that the swamp was a wetland subject to the permit requirements of the Clean Water Act (CWA). The plaintiff sought to challenge the COE determination, but the trial court ruled for the COE, holding that the plaintiff had three options: (1) abandon the project; (2) seek a federal permit costing over $270,000; or (3) proceed with the project and risk fines of up to $75,000 daily and/or criminal sanctions including imprisonment. On appeal, the court unanimously reversed, strongly criticizing the trial court's opinion. Based on Sackett v. Environmental Protection Agency, 132 S. Ct. 1367 (2012), the court held that COE Jurisdictional Determinations constitute final agency actions that are immediately appealable in court. The court noted that to hold elsewise would allow the COE to effectively kill the project without any determination of whether it's position as to jurisdiction over the wetland at issue was correct in light of Rapanos v. United States, 547 U.S. 715 (U.S. 2006). The court noted that the COE had deliberately left vague the "definitions used to make jurisdictional determinations" so as to expand its regulatory reach. While the COE claimed that the jurisdictional determination was merely advisory and that the plaintiff had adequate ways to contest the determination, the court determined that such alternatives were cost prohibitive and futile. The court stated that the COE's assertion that the jurisdictional determination (and the trial court's opinion) was merely advisory ignored reality and had a powerful coercive effect. The court held that the Fifth Circuit, which reached the opposition conclusion with respect to a COE Jurisdictional Determination in Belle Co., LLC v. United States Army Corps. of Engineers, 761 F.3d 383 (5th Cir. 2014), cert. den., 83 U.S.L.W. 3291 (U.S. Mar. 23, 2015), misapplied the Supreme Court's decision in Sackett. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, 782 F.3d 984 (8th Cir. 2015), rev'g., 963 F. Supp. 2d 868 (D. Minn. 2013). In a later decision, the court denied a petition to rehear the case en banc and by the panel. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, No. 13-3067, 2015 U.S. App. LEXIS 11697 (8th Cir. Jul. 7, 2015). In December of 2015, the U.S. Supreme Court agreed to hear the case and affirmed the Eighth Circuit on May 31, 2016. The Court, in a unanimous opinion, noted that the memorandum of agreement between the EPA and the Corps established that jurisdictional determinations are “final actions” that represent the Government’s position, are binding on the Government in any subsequent Federal action or litigation involving the position taken in the jurisdictional determination. When the landowners received an “approved determination” that meant that the Government had determined that jurisdictional waters were present on the property due to a “nexus” with the Red River of the North, located 120 miles away. As such, the landowners had the right to appeal in Court after exhausting administrative remedies and the Government’s position take in the jurisdictional determination was judicially reviewable. Not only did the jurisdictional determination constitute final agency action under the Administrative Procedure Act, it also determined rights or obligations from which legal consequences would flow. That made the determination judicially reviewable. United States Army Corps of Engineers v. Hawkes Company, 136 S. Ct. 1807 (2016).
- 8. Proposed Regulations Under I.R.C. §2704. In early August, the IRS issued new I.R.C. §2704 regulations that could seriously impact the ability to generate minority interest discounts for the transfer of family-owned entities. Prop. Reg. – 163113-02 (Aug. 2, 2016). The proposed regulations, if adopted in their present form, will impose significant restrictions on the availability of valuation discounts for gift and estate tax purposes in a family-controlled environment. Prop. Treas. Regs. §§25.2704-1; 25.2704-4; REG- 163113-02 (Aug. 2, 2016). They also redefine via regulation and thereby overturn decades of court decisions honoring the well-established willing-buyer/willing-seller approach to determining fair market value (FMV) of entity interests at death or via gift of closely-held entities, including farms and ranches. The proposed regulations would have a significant impact on estate, business and succession planning in the agricultural context for many agricultural producers across the country and will make it more difficult for family farm and ranch businesses to survive when a family business partner dies. Specifically, the proposed regulations treat transfer within three years of death as death-bed transfers, create new “disregarded restrictions” and move entirely away from examining only those restrictions that are more restrictive than state law. As such, the proposed regulations appear to exceed the authority granted to the Treasury by Congress to promulgate regulations under I.R.C. §2704 and should be withdrawn. A hearing on the regulations was held in early December.
- 7. Capitalization Required For Interest and Real Property Taxes Associated with Crops Having More Than Two-Year Preproductive Period. The petitioner (three partnerships) bought land that they planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They then began planting almond trees. They deducted the interest and property taxes on their returns. The IRS objected to the deduction on the basis that the interest and taxes were indirect costs of the “production of real property” (i.e., the almonds trees that were growing on the land. The Tax Court agreed with the IRS noting that I.R.C. §263A requires the capitalization of certain costs and that those costs include the interest paid to buy the land and the property taxes paid on the land attributable to growing crops and plants where the preproductive period of the crop or plant exceeds two years. I.R.C. §263A(f)(1) states that “interest is capitalized where (1) the interest is paid during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million.” The corresponding regulation, the court noted, requires that the interest be capitalized under the avoided cost method. The court also noted that the definition of “real property produced by the taxpayer for the taxpayer’s use in a trade or business or in an activity conducted for profit” included “land” and “unsevered natural products of the land” and that “unsevered natural products of the land” general includes growing crops and plants where the preproductive period of the crop or plant exceeds two years. Because almond trees have a preproductive period exceeding two years in accordance with IRS Notice 2000-45, and because the land was “necessarily intertwined” with the growing of the almond trees, the interest and tax cost of the land is a necessary and indispensable part of the growing of the almond trees and must be capitalized. Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo. 2016-224.
6. No Recapture of Prepaid Expenses Deducted in Prior Year When Surviving Spouse Claims Same Deduction in Later Year. The decedent, a materially participating Nebraska farmer, bought farm inputs in 2010 and deducted their cost on his 2010 Schedule F. He died in the spring of 2011 before using the inputs to put the spring 2011 crop in the ground. Upon his death, the inputs were included in the decedent’s estate at their purchase price value and then passed to a testamentary trust for the benefit of his wife. The surviving spouse took over the farming operation, and in the spring of 2011, took a distribution of the inputs from the trust to plant the 2011 crops. For 2011, two Schedule Fs were filed. A Schedule F was filed for the decedent to report the crop sales deferred to 2011, and a Schedule F was filed for the wife to report the crops sold by her in 2011 and claim the expenses of producing the crop which included the amount of the inputs (at their date-of-death value which equaled their purchase price) that had been previously deducted as prepaid inputs by the husband on the couple’s joint 2010 return. The IRS denied the deduction on the basis that the farming expense deduction by the surviving spouse was inconsistent with the deduction for prepaid inputs taken in the prior year by the decedent and, as a result, the “tax benefit rule” applied. The court disagreed, noting that the basis step-up rule of I.R.C. §1014 allowed the deduction by the surviving spouse which was not inconsistent with the deduction for the same inputs in her deceased husband’s separate farming business. The court also noted that inherited property is not recognized as income by the recipient, which meant that another requisite for application of the tax benefit rule did not apply. Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016).
Those were developments ten through six, at least as I see it for 2016. On Friday, we will list the five biggest developments for 2016.
January 4, 2017 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, January 2, 2017
This week we will be taking a look at what I view as the most significant developments in agricultural law and agricultural taxation during 2016. There were many important happenings in the courts, the IRS and with administrative agencies that have an impact on farm and ranch operations, rural landowners and agribusinesses. What I am writing about this week are those developments that will have the biggest impact nationally. Certainly, there were significant state developments, but they typically will not have the national impact of those that result from federal courts, the IRS and federal agencies.
It’s tough to get it down to the ten biggest developments of the year, and I do spend considerable time going sorting through the cases and rulings get to the final cut. Today we take a quick look at those developments that I felt were close to the top ten, but didn’t quite make the list. Later this week we will look at those that I feel were worthy of the top ten. Again, the measuring stick is the impact that the development has on the ag sector as a whole.
Almost, But Not Quite
Those developments that were the last ones on the chopping block before the final “top ten” are always the most difficult to determine. But, as I see it, here they are (in no particular order):
- HRA Relief for Small Businesses. Late in 2016, the President signed into law H.R. 6, the 21st Century Cures Act. Section 18001 of the legislation repeals the restrictions included in Obamacare that hindered the ability of small businesses (including farming operations) to use health reimbursement arrangements (HRAs). The provision allows a "small employer" (defined as one with less than 50 full-time employees who does not offer a group health plan to any employees) to offer a health reimbursement arrangement (HRA) that the employer funds to reimburse employees for qualified medical expenses, including health insurance premiums. If various technical rules are satisfied, the basic effect of the provision is that, effective for plan years beginning after December 31, 2016, such HRAs will no longer be a violation of Obamacare's market "reforms" that would subject the employer to a penalty of $100/day per affected person). It appears that the relief also applies to any plan year beginning before 2017, but that is less clear. Of course, all of this becomes moot if Obamacare is repealed in its entirety in 2017.
- More Obamacare litigation. In a somewhat related development, in May the U.S. District Court for the District of Columbia ruled in United States House of Representatives v. Burwell, No. 14-1967 (RMC), 2016 U.S. Dist. LEXIS 62646 (D. D.C. May, 12, 2016), that the Obama Administration did not have the power under the Constitution to spend taxpayer dollars on "cost sharing reduction payments" to insurers without a congressional appropriation. The Obama Administration had argued that congressional approval was unnecessary because the funds were guaranteed by the same section of Obamacare that provides for the premium assistance tax credit that is designed to help offset the higher cost of health insurance as a result of the law. However, the court rejected that argument and enjoined the use of unappropriated funds due insurers under the law. The court ruled that the section at issue only appropriated funds for tax credits and that the insurer payments required a separate congressional appropriation. The court stayed its opinion pending appeal. A decision on appeal is expected in early 2017, but would, of course, be mooted by a repeal of Obamacare.
- Veterinary Feed Directive Rule. The Food and Drug Administration revised existing regulations involving the animal use of antibiotics that are also provided to humans. The new rules arose out of a belief of bacterial resistance in humans to antibiotics even though there is no scientific proof that antibiotic resistant bacterial infections in humans are related to antibiotic use in livestock. As a result, at the beginning of 2017, veterinarians will be required to provide a “directive” to livestock owners seeking to use or obtain animal feed products containing medically important antimicrobials as additives. A “directive” is the functional equivalent of receiving a veterinarian’s prescription to use antibiotics that are injected in animals. 21 C.F.R. Part 558.
- Final Drone Rules. The Federal Aviation Administration (FAA) issued a Final Rule on UASs (“drones”) on June 21, 2016. The Final Rule largely follows the Notice of Proposed Rulemaking issued in early 2015 (80 Fed. Reg. 9544 (Feb. 23, 2015)) and allows for greater commercial operation of drones in the National Airspace System. At its core, the Final Rule allows for increased routine commercial operation of drones which prior regulations required commercial users of drones to make application to the FAA for permission to use drones - applications the FAA would review on a case-by-case basis. The Final Rule (FAA-2015-0150 at 10 (2016)) adds Part 107 to Title 14 of the Code of Federal Regulations and applies to unmanned “aircraft” that weigh less than 55 pounds (that are not model aircraft and weigh more than 0.5 pounds). The Final Rule became effective on August 29, 2016.
- County Bans on GMO Crops Struck Down. A federal appellate court struck down county ordinances in Hawaii that banned the cultivation and testing of genetically modified (engineered) organisms. The court decisions note that either the state (HI) had regulated the matter sufficiently to remove the ability of counties to enact their own rules, or that federal law preempted the county rules. Shaka Movement v. County of Maui, 842 F.3d 688 (9th Cir. 2016) and Syngenta Seeds, Inc. v. County of Kauai, No. 14-16833, 2016 U.S. App. LEXIS 20689 (9th Cir. Nov. 18, 2016).
- Insecticide-Coated Seeds Exempt from EPA Regulation Under FIFRA. A federal court held that an existing exemption for registered pesticides applied to exempt insecticide-coated seeds from separate regulation under the Federal Insecticide, Rodenticide Act which would require their separate registration before usage. Anderson v. McCarthy, No. C16-00068, WHA, 2016 U.S. Dist. LEXIS 162124 (N.D. Cal. Nov. 21, 2016).
- Appellate Court to Decide Fate of EPA’s “Waters of the United States” Final Rule. The U.S. Court of Appeals for the Sixth Circuit ruled that it had jurisdiction to hear a challenge to the EPA’s final rule involving the scope and effect of the rule defining what waters the federal government can regulate under the Clean Water Act. Murray Energy Corp. v. United States Department of Defense, 817 F.3d 261 (6th Cir. 2016).
- California Proposition Involving Egg Production Safe From Challenge. California enacted legislation making it a crime to sell shelled eggs in the state (regardless of where they were produced) that came from a laying hen that was confined in a cage not allowing the hen to “lie down, stand up, fully extend its limbs, and turn around freely.” The law was challenged by other states as an unconstitutional violation of the Commerce Clause by “conditioning the flow of goods across its state lines on the method of their production” and as being preempted by the Federal Egg Products Inspection Act. The trial court determined that the plaintiffs lacked standing and the appellate court affirmed. Missouri v. Harris, 842 F.3d 658 (9th Cir. 2016).
- NRCS Properly Determined Wetland Status of Farmland. The Natural Resource Conservation Service (NRCS) determined that a 0.8-acre area of a farm field was a prairie pothole that was a wetland that could not be farmed without the plaintiffs losing farm program eligibility. The NRCS made its determination based on “color tone” differences in photographs, wetland signatures and a comparison site that was 40 miles away. The court upheld the NRCS determination as satisfying regulatory criteria for identifying a wetland and was not arbitrary, capricious or contrary to the law. Certiorari has been filed with the U.S. Supreme Court asking the court to clear up a conflict between the circuit courts of appeal on the level of deference to be given federal government agency interpretive manuals. Foster v. Vilsack, 820 F.3d 330 (8th Cir. 2016).
- Family Limited Partnerships (FLPs) and the “Business Purpose” Requirement. In 2016, there were two cases involving FLPs and the retained interest section of the Code. That follows one case late in 2015 which was the first one in over two years. In Estate of Holliday v. Comr., T.C. Memo. 2016-51, the court held that the transfers of marketable securities to an FLP two years before the transferor’s death was not a bona fide sale, with the result that the decedent (transferor) was held to have retained an interest under I.R.C. §2036(a) and the FLP interest was included in the estate at no discount. Transferring marketable securities to an FLP always seems to trigger issues with the IRS. In Estate of Beyer v. Comr., T.C. Memo. 2016-183, the court upheld the assessment of gift and estate tax (and gift tax penalties) with respect to transfers to an FLP because the court determined that every benefit allegedly springing from the FLP could have been accomplished by trusts and other arrangements. There needs to be a separate non-tax business purpose to the FLP structure. A deeper dive into the court opinions also points out that the application of the “business purpose” requirement with respect to I.R.C. §2036 is very subjective. It’s important to treat the FLP as a business entity, not put personal assets in the FLP, or at least pay rent for their use, and follow all formalities of state law.
These are the developments that were important, but just not big enough in terms of their overall impact on the ag sector to make the list of the “top ten.” The next post will take a look at developments ten through six.
January 2, 2017 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Thursday, December 1, 2016
Section 121 of the Internal Revenue Code provides for the exclusion of gain that is attributable to the sale of the taxpayer’s principal residence. The maximum exclusion is $500,000 for taxpayers that are married and file jointly. It’s one-half of that amount for single filers. Of course, the IRS just doesn’t give the exclusion away. The taxpayer has to meet certain requirements. In addition, the provision only applies to the taxpayer’s “principal residence.” But, what if the residence is sold with the farm? In that event, how much (if any) of the farmland and outbuildings can be included with the residence under the provision? Also, what if the taxpayer uses a part of the residence for business? How does that impact the exclusion? What if the farm and residence are sold on an installment basis and the buyer defaults and the seller gets the property back? What then? These issues are the focus of today’s blog post.
To be able to claim the I.R.C. §121 exclusion, the taxpayer must have owned the residence for at least two years or more (in the aggregate) during the five years immediately preceding the sale date. Also, the taxpayer must have occupied and used the home as the taxpayer’s principal residence for at least two years (in the aggregate) of the five years preceding the sale date. In addition, the taxpayer must not have used the gain exclusion during the immediately preceding two years before the sale.
Regulations finalized in late 2002 address the eligibility of vacant land for the exclusion. Under the regulations, vacant land can be treated as part of the principal residence if it is adjacent to land containing the principal residence, the taxpayer sells or exchanges the dwelling in a sale or exchange that meets the requirements to the exclusion within two years before or two years after the date of sale or exchange of the vacant land, the taxpayer owned and used the vacant land as part of the taxpayer’s principal residence, and the requirements have otherwise been met for the exclusion with respect to the vacant land. Treas. Reg. § 1.121-1(b)(3).
Based on those requirements, land that has been used in farming within the two-year period before the sale won’t be eligible. Also, the sale of the principal residence and the adjacent land are treated as a single sale for purposes of the gain limitation amount. That’s the case even if the sales occur in different years. In addition, because the separate transactions are treated as a single sale for purposes of applying the rule under I.R.C. §121 that bars use of the provision more frequently than every two years. Thus, if the principal residence is sold in a later tax year than the qualified adjacent land is sold that is after the filing date (including extensions) for the return that includes the land sale, the gain from the land sale has to be reported as a taxable event. When the residence is later sold, the taxpayer then can claim the I.R.C. §121 exclusion with respect to the vacant land by filing an amended return. Procedurally, when calculating the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land. Treas. Reg. §1.121-1(b)(3)(ii)(C).
Business Use of the Residence
If part of the principal residence is used for business purposes, the I.R.C. §121 exclusion does not apply. At least that’s the rule to the extent any depreciation is claimed. Also, the exclusion is inapplicable to a portion of the property that is separate from the dwelling unit. On that separate portion, the problem is that the taxpayer hasn’t satisfied the personal occupancy requirement. So, in that case, only the gain that is allocated to the residential portion is excludible. But, no allocation is required is both the residential and business portions of the property are within the dwelling unit, other than to the extent that the gain is attributable to depreciation.
It might also be possible to trade the home that has an office in it for qualified replacement property and qualify the transaction as a tax-deferred exchange under I.R.C. §1031. Of course, this can only happen if both the principal residence that is traded away and the replacement property that is received both have at least a portion of the property that is used in the taxpayer’s trade or business or held for investment. But, legislation enacted in 2004 denies the I.R.C. § 121 exclusion to property acquired in a like-kind exchange within the prior five-year period beginning with the date of property acquisition. The provision is designed to counter situations where (1) the property is exchanged for residential real property, tax-free, under I.R.C. § 1031; (2) the property is converted to personal use; and (3) a tax-free sale is arranged under I.R.C. § 121. The provision applies to sales or exchanges after October 22, 2004. Legislation enacted in late 2005 clarifies that the five-year ineligibility period also applies to exchanges by the taxpayer or by any person whose basis in the property is determined by reference to the basis in the hands of the taxpayer (such as by gift)
However, if like-kind exchange treatment applies to the residence, the homeowner may also be able to benefit from exclusion of gain. In early 2005, IRS published guidance (Rev. Proc. 2005-14) on coupling the I.R.C. § 121 exclusion with like-kind exchange procedures. Under that guidance, the IRS said that the I.R.C. §121 exclusion is applied before the I.R.C. §1031 like-kind exchange rules, and that the I.R.C. §121 exclusion cannot apply to gain attributable to depreciation of the residence after May 6, 1997. But, the I.R.C. §1031 rules may apply to that gain. Also, the IRS said that when the I.R.C. §1031 rules are applied, any boot or non-like-kind property that is received is taxable only to the extent the boot exceeds the gain excluded under I.R.C. §121. In addition, when determining basis of the property received in the exchange, any gain that is excluded under I.R.C. §121 on the former property is treated as providing basis to the taxpayer in the replacement property. The impact of the guidance is that, for farm residences, the amount of the allowable exclusion will more than cover the gain involved. In other situations, the Rev. Proc. may allow deferral of realized gain into replacement property.
What if the principal residence and the farmland are sold via an installment sale and the seller claimed the I.R.C. §121 exclusion on the principal residence? The normal rules would apply and the gain attributable to the principal residence would be excluded up to the applicable limit. But what if the buyer, after making a few payments, defaults on the contract and the seller gets the property back – including the principal residence on which the gain was previously excluded? This is not an unlikely possibility given the downturn in the farm economy in recent years which could result in a buyer not having the ability to make the annual payments that the installment contract requires. This situation occurred in Debough v. Comr., 142 T.C. No. 17 (2014). In that case, the taxpayer had purchased a personal residence in 1966 along with 80 acres for $25,000. He agreed to sell the residence and the land in 2006 for $1.4 million with the purchase price to be paid in installments through 2014. He reported the gain for the year of sale (computed in accordance with the calculated gross profit percentage) after excluding the gain attributable to the principal residence, and then received another $505,000 in payments that he reported on the installment method. The buyer defaulted and the seller reacquired the property in 2009. The reacquisition triggered tax to the taxpayer, but he didn’t report the portion of the gain that was previously excluded under I.R.C. §121. The IRS disagreed, pointing out that I.R.C. §1038(e) specifies that, with respect to I.R.C. §121, a taxpayer that reacquires property and sells it within one year can treat the subsequent sale as the original sale for I.R.C. §121 purposes. The taxpayer didn’t do that, so the provision didn’t apply. That meant that the only way to exclude the gain was to move back into the residence to meet the two-out-of-five-year ownership and use test. Of course, the taxpayer didn’t want to do that. The only relief available was that the reacquisition would cause an increase in the basis of the residence to the extent of the gain recognized on repossession which, in turn, would result in less gain on resale. In 2015, the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court.
The home sale exclusion rule comes in handy when a principal residence is sold. But, careful planning is needed when the residence is sold with the farm, when a portion of the residence is used for business purposes, or when the transaction is structured as a deferred exchange or installment sale.
Friday, September 30, 2016
The title of today’s blog post might seem a bit odd. Indeed, in the normal course of events, when a farmer or rancher sells farm or ranch land the resulting gain would be treated as capital gain. That’s also the case for an investor in land that later sells it as an investment asset. In both instances, the land is a capital asset that was being used in the seller’s business of farming (or ranching) or it capital in nature as an investment asset. Seems rather straightforward. But, what if the facts are tweaked a bit? Let’s say that urban development was moving toward the farm or ranch and the seller, to take advantage of the upward price pressure on the land, started to parcel out the land and sell it in small tracts. What if the seller had the land platted? What if marketing steps were taken? What if the buyer believed the land had a strategic location at the time of purchase, farmed it for a period of time and then began steps to prepare it to be sold off in smaller residential tracts at substantial gain? Do those things change the character of the gain recognized on sale? Possibly.
Sales that are deemed to be in the ordinary course of the taxpayer’s business generate ordinary income. I.R.C. §1221(a)(1). However, the sale of a capital asset (such as land) generates capital gain. The different tax rates applicable to ordinary income and capital gain are often large for many taxpayers (at least a 15 percentage-point difference) with the capital gain rates being lower. So, a farmer, rancher or land investor will want to treat the gain from the sale of land as a capital gain taxed at the preferential lower rate. That will be the outcome, unless the land is determined to have been held by the seller for sale to others in the ordinary course of their business. The determination of the character of gain on sale is fact dependent and some recent cases shed light on the key factors.
In a California case, Allen v. United States, No. 13-cv-02501-WHO, 2014 U.S. Dist. LEXIS 73367 (N.D. Cal. May 28, 2014), a married couple sold 2.63 acres of undeveloped land that generated over $60,000. They reported the income as capital gain, but the IRS claimed that the income was "other income" taxable as ordinary income. The couple admitted that they bought the land for the purpose of development, and they did attempt to find a partner to develop the property. Ultimately, the property was sold to a developer and the couple received a payment each time a developed portion of the property was sold. The IRS denied capital gain treatment, asserting that the income was from property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." The court noted that the determination of the nature of the income is a fact-based determination, and that the facts supported the IRS. The taxpayers intended to develop and sell the property at the time it was acquired, and the taxpayers were active in getting the property developed. The fact that the property was the only one purchased for development was not determinative. The court granted summary judgment to the IRS.
A U.S. Tax Court case, Fargo v. Comr., T.C. Memo. 2015-96, involved a partnership that acquired a leasehold interest in a tract of land with the intent to develop an apartment complex and retail space. The lease originally ran for 20 years, but was extended for another 34 years. The property generated only rental income and the taxpayer made no substantial effort to sell the property for 13 years. Ultimately, the property was sold for $14.5 million plus a share of the profits from the homes to be developed on the property. The partnership reported $628,222 of capital gain, but IRS took the position that the transaction triggered $7.5 million of ordinary income. The court agreed with the IRS. The court noted the following factors were important in making the gain characterization distinction: (1) the property was initially acquired for developmental purposes; (2) efforts to obtain financing and continue that development were made; (3) the sale was to an unrelated party with the plan for the petitioner to develop the property; and (4) efforts continued to develop the property up until the purchase date. While there were some factors that favored the taxpayer (only minor improvements were made; there were no prior sales; and no advertising or marketing had been performed), the court held that the factors weighed in the favor of the IRS and the sale was in the ordinary course of business under I.R.C. §1221(a)(1).
In yet another recent case, Long v. Comr., 772 F.3d 670 (11th Cir. 2014), the plaintiff, a real estate developer, entered into a contract with another party to buy land on which the plaintiff was planning on building a high-rise condominium building. The plaintiff hired architects, sought a zoning permit, printed promotional materials about the condominium, negotiated contracts with purchasers of condominium units and obtained deposits for units. However, the seller of the land unilaterally terminated the contract. The plaintiff sued for specific performance and the trial court ordered the seller to honor the contract. While the trial court's decision was on appeal, the plaintiff sold his position as the plaintiff in the contract litigation to a buyer for $5.75 million. The IRS characterized the $5.75 million as ordinary income rather than capital gain. The Tax Court agreed with the IRS on the basis that the plaintiff held the property (which the court said was the land subject to the contract) primarily for sale to customers in the ordinary course of business. On appeal, the court reversed on the basis that the taxpayer never actually owned the land and instead sold a right to buy the land - a contractual right. Accordingly, there was no intent to sell contract rights in the ordinary course of business. The plaintiff intended the contract to be fulfilled and develop the property, and the sale of the right to earn future undetermined income was a capital asset.
The Tax Court in a 2015 case, SI Boo, LLC v. Comr., T.C. Memo. 2015-19, held that ordinary income and self-employment tax was triggered on sale of properties acquired by tax deeds. The court noted that the taxpayers regularly did this. While they bought the tax liens primary to profit from redemptions of the liens, the court determined that the repeated sales of properties forfeited to them as lien holders constituted ordinary income as a dealer in real estate. They had also hired persons to act on their behalf to acquire the tax deeds, prepare the tracts for sale and maintain business records. The court also held that, under another rule, the income from the sales was not reportable on the installment method.
The most recent court decision involving the issue, Boree v. Comr., No. 14-15149, 2016 U.S. App. LEXIS 16682 (11th Cir. Sept. 2, 2016), aff’g., T.C. Memo. 2014-85, involved a taxpayer that was a self-described real estate professional who received income from land sales. The taxpayer reported the income as capital gain, but the Tax Court held that it was ordinary income because the taxpayer was found to have held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business. The court noted that the issue of whether the taxpayer was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status. That was the result because he held his business out to customers as a real estate business, and he engaged in development and frequent sales of numerous tracts over an extended period of time. Also, in prior years, he had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed.
The bottom line is that for most sales of farm or ranch land, the income from the sale will be characterized as capital gain. However, there are factors that can change the gain to ordinary.