Wednesday, July 17, 2019
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered. A recent case involving damages that a dairy sustained as a result of stray voltage illustrates this point.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
Impact of the Tax Cuts and Jobs Act (TCJA)
Under the TCJA, some settlement recoveries will cause the full amount of the award (the gross recovery) to be subjected to taxation. Due to the TCJA’s limitation on itemized deductions, the award is included in income without an offset for attorney fees. However, the TCJA does not impact awards that are on account of qualified personal physical injury. Those awards are tax-free as noted above. Also not impacted are employer-related claims – attorney fees for these type of cases remain an “above-the-line” deduction. The TCJA does, however, modify the tax rules involving sexual harassment cases.
Facts. The issue of the proper tax treatment of a jury award and interest was at issue recently in a case involving a Wisconsin dairy operation what suffered affected by stray voltage. In Allen v. United States, 331 F. Supp. 3d 852 (E.D. Wisc. 2018), the plaintiff received a jury award of damages, plus interest, as a result of his lawsuit against a utility company. Stray voltage had harmed his cattle and dairy operation causing decreased milk production, damage to his property and dairy herd, lost profits and increased veterinary bills from 1976 to 2000. The plaintiff’s expert testified that the inflation-adjusted economic losses to the dairy and cattle operation were almost $14 million. The jury returned a verdict for the plaintiff in the amount of $1,750,000 with $750,000 to economic damages and $1,000,000 to tort damages. In 2005, after the jury’s award was affirmed on appeal, the plaintiff received the funds along with $519,233,35 in accrued interest. The plaintiff also paid attorney fees, costs and expenses of $1,230,384.38.
On the plaintiff’s 2005 return, the plaintiff reported the $750,000 of economic damages as ordinary income on Schedule F and the $519,233.35 of interest as capital gain on Schedule B. $548,736 of legal expenses were reported on Schedule F as farm business expense. The $1,000,000 of tort damages was not reported, nor was Form 8275 filed explaining why the tort damages were not reported on the return. The 2005 return showed a tax liability of $124,827 which the plaintiff paid. The IRS audited and treated the $750,000 of economic damages, $1,000,000 of tort damages and $519,233.28 of interest as ordinary income on Schedule F. The IRS also assessed an accuracy-related penalty for the $1 million of underreported income. The IRS assessed an additional $145,836.89 in tax, interest and penalties. The plaintiff then filed an amended 2005 return with the IRS seeking a refund of $130,215. On the amended return, the plaintiff claimed $119,408 of legal expenses as an itemized deduction on Schedule A, categorized the $519,233.25 of interest as capital gain income on Schedule B, and claimed the $1,000,000 tort damage award as a nontaxable recovery of capital on Schedule B, Form 4797. The plaintiff also did not include the $750,000 of economic damages, but later agreed that it constituted ordinary income as reported on the original 2005 return. The plaintiff then sued in federal district court for a refund.
Interest. The court determined that the interest award was properly includible in the plaintiff’s gross income as arising directly from the plaintiff’s damage award for loss to the cattle and dairy business. The court noted that the plaintiff had failed to rebut the determination of the IRS that the interest award was ordinary income. As such, the interest award was also subject to self-employment tax – there was a nexus between the interest on the damage award for loss to the plaintiff’s cattle and dairy business and the underlying business.
Tort damages. The court also held that the $1 million of tort damages constituted ordinary income, based on the origin of the claim and because the facts did not show that the plaintiff was asserting any recovery for interfering with (and devaluing) his real property as a capital asset. The plaintiff had exclusively presented evidence on economic damages - lost profits from milk production and the sale of both dairy and beef cattle. The court noted that the plaintiff had advised the jury to base the amount of the tort damages on economic damages. The plaintiff’s lawyers made no attempt to establish that the plaintiff was seeking recovery for interference with the plaintiff’s real property as a capital asset.
Penalty. The court also upheld the accuracy-related penalty on the basis that the plaintiff did not disclose his position with respect to the non-reporting of the tort damages and because he was advised by an accountant that his treatment of the tort damages was not correct. Thus, the plaintiff did not qualify for the reasonable cause exception to the I.R.C. §6662 penalty contained in I.R.C. §6664(c)(1).
Jury awards and cases where an award is received as a result of a settlement can result in some tricky tax consequences. As Allen illustrates, ag cases can involve a mix of damages with numerous and unique tax consequences.
Monday, July 15, 2019
Major weather events beginning early in 2019 and continuing through May and June in many parts of the Midwest and Great Plains have impacted agricultural producers. A “bomb cyclone” hit parts of Colorado, Kansas, Nebraska and South Dakota in March, leaving billions of dollars of devastation to agricultural livestock, crops, land, equipment and everything else in its path. Rains have been excessive in many places, mirroring the flooding of 1993 that hit the Midwest. Downstream flooding of the Missouri River has impacted parts of Nebraska, Iowa and Missouri.
Some of the impacted ag producers may feel that the need for tax planning is not necessary for 2019. After all, crops and livestock have been lost and other property has been destroyed. What’s there to plan for? Actually, there may be a lot to plan for. Income may actually end up higher than anticipated.
What tax planning considerations are there for farmers and ranchers impacted by weather events in 2019? It’s the topic of today’s blog post.
"What’s Past is Prologue"
The Shakespeare quote from The Tempest is certainly appropriate in the context of today’s topic. The very first Extension meeting that I held was in Topeka, Kansas, in the fall of 1993 and the topic was “Tax and Legal Issues Associated with the 1993 Flood.” I should dust that one off and update it. Many of the concepts will be the same. I remember telling the assembled crowd that evening that tax planning is still very important in what seems like a bad year. But, what are those issues and concepts?
What was experienced in 1993 that is likely to be the experience in 2019? For starters, many ag producers defer income into the following year. Thus, grain and livestock that were sold in 2018 might have been sold under a deferred payment contract that effectively deferred the income to 2019. I discussed the requirements of deferred payment contracts in a prior post here: https://lawprofessors.typepad.com/agriculturallaw/2017/08/deferred-payment-contracts.html. Many producers are also likely to have less crop input expense in 2019 compared to 2018 and prior years. That could be caused by prepaid input expenses in 2018 that aren’t fully utilized in 2019 due to land not in production in 2019 due to flooding, etc. But, to the extent the inputs that were pre-paid in 2018 aren’t used in 2019, that presents another tax/accounting issue. I have discussed the pre-paid expense rules here: https://lawprofessors.typepad.com/agriculturallaw/2017/10/the-tax-rules-involving-prepaid-farm-expenses.html. In addition, a producer may have lower operating expenses (e.g. fuel expense and equipment repairs) in 2019 because fewer acres may be farmed. Similarly, some producers may have little to no equipment purchases in 2019. But, it’s also possible that there could be greater equipment purchases in 2019 due to the need to replace equipment that was destroyed. There may also be a relatively large crop insurance payout in 2019. Also, don’t forget to add in a Market Facilitation Program (MFP) payment(s). While not weather-related, it is something new for 2018 and 2019.
Many farmers may fit this profile in 2019. For them, tax planning is an absolute necessity. Different tools in the tax practitioner’s toolbox may have to be used, but planning is still necessary.
As noted above, the receipt of crop insurance proceeds could be significant for some producers in 2019. I discussed the crop insurance deferral rules here: https://lawprofessors.typepad.com/agriculturallaw/2016/08/proper-reporting-of-crop-insurance-proceeds.html. In general, the proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received. But, taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's practice to report income from sale of the crop in the later year. I.R.C. §451(d). Included are payments made because of damage to crops or the inability to plant crops. The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”
Another item that I noted in that post is the “50 percent test.” Based on Rev. Rul. 74-145, 1974-1 C.B. 113, for a farmer on the cash method of accounting to be eligible to make an election, the taxpayer must establish that a substantial part of the crops (more than 50 percent) has been carried over into the following year. If multiple crops are involved, the “substantial portion” test must be met with respect to each crop if each crop is associated with a separate business of the taxpayer. Otherwise, the 50 percent test is computed in the aggregate if the crops are reported as part of a single business. Also, a taxpayer may not elect to defer only a portion of the insurance proceeds to the following year. It’s an all or nothing election.
Also included in my crop insurance post is a suggested methodology on how to determine the deductible portion of crop insurance related to policies that pay-out for events other than just physical crop loss.
Also, as for crop insurance, if payment is made in 2020 for a 2019 claim, deferral has already occurred. The proceeds can’t be deferred until 2021. Similarly, unless the crop insurance proceeds were somehow constructively received in 2019 (I can’t see how that would be possible), proceeds paid in 2020 relating to a 2019 crop are reported in 2020.
With respect to deducting input costs, be wary of deducting those that are financed via promissory note or vendor-financed. I discussed that matter here: https://lawprofessors.typepad.com/agriculturallaw/2017/06/input-costs-when-can-a-deduction-be-claimed.html.
For a casualty loss to be deductible, the loss must be of a sudden, unexpected and unusual nature. My blog post on the casualty loss rules and the comparable involuntary conversion rules is here: https://lawprofessors.typepad.com/agriculturallaw/2017/03/farm-related-casualty-losses-and-involuntary-conversions-helpful-tax-rules-in-times-of-distress.html. Can a casualty loss be claimed on land? That’s an important question given that some land in southeastern Nebraska and southwestern Iowa (and elsewhere) is completely covered in sand as a result of the flooding this spring.
The Tax Court dealt with a case in 2016, that can provide assistance in answering this question. In Coates v. Comr., T.C. Memo. 2016-197, the petitioners, a married couple, owned 700 acres. One tract consisted of 80 acres and comprised their home and two barns. Another tract contained 440 acres of woodland. In May of 2010, a tornado flattened most of the trees on the 440-acre tract and also damaged property on the other tract. The petitioners reported a $127,731 casualty loss for 2010 based primarily on their estimate of the tract’s fair market value before and after the tornado, with insurance reimbursements subtracted out of the calculation. The IRS disallowed the entire loss and tacked-on an accuracy-related penalty. The IRS took issue with the fact that the petitioners provided their own property valuation rather than that of a disinterested certified appraiser. The Tax Court wasn’t troubled by the petitioners’ valuation of their property and the IRS didn’t challenge it in its opening brief filed after trial. The Tax Court upheld the amount of the casualty with respect to the 80-acre tract. However, the Tax Court held that the petitioners did not establish that they had any tax basis in the timber tract, and the IRS had challenged the basis that the petitioners had assigned to it. There was also a discrepancy as to whether the petitioners had purchased the property or whether it was gifted to them. Ultimately, the Tax Court allowed a total casualty loss deduction for 2010 of $39,731, entirely attributable to the 80-acre tract. That amount represented the drop in the property value after the tornado, less insurance reimbursements and the statutory reduction of $100 and 10 percent of gross income. The Tax Court also refused to uphold the accuracy-related penalty that the IRS had imposed.
Of course, tax provisions exist for weather-related sales of livestock. If they were killed in a disaster such as the flooding brought on by the “bomb cyclone” or blizzard or prairie fire, the USDA Livestock Indemnity Program (LIP) provides financial assistance. With that financial assistance comes tax consequences. I covered LIP payments here: https://lawprofessors.typepad.com/agriculturallaw/2017/03/livestock-indemnity-payments-what-they-are-and-tax-reporting-options.html.
Another thought for consideration is the possibility of extending the planning horizon over both 2019 and 2020 together. That brings up the possible need to consider an income averaging election. For more details on the income averaging election and planning points to consider see: https://lawprofessors.typepad.com/agriculturallaw/2017/03/using-schedule-j-as-a-planning-tool-for-clients-with-farm-income.html
Just because 2019 may seem like a low-income year due to weather-related events, does not mean that tax planning is not necessary. More thought might be necessary. 2019 might actually turn out to be a better year than first-thought. In any event, the tax planning for 2019 could be different that it has been in prior years. This all means that year-end tax planning may need to be engaged in sooner rather than later. Now might be a good time to start if the process hasn’t already begun.
Thursday, July 11, 2019
My post last fall on what constitutes real estate for purposes of a like-kind exchange under I.R.C. §1031 generated a great deal of interest among readers, lots of good questions and lengthy discussion. https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html In light of that, it’s worth expanding the topic a bit to address some rather interesting scenarios that can arise in the context of like-kind exchanges.
That’s the topic of today’s post – a deeper dive on like-kind exchanges.
I.R.C. §1031 provides for tax deferred treatment of real property that is exchanged for real property of “like-kind.” Personal property trades were eligible for tax-deferred treatment before 2018, but now the provision only applies to real estate trades. Thus, real estate that is used in the taxpayer’s trade or business or held for investment can be “traded” for any other real estate that the taxpayer will hold for use in the taxpayer’s trade or business or for investment. It’s a broad standard. For example, eligible real estate can be rental properties; farmland; office buildings; retail real estate properties; storage units; bare land held for investment; golf courses; conservation easements; partial interests in property; water rights (in some states (as pointed out in the prior post); and even vacation homes (if certain requirements are satisfied). In addition, the rules don’t require real property trades to be by type. Any type of real estate can be traded with any other type. Treas. Reg. §1.1031(a)-1(b). What matters is the reason the taxpayer held the relinquished property and the replacement property.
What About Property That Doesn’t Produce Income?
A permissible reason for trading real estate is to hold the replacement property on the hopes that it will appreciate in value. Thus, real estate that is held for appreciation purposes without producing income can be traded for other real estate. The replacement real estate can also be held for value-appreciation purposes. Basically, this is a favorable tax rules for those that speculate on a tract of real estate appreciating in value. It also means, for example, that a farmer can defer tax on a trade of farmland that the farmer uses in the farming operation for farmland that is not farmed but used for hunting or fishing purposes, etc. The farmer is deemed to hold the replacement property for investment purposes. But, whenever real estate is traded for real estate that will be held for investment purposes, depending on the real estate market, the replacement property should be held long enough to sufficiently illustrate the investment purpose of holding the replacement property. There is no bright line to determined how long is long enough.
But, there is a distinction to note with respect to property held for investment purposes. I.R.C. §1031 treatment does not apply to real estate that is held for resale or as inventory. This is a rule that is of particular importance to land developers and building contractors. That’s because the real estate that such parties hold constitute inventory. The same result occurs for a taxpayer that acquires an apartment complex with the intent at the time of the acquisition of selling the complex to current occupants as condominiums. The IRS views such deals as a “resale” transaction.
The line between property that is held for investment purposes and property that is held for resale can be rather fine. For example, what about a taxpayer that buys homes, renovates them and then as soon as the home has been renovated (i.e., updated) list the homes for sale at a profit? You may have seen the television shows featuring parties that do this. Rather than being sold, can these homes qualify for I.R.C. §1031 treatment? It’s not likely. In these situations, the IRS has a legitimate claim that the homes were acquired and “held” for the intent and purpose of selling them (resale) and not for investment purposes. To qualify for I.R.C. §1031 treatment at some point in the future, the homes would need to be rented out for a period of time (the longer the better) or be clearly held for appreciation.
Mixed-Use Real Estate
Quite often, the question arises as to how to handle a like-kind exchange of farmland when a personal residence is involved. Indeed, I had this question come up at a tax seminar in Missouri earlier this week. It’s a great question. Many exchanges of farmland involve more than just bare farmland. Buildings, structures, and the farm residence may also be involved in the transaction. As for the personal residence, I.R.C. §121 allows the exclusion of gain of up to $500,000 on a joint return ($250,000 on a single return) if the taxpayer owned the home and used it as the taxpayer’s principal residence for at least two of the immediately previous five years. If the residence gain can qualify for the I.R.C. §121 exclusion, the residence portion of the real estate should be parceled out from the other real estate that will qualify for a like-kind exchange? Keeping in mind that an exclusion from income is better from a tax standpoint than is income tax deferral, as much real estate as possible should be included with the residence. But, how much? The maximum benefit is obtained if enough real estate along with the residence can be combined to “max-out” the $500,000 exclusion. Certainly, land that is adjacent to the residence that is functionally used along with and as part of the residence counts as the “residence” for purposes of the I.R.C. §121 exclusion. The caselaw is all over the board on this issue. It’s a very fact-specific issue with the question being how much land can reasonably be claimed to be used along with the residence. For additional guidance on the matter see Rev. Proc. 2005-14, 2005-1 C.B. 528.
From a transactional and practice standpoint, the documents supporting the exchange (known as the “exchange agreement”) should detail only the real estate that qualifies for tax deferral under I.R.C. §1031. To this end, it may be helpful to include in the documentation a map of the property that distinguishes the property that will be treated as the personal residence for purposes of I.R.C. §121 from the I.R.C. §1031 property with the exchange agreement only listing the I.R.C. §1031 property. A closing statement can then be utilized for the I.R.C. §121 property, and then a separate statement can be used for the I.R.C. §1031 property. Indeed, separate closing statements can be used in any transaction involving mixed-use properties – not just when a principal residence is involved. This is of particular importance post-2017 because personal property involved in a trade of real-property no longer qualifies for I.R.C. §1031 treatment.
Also, the IRS position is that property that is used for both business and personal purposes cannot be treated as two separate properties for purposes of the holding requirement – that the property be held for the productive use in a trade or business or for investment. See, e.g., C.C.A. 201605017 (Jan. 29, 2016).
Do Vacation Homes Qualify?
The upfront answer is, “no” – a vacation home doesn’t qualify for I.R.C. §1031 treatment. It’s not qualifying property unless it is held for the right reason – as trade or business property or for investment purposes. So, while a vacation home wouldn’t normally meet the test, it may be possible to convert the home to a qualified use to eventually allow it to qualify as part of an I.R.C. §1031 exchange. That can be accomplished by the taxpayer renting the vacation home out and either limiting or eliminating personal use. For example, in a case involving the exchange of two vacation houses, Moore, et ux. v. Comr., T.C. Memo. 2007-134, the Tax Court determined that the vacation homes at issue failed to qualify for I.R.C. §1031 treatment because the taxpayer failed to prove that they were held for primarily for investment. Instead, the evidence revealed that the taxpayer basically used the home as a second residence and for personal vacation retreats for family. The Tax Court also pointed out that the taxpayer did not rent or attempt to rent the properties; didn’t offer the replacement property for sale until forced to do so by liquidity needs; spent a great deal of time fixing up the property; kept a boat at the lake for personal use; didn’t claim any deductions for depreciation or maintenance expenses; claimed home mortgage interest deductions; and failed to maintain the relinquished property during the last two years of ownership (i.e., failed to protect the taxpayer’s investment in the property).
But, Moore doesn’t stand for the proposition that a vacation home cannot qualify as part of an I.R.C. §1031 transaction. Under an I.R.S. safe harbor (that was issued after Moore was decided), if the relinquished and/or the replacement property is owned for two years either immediately before or after the exchange; the taxpayer rents out the property at fair market value for 14 days or more during the tax year; and the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period during which the property is rented at fair market rental, the safe harbor applies. See, Rev. Proc. 2008-16, 2008-1 C.B. 547. In addition, the safe harbor is just that – a safe harbor. A transaction involving a vacation home can still qualify under I.R.C. §1031 without being in the safe harbor, but it could be subject to IRS challenge.
Like-kind exchanges are tricky. While the rules presently in place only allow deferred tax treatment on real estate trades, the appropriate reason for holding the properties exchanged must be satisfied. In addition, mixed use properties can present special problems. Again, it’s best to seek out competent counsel. And, one thing I didn’t address, is that often a “qualified intermediary” (Q.I.) must be involved in the exchange to make sure that deferred tax treatment is preserved. One such Q.I. is a firm in Iowa operated by a colleague of mine (and his wife) that were in law school with me. They do a fine job. Let me know if you need assistance on trades and I can point you in the right direction.
Tuesday, July 9, 2019
Agriculture and the law intersect in many ways. Of course, tax and estate/business planning issues predominate for many farmers and ranchers. But, there are many other issues that arise from time-to-time. Outside of tax, leases and fences are issues that seem to come up repeatedly. Other issues are cyclical. Bankruptcy is one of those issues that has increased in importance in recent months. Of course, legal issues associated with the administration of federal farm programs is big too. In addition, legal issues associated with market structure and competition in various sectors of agriculture are of primary importance particularly in the poultry and cattle sectors.
Periodically, I step away from the technical article aspect of this blog and do a survey of some recent ag-related developments in the courts. That’s what today’s post is about – it’s “ag in the courtroom” day today – at least with respect to a couple of recent cases.
Abandoned Rail Lines
One matter that is a big one in ag for those farms and ranches impacted by it involves the legal issues associated with abandoned rail lines. It’s often a contentious matter, and it doesn’t help that the Congress changed the rules several decades ago to, in the view of many impacted adjacent landowners, diminish private property rights.
Recently, another abandoned rail line case was decided. This time the decision was rendered by the Kansas Court of Appeals. In Central Kansas Conservancy, Inc., v. Sides, No.119,605, 2019 Kan. App. LEXIS 29 (Kan. Ct. App. May 17, 2019), the Union Pacific Railroad acquired a right-of-way over a railroad corridor that it abandoned in the mid-1990s. At issue in the case was a 12.6-mile length of the abandoned line between McPherson and Lindsborg, Kansas. A Notice of Interim Trail Use (NITU) was issued in the fall of 1995. The corridor was converted into a trail use easement under the National Trails System Act. In 1997, Union Pacific gave the plaintiff a "Donative Quitclaim Deed" to the railroad’s easement rights over the corridor, with one-quarter mile of it running through the defendant’s property at a width of 66 feet. Pursuant to a separate agreement, the plaintiff agreed to quit claim deed its rights back to the railroad if the railroad needed to operate the line in the future. By virtue of the easement, the plaintiff intended to develop the corridor into a public trail.
In 2013, the plaintiff contacted the defendant about developing the trail through the defendant’s land. The defendant had placed machinery and equipment and fencing in and across the corridor which they refused to remove. In 2015, the plaintiff sued to quiet title to the .75-mile corridor strip and sought an injunction concerning the trail use easement over the defendant’s property. The defendant admitted to blocking the railway with fencing and equipment, but claimed the right to do so via adverse possession or by means of a prescriptive easement. The defendant had farmed, grazed cattle on, and hunted the corridor at issue since the mid-1990s. The defendant also claimed that the plaintiff had lost its rights to the trail because it had failed to complete development of the trail within two years as the Kansas Recreational Trail Act (KRTA) required.
In late 2016, the trial court determined that the two-year development provision was inapplicable because the Interstate Commerce Commission had approved NITU negotiations before the KRTA became effective in 1996. The trial court also rejected the defendant’s adverse possession/prescriptive easement arguments because trail use easements are easements for public use against which adverse possession or easement by prescription does not apply.
During the summer of 2017 the plaintiff attempted work on the trail. When volunteers arrived, the defendant had placed equipment and a mobile home on the corridor preventing any work. The plaintiff sought a "permanent prohibitory injunction and permanent mandatory injunction." The defendant argued that he had not violated the prior court order because "[a]ll the Court ha[d] done [was] issue non-final rulings on partial motions for summary judgments, which [were], by their nature, subject to revision until they [were] made final decisions." Ultimately, the trial court granted the plaintiff’s request for an injunction, determined that the defendant had violated the prior summary judgment order, but also held that the plaintiff had not built or maintained fencing in accordance with state law.
On appeal, the appellate court partially affirmed, partially reversed, and remanded the case. The appellate court determined that the defendant did not obtain rights over the abandoned line via adverse possession or prescriptive easement because such claims cannot be made against land that is held for public use such as a recreational trail created in accordance with the federal rails-to-trails legislation. The appellate court also determined that the plaintiff didn’t lose rights to develop the trail for failing to comply with the two-year timeframe for development under the KRTA. The appellate court held that the KRTA two-year provision was inapplicable because a NITU was issued before the effective date of the KRTA. However, the appellate court determined that the plaintiff did not follow state law concerning its duty to maintain fences. The appellate court held that Kan. Stat. Ann. §58-3212(a) requires the plaintiff to maintain any existing fencing along the corridor and maintain any fence later installed on the corridor. In addition, any fence that is installed on the corridor must match the fencing maintained on the sides of adjacent property. If there is no fencing on adjacent sides of a landowner’s tract that abuts the corridor, the plaintiff and landowner will split the cost of the corridor fence equally. The appellate court remanded the case for a determination of the type and extent of fencing on the defendant’s property, and that the plaintiff has the right to enter the defendant’s property to build a fence along the corridor. Any fence along the corridor is to be located where an existing fence is located. If no existing fence exists along the corridor, the corridor fence is to be located where the plaintiff’s trail easement is separated from the defendant’s property. The appellate court remanded to the trial court for a reconsideration of its ruling on fence issues.
Feasibility of Chapter 12 Plan
As I mentioned at the beginning of the post, bankruptcy is one of those ag legal issues that has increased in relevancy in recent months. In certain parts of the country Chapter 12 (farm) bankruptcy has been on the rise. Once a farmer qualifies for Chapter 12 (not always an easy task), the reorganization plan was be proposed in good faith and be feasible. Those issues were at stake in a recent case from Iowa.
In In re Fuelling, No. 18-00644, 2019 Bankr. LEXIS 1379 (Bankr. N.D. Iowa May 1, 2019), the debtor was a farmer that granted the bank a first priority lien on all farm assets other than a truck and cash proceeds to the 2017 crop. To pay for the 2017 inputs, the debtor secured financing though another creditor (not the bank). The creditor obtained a subordination agreement from the bank, giving the creditor a $151,000 first priority lien in the 2017 crop sale proceeds. However, the proceeds from the 2017 crop were not enough to repay the creditor or continue making payments to the bank. The debtor filed Chapter 12 bankruptcy in May of 2018. The debtor sold the 2017 crops and various equipment to repay secured creditors. The creditor’s remaining claim was $107,506.45, $66,625.37 of which is secured by the remaining 2017 crop sale proceeds that the debtor still held.
The parties agreed that the bank's secured claim was $214,093.86 for purposes of plan confirmation. The creditors filed a motion for relief that would allow them to collect the remainder of the 2017 crop proceeds. The debtor filed a motion to use cash collateral to start a cattle feeding operation and grant the creditor a lien in the cattle and feed. The debtor also proposed to use rental payments from the grain bins on the property to make interest payments to the creditor and the bank for five years. The entire principal of the loans would come due as a balloon payment at the end of the plan period.
The bank, the Chapter 12 Trustee, the Iowa Department of Revenue, and the creditor objected to the debtor’s plan. The bankruptcy court denied the debtor’s proposed plan and motion to use cash collateral. The creditors’ motion for relief of stay was granted due to the court finding that the debtor’s plan was not feasible. The court denied the plan for multiple reasons. First the plan improperly substituted the creditor’s lien in the crop with a lien in cattle. Second the plan impermissibly utilized rental payments covered by the bank lien for payments towards the other creditors. The court also determined that the debtor’s proposed interest rate was not correct. The court agreed with the bank and the creditor that the plan was not feasible based on the information in the record. The debtor’s health issues, overly optimistic rental rates for the grain bins, and the balloon payment all factored in the court’s decision of lack of feasibility, even though the plan was submitted in good faith. Since the debtor’s plan to feed cattle was impermissible and not feasible, the court did not need any additional analysis to deny the debtor’s motion to use cash collateral. The debtor claimed that the remaining proceeds were necessary for reorganization, but the court concluded that the debtor’s proposed use of the proceeds impermissibly substituted the creditors. In the end, the court simply could not find a permissible way for the funds to be utilized in reorganization.
These are just two recent cases involving ag legal issues. There are many more. This all points out the need for well-trained lawyers in the legal issues that face farmers and ranchers.
Friday, July 5, 2019
It’s costly to start a business – especially a farming or ranching business. From a tax standpoint are the start-up costs deductible? As with many tax questions, that answer is that it “depends.” One item that the answer depends upon is when the business begins. That’s a key determination in properly deducting business-related expenses.
Deducting costs associated with starting a business – that’s the topic of today’s post.
Categorization – In General
The tax Code allows deductions for various expenses that are related to a taxpayer’s investments that don’t amount to a business if the expenses are ordinary and necessary for the production or collection of income or are for the management, conservation or maintenance of property held for the production of income. I.R.C. §212.
Once the business begins, all of the ordinary and necessary expenses of operating the business (on a basis that is regular, continuous and substantial) that are paid or incurred during the tax year are deductible. I.R.C. §162. But, business start-up costs are handled differently. I.R.C. §195.
I.R.C. §195(a) generally precludes taxpayers from deducting startup expenditures. However, by election, a taxpayer can deduct business start-up expenses on the return for the year that the business begins. I.R.C. §195(b). The election is irrevocable. Treas. Reg. §1.195-1(b). The deduction is the lesser of the amount of start-up expenses for the active trade or business, or $5,000 reduced (but not below zero) by the amount by which the start-up expenses exceed $50,000. I.R.C. §195(b)(1)(A); I.R.C. §195(b)(1)(A)(i). Once the election is made, the balance of start-up expenses are deducted ratably over 180 months beginning with the month in which the active trade or business begins. I.R.C. §195(b)(1)(B); Treas. Reg. §1.195-1(a). This all means that in the tax year in which the taxpayer’s active trade or business begins, the taxpayer can deduct the $5,000 amount (if that’s the lesser of, etc.) and the ratable portion of any excess start-up costs.
The election is normally made on a timely filed return for the tax year in which the active trade or business begins. However, if the return that year was timely filed without the election, the election can be made on an amended return that is filed within six months of the due date for the return (excluding extensions). The amended return should clearly indicate that the election is being made and should state, “Filed pursuant to section 301.9100-2” at the top of the amended return. Without the election, the start-up costs should be capitalized.
What are start-up expenses? Amounts paid or incurred in connection with creating an active trade or business are startup expenditures. I.R.C. §195(c). More specifically, start-up costs are amounts that the taxpayer pays or incurs for: investigating the creation or acquisition of an active trade or business; creating an active trade or business; or activities that the taxpayer engages in for profit and for the production of income before that day on which the active trade or business begins, in anticipation of the activities becoming an active trade or business, and which would be deductible in the year paid or incurred if in connection with an active trade or business. I.R.C. §§195(c)(1)(A)(i-iii); 195(c)(1)(B). Common types of start-up expenses include advertising costs; salaries and wages; and expenses related to travel. See, e.g., IRS Field Service Advice 789 (1993). But, interest expense, state and local taxes, and research and experimental expenses are not start-up expenses. I.R.C. §195(c)(1).
Start-up expenses are limited to expenses that are capital in nature rather than ordinary. That’s an important point because it means that I.R.C. §195 does not bar the deductibility of ordinary and necessary expenses a taxpayer incurs in an ongoing activity for the production of income under I.R.C. §212. In addition, it makes no difference that the activity is later transformed into a trade or business activity under I.R.C. §162. For example, in Toth v. Comr., 128 T.C. 1 (2007), the taxpayer started operating a horse boarding and training facility for profit in 1998. The activity showed modest profit the first few years, but had really taken off by 2004. For 1998 and 2001, the taxpayer claimed expenses from the activity on Schedule C as ordinary and necessary business expenses deductible in accordance with I.R.C. §162, but she later determined that the expenses should be deducted in accordance with I.R.C. §212 as miscellaneous itemized deduction on Schedule A (which are presently suspended through 2025). However, the IRS took the position that the taxpayer anticipated that the horse activity would become an active trade or business and, as such, her expenses had to be capitalized under I.R.C. §195. The Tax Court agreed with the taxpayer. Start-up expenses, the Tax Court said, were capital in nature rather than ordinary. Thus, once her income producing activity began her expense deductions were not barred by I.R.C. §195. It didn’t matter that the activity later became a trade or business activity under I.R.C. §162.
When does the business begin? A taxpayer cannot deduct or amortize startup expenditures if the activities to which the expenditures relate fail to become an “active trade or business.” See I.R.C. §§195(a), (c). There are no regulations that help define when a trade or business begins, so the question is answered based on the facts and circumstances of a particular situation. To be engaged in a trade or business, a taxpayer must: (1) undertake an activity intending to make a profit, (2) be regularly and actively involved in the activity, and (3) actually have commenced business operations. See, e.g., McManus v. Comr., T.C. Memo. 1987-457, aff’d., 865 F.2d 255 (4th Cir. 1988). In addition, the courts have held that a taxpayer is not engaged in a trade or business “until such time as the business has begun to function as a going concern and performed those activities for which it was organized.” Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965). Likewise, an activity doesn’t have to generate sales or other revenue for the business to be deemed to have begun. Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), aff’g., in part, rev’g. in part, and remanding T.C. Memo. 1994-316; Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th Cir. 1989), aff’g., 86 T.C. 492 (1986). However, merely researching or investigating a potential business is not enough. Dean v. Commissioner, 56 T.C. 895, 902-903 (1971).
Earlier this week, the U.S. Tax Court dealt with I.R.C. §195 and the issue of when the taxpayer’s business began. In Smith v. Comr., T.C. Sum. Op 2019-12, the Tax Court was convinced that the taxpayer had started his vegan food exporting business. The Tax Court noted that the taxpayer had been peddling his vegan food products in Jamaica, the Dominican Republic, Brazil Argentina and Columbia. However, he was having trouble getting shelf space. Thus, for the tax year at issue, he showed expenses associated with the activity of about $41,000 and gross sales of slightly over $2,000. The IRS largely disallowed the Schedule C expenses due to lack of documentation, and tacked on an accuracy-related penalty. After issuing the statutory notice of deficiency, the IRS said the expenses were not deductible because they were start-up expenditures. Because IRS raised the I.R.C. §195 issue at trial, the IRS bore the burden of proof on the issue. The Tax Court determined that the taxpayer was, based on the facts, engaged in a trade or business. He had secured products to sell, actively marketed those products, attended food shows and other meetings around the Caribbean and South America and had established a network to find potential customers. Thus, I.R.C. §195 did not apply to limit the deduction of the expenses – they would be deductible under I.R.C. §162. Or would they?
Substantiation. To be deductible under I.R.C. §162 as an ordinary and necessary business expense on Schedule C (or Schedule F), the taxpayer must substantiate the expenses. Here’s where the IRS largely prevailed in Smith. The Tax Court determined that the taxpayer had not substantiated his expenses. Thus, the expenses were not deductible beyond (with a small exception) what the IRS allowed. The Tax Court also upheld the accuracy-related penalty.
When a business is in its early phase, it’s important to determine the proper tax treatment of expenses. It’s also important to determine if and when the business begins. The Tax Cuts and Jobs Act makes this determination even more important. Once these hurdles are cleared, the recent Tax Court case illustrates the importance of substantiating expenses to preserve their deductibility.
Wednesday, July 3, 2019
On August 13-14 Washburn University School of Law along with co-sponsors Kansas State University Department of Agricultural Economics and WealthCounsel, LLC will be conducting the 2019 National Summer Farm Income Tax/Estate and Business Planning Conference in Steamboat Springs, CO. This is a great opportunity for practitioners with agricultural clients as well as agricultural producers to get two days of in-depth education/training on issues that impact the agricultural sector.
The Steamboat Springs seminar, it’s the topic of today’s post.
Speakers and Agenda
This is the 15th summer that I have been conducting a national event, with that first one held in beautiful Ely, Minnesota. Sometimes there is more than one during the summer, with the event usually held at a very nice location so that attendees can enjoy the area with their families if they choose to do so. This summer is no exception. Steamboat Springs is a lovely place on the western side of the Rocky Mountain National Park.
The speakers this year in addition to myself are Paul Neiffer, Stan Miller and Timothy O’Sullivan. Paul has taught with me for several years at this event (and others) and many of you are familiar with him. Stan is a partner in a law firm in Little Rock, Arkansas and the founder of WealthCounsel, LLC. Stan will be speaking on the second day and will be addressing the necessary planning steps to assist farm and ranch families keep the business going into the future. Also, on the Day 2, Tim O’Sullivan will provide the key details on long-term care planning, and dealing with family disharmony and its impact on the tax and estate planning/business succession planning process. Tim has an extensive estate planning practice with Foulston Siefkin, LLP in Wichita, Kansas. He is particularly focused and has expertise in the areas of Elder Law and Trusts and Estates.
On the first day, Paul and myself will go through the current, key farm income tax issues. Of course, the I.R.C. §199A deduction will be a big topic. Just a couple of weeks ago, the Treasury released the draft proposed regulations on how the deduction applies in the context of agricultural/horticultural cooperatives and patrons. We will take a deep dive into that topic, for sure. Many questions remain. We will also numerous other topics and provide insight into discussions in D.C. on specific issues and the legislative front. It will be a full day.
You can see the full agenda here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
The event will be held at the beautiful Steamboat Grand Hotel. A roomblock is established for the conference. Information on the hotel can be found here: https://steamboatgrand.com/ For those brining families, there are many sights to see and places to visit in the town and the surrounding area.
You can register for both days or just a single day. Also, the conference is live streamed in the event you are not able to attend in person. Just click on the conference link provided above to learn more. You can register here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html
On Monday, August 12 I will be participating in another conference at the Steamboat Grand Hotel focusing on conservation easements. That event is sponsored by several land trusts. Contact me personally about that conference if you are interested in learning more.
I hope to see you in Steamboat Springs next month! If you can’t attend in person, we trust you will benefit from watching the live presentation online.
Monday, July 1, 2019
Financial and economic continue to predominate in numerous parts of the ag economy. Current statistics show that economic woes are the most difficult in the dairy sector and other areas on a regional basis – particularly parts of the Great Plains and the Upper Midwest.
Initially passed in the midst of the farm debt crisis of the 1980s, Chapter 12 bankruptcy is uniquely tailored to address the needs of farmers in financial distress. That’s particularly true because of a special tax rule and the ability to avoid something known as the “absolute priority” rule of Chapter 11. However, appropriate planning must be utilized for a farmer to take advantage of Chapter 12.
The peril of a farmer not being eligible for Chapter 12 bankruptcy – that’s the topic of today’s post.
I was asked during a recent radio interview what I would tell a farmer or rancher facing potential financial problems if there was only one piece of advice I could give. My response – “listen to your wife.” Why? In many farming and ranching operations, the operating spouse simply works in the business of farming or ranching rather than working on it. There is a big difference between the two. The spouse that works on the business is the one keeping the books and records, tracking income and expense and monitoring the financial strength of the business. The operating spouse often is not tuned-in to these important aspects of the business. Instead, if lenders will continue to lend, the farmer can continue doing what they do best – farm, ranch and… sign lending documents without having legal counsel review them. But, this can lead to ignoring financial problems until it’s too late. Then, it might be necessary to liquidate assets.
This is the problem that Chapter 12 was designed to address. Chapter 12 allows a farmer to downsize the operation so that it can continue. The business gets reorganized, not liquidated. While the sale of assets to “right-size” the operation can trigger significant taxes, Congress added 11 U.S.C. §1222(a)(2)(A) with the overhaul of the Bankruptcy Code in 2005. Under that provision (and an amendment to it that took effect for new Chapter 12 cases on or after October 26, 2017), a Chapter 12 debtor can treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. The amendment addressed a major problem faced by many family farmers filing under Chapter 12 where the sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors. Even though the priority tax claims could be paid in full in deferred payments under prior law, in many instances the debtor operation did not generate sufficient funds to allow payment of the priority tax claims in full even in deferred payments. That was the core problem that the 2005 provision attempted to address.
Among other eligibility requirements, a farmer must have aggregate debt not exceeding $4,411,400. That is presenting a very real problem for many farmers at the present time. If Chapter 12 is not available because a farmer has debt exceeding the limit, what are the options? In terms of bankruptcy, the only viable options are a Chapter 7 liquidation bankruptcy and a Chapter 11 reorganization. But, in terms of reorganization, Chapter 11 is not nearly as favorable to the farm debtor as is Chapter 12 for the reasons noted below. Thus, for a farmer with excessive debt the strategy would be to identify and liquidate underperforming assets; repay creditors; and get the debt limit beneath the $4,411,400 threshold. That will allow the farmer to file Chapter 12 and get a stronger bargaining position in negotiating a debt settlement with creditors and get favorable tax treatment upon sale, etc., of farm assets.
The Perils of Chapter 11
Chapter 11 is the general reorganization provision for individuals and firms operating a business. There is no debt limit associated with Chapter 11, but major drawbacks of Chapter 11 include the relatively short time the debtor has to overcome existing financial problems, and an absolute priority rule that prohibits debtors from retaining ownership of their property unless unsecured creditors receive 100 percent of their claims.
The absolute priority rule. Under 11 U.S.C. §1129(b)(1), a creditor's plan objection will be upheld if the plan: (1) discriminates unfairly; or (2) is not fair and equitable with respect to each non-accepting class of claims or interests that is impaired under the plan. In this context, "impaired" means that the plan alters the rights of a class of creditors compared to the contractual rights prior to bankruptcy. The rule arose from several railroad case about a century ago. For example, in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), the debtor’s reorganization plan proposed to not pay the claims of junior creditors. The Court refused to approve the plan. Instead, the Court concluded that an “absolute priority rule,” as applied to a dissenting class of impaired unsecured creditors, must result in a plan being "fair and equitable." As codified, the “fair and equitable” test (i.e., the “absolute priority rule”) is satisfied only if the allowed value of the claim is to be paid in full, or if the holder of any claim or interest that is junior to the dissenting creditors will not receive or retain any property under the plan on account of such junior claim or interest. See 11 U.S.C. §1129(b)(2)(B)(ii).
The absolute priority rule came up in a recent Wisconsin bankruptcy case involving a dairy. In In re Schroeder Bros. Farms of Camp Douglas LLP, No. 16-13719-11, 2019 Bankr. LEXIS 1705 (Bankr. W.D. Wisc. May 30, 2019), a dairy was structured as a limited liability partnership (LLP). The LLP filed Chapter 11 in late 2016. At the time the Chapter 11 petition was filed, the debtor was ineligible to file Chapter 12 because aggregate debts exceeded the limit for Chapter 12 eligibility. The bankruptcy court confirmed the debtor’s reorganization plan in mid-2018. The debtor became unable to make plan payments and the committee of unsecured creditors motioned for the appointment of a liquidating trustee. The debtor objected on the basis that the sale of any assets would trigger capital gain taxes, and the combination of those taxes, the liquidating trustee’s fees, attorney fees and committee attorney fees would completely consume the sale proceeds of the encumbered real estate, farm equipment and cattle rendering the estate insolvent and leaving the individuals subject to pay the unpaid income taxes.
The debtor subsequently claimed that total debts had fallen beneath the debt limit for a Chapter 12 filing and sought to convert the Chapter 11 case to Chapter 12. Doing so would allow the debtor to take advantage of 11 U.S.C. §1222(a)(2)(A) (the predecessor to current 11 U.S.C. §1232) so that capital gain taxes could be treated as an unsecured claim. The committee of unsecured creditors asserted that the non-priority treatment of capital gain taxes was a non-issue because the debtor, as a pass-through entity, had no liability for any taxes. Instead, it would be the partners of the LLP that would have personal liability for taxes arising from asset sales. The debtor claimed it could elect to be taxed as a corporation via IRS Form 8832 upon making an election. Doing so, the debtor claimed, would result in the capital gain taxes being discharged as an unsecured claim. The committee claimed that the debtor was ineligible to convert to Chapter 12 because it was ineligible at the time the petition was filed.
The bankruptcy court agreed with the committee of unsecured creditors. The original petition date of the debtor’s Chapter 11 filing is the measuring date for the debtor’s Chapter 12 eligibility. However, when the debtor filed Chapter 11, the debtor was ineligible for Chapter 12. The bankruptcy court also pointed out that the debtor’s bankruptcy filing did not impact the debtor’s tax status. The bankruptcy court reasoned that allowing the debtor to make an election to be treated for tax purposes as a corporation would violate the absolute priority rule of 11 U.S.C. §1129(b)(2)(B) – a mainstay of Chapter 11. The absolute priority rule, the court noted, bars a court from approving a plan that gives a holder of a claim anything unless objecting classes have been paid in full. Thus, the proposed conversion of tax status would dilute the class of unsecured creditors and shift unfavorable tax treatment to the detriment of creditors. Accordingly, the bankruptcy court determined that the proposed tax election was not in the best interests of the debtor, the bankruptcy estate or the creditor and denied the tax election. The bankruptcy court approved the appointment of a liquidating trustee.
For farmers and ranchers, proper planning is the key to dealing with financial distress so they can utilize the advantages of Chapter 12. In the In re Schroeder Bros. case, a suggested approach for the dairy would have been to file the election to be treated as a C corporation at least one year before filing the bankruptcy petition. Then a pre-petition partial liquidation could have been utilized to get the debt level within the Chapter 12 limit. If the LLP couldn’t be treated taxwise as a C corporation, the farmer would have needed to file Chapter 12 individually to utilize the tax provisions of 11 U.S.C. §1232. In the alternative, two jointly administered petitions could have been filed.
Chapter 11 has serious limitations and is clearly disadvantageous compared to Chapter 12. It’s never too early to seek out competent legal counsel. A great deal of advance planning is often required to obtain the best possible result in a difficult situation.
Thursday, June 27, 2019
A significant amount of governmental regulation of agricultural activities is conducted by and through administrative agencies that promulgate regulations and make decisions. The rules for and scope of regulations is determined by unelected bureaucrats and often has the force of law. In addition, much of administrative law involves the administrative agency that developed the regulation at issue serving as judge and jury over disputed matters involving those same regulations. This raises fundamental questions of fairness.
In theory, governmental administrative agencies cannot exceed the authority provided by the legislative body. Ultimately, the courts serve as the check on the exercise of authority. But, how? Under what standard do the courts review administrative agency decisions? It’s an issue that was addressed by the U.S. Supreme Court yesterday, and it didn’t turn out the way that many in agriculture had hoped.
Today’s post takes a deeper look at administrative agencies, how farmers and ranchers can best deal with them, and review of administrative agency determinations by the courts. The deference provided to administrative agency decisions – that’s the topic of today’s post.
Administrative Agency Basics
At the federal level, the Congress enacts basic enabling legislation, but leaves the particular administrative departments (such as the USDA) to implement and administer congressionally created programs. As a result, the enabling legislation tends to be vague with the administrative agencies (such as the USDA) needing to fill in the specific provisions by promulgating regulations. The procedures that administrative agencies must follow in promulgating rules and regulations, and the rights of individuals affected by administrative agency decisions are specified in the Administrative Procedures Act (APA). 5 U.S.C. §§ 500 et seq. The provisions of the APA constitute the operative law for many of the relationships between farmers and ranchers and the government.
Administrative Agency Procedure
Usually, a farmer or rancher's contact with an administrative agency is in the context of participation in an agency-administered program, or being cited for failure to comply with either a statutory or administrative rule. So, it’s helpful for farmers and ranchers to have a general understanding of how administrative agencies work and the legal effects of their decisions. In general, disputed matters involving administrative agencies must first be dealt with in accordance with the particular agency's own procedural rules before the matter can be addressed by a court of law. This is known as exhausting administrative remedies. 7 U.S.C. §6912(e). See also Johnston v. Patterson, No. 4:14-CV-210-BO, 2014 U.S. Dist. LEXIS 172224 (E.D. N.C. Dec. 12, 2014). About the only exception to the rule of exhaustion occurs when a facial challenge is made to the regulation itself. See Gold Dollar Warehouse, Inc. v. Glickman, 211 F.3d 93 (4th Cir. 2000). Thus, participating carefully in administrative proceedings can be vitally important to a farmer or rancher, especially in terms of properly preserving a record for subsequent court review.
Going through the administrative process is critical because, typically, an appeal to a court of law is made only on the basis of the record generated in the administrative proceeding. Courts are limited in the extent to which they can substitute their judgment for that of an administrative agency regarding the facts of the dispute. Thus, it is critical to preserve all disputed factual and legal issues in the record of the administrative proceeding so that they can later be considered by a court. The exhaustion of administrative remedies, as a general rule, also requires that legal issues must be raised during the administrative process so as to be preserved for judicial review. If they are raised in the administrative process, then they will likely be precluded. Also, exhaustion is required as to each legal issue. See, e.g., Ballanger v. Johanns, 495 F.3d 866 (8th Cir. 2007).
What’s the Standard For Reviewing Agency Action?
Courts generally consider only whether the administrative agency acted rationally and within its statutory authority. Consequently, a particular farmer or rancher bears the burden of insuring that the record is adequate for the appeal of the issues involved before the matter leaves the administrative process. Otherwise, an appeal of an administrative agency's decision must be based solely on arguments that the agency acted arbitrarily, capriciously, beyond legal authority or that it abused its discretion.
In general, when dealing with administrative appeals from a federal agency such as the USDA, the court generally defers to the agency’s interpretation of its regulations as contained in the agency’s interpretive manuals. Prevailing in court on this type of a claim can be quite difficult. However, in Christensen v. Harris County, 529 U.S. 576 (2000), the U.S. Supreme Court ruled that statutory interpretations made by governmental agencies in pronouncements that do not have the force of law, such as opinion letters, policy statements, agency manuals, and enforcement guidelines, are not entitled to such great deference. Christensen is a significant case for the agricultural sector because the USDA often makes interpretations of the laws they administer in formats that do not have the force of law. Similarly, in Meister v. United States Department of Agriculture, 623 F.3d 363 (6th Cir. 2010), the court noted than an agency is not entitled to deference simply because it is a governmental agency. The case involved a claim that the U.S. Forest Service had failed to comply with its own regulations and a federal statute in developing its 2006 management plan for national forests in northern Michigan. The trial court granted the government’s motion for summary judgment, but the appellate court reversed. The appellate court noted that it was insufficient for the government to only identify the lands on which a particular activity (such as snowmobiling) could occur. Instead, the government had to identify the supply of lands on which participants in particular activities would experience a quality recreational experience. As a result, the issuance of the agency’s plan was arbitrary because the estimates of snowmobile and cross-country visitors to the forests were entirely arbitrary and there was no coordination with Michigan's recreational planning, and the agency did not minimize conflicts between off-road vehicle use and other uses and interests of the forests. The court specifically noted that agency deference was not automatic. Instead, the agency must apply the relevant statutory and regulatory authority.
On the deference issue, it was believed that a change might be in the wind. In 1997, the U.S. Supreme Court again reiterated the principle of agency deference. Auer v. Robbins, 519 U.S. 452 (1997). This so-called “Auer deference” involves a court deferring (or give “controlling weight”) to agency interpretations of its own ambiguous regulations. Another type of deference, known as “Chevron deference” involves a court deferring to an agency interpretation of ambiguous statutes that the agency administers. Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). However, the Court, in 2013 criticized the Court’s 1997 decision and suggested that it might be time to reconsider principles of agency deference. Decker v. Northwest Environmental Defense Center, 133 S. Ct. 1326 (2013).
The amount of deference a court gives to agency interpretations of its own regulations is important to agriculture. For example, the USDA administers the Packers and Stockyards Act (PSA). The PSA, bars packers (and others) from engaging in any “unfair, unjustly discriminatory, or deceptive practice.” 7 U.S.C. §192(a). The PSA also prohibits the making or giving of any “undue or unreasonable preference or advantage” to any person. 7 U.S.C. §192(b). The courts have construed this language to require harm to competition be shown to establish a violation. In late 2016, the USDA published an interim final rule removing the requirement to show harm to competition to establish a violation. But, the USDA later withdrew the rule. The withdrawal of the rule was challenged as arbitrary and capricious (the standard for overturning agency action). But, the Eighth Circuit denied the plaintiffs’ claims. Organization for Competitive Markets v. United States Department of Agriculture, 912 F.3d 455 (8th Cir. 2018). The court determined that the USDA, in abandoning the proposed rule, had provided a reasoned analysis based on principles that were “rational, neutral, and in accord with the agency’s proper understanding of its authority” – the USDA didn’t want to get sued. The case is an example of deference toward a governmental agency’s actions.
Yesterday, the U.S. Supreme Court addressed the issue of deference again in Kisor v. Wilkie, No. 18-15, 2019 U.S. LEXIS ___ (U.S. Sup. Ct. Jun. 26, 2019). The facts of the case didn’t involve agriculture. That’s not the important part. What is important is that the Court again reaffirmed (5-4, thanks to Chief Justice Roberts) Auer deference. However, the Court did appear to place some limitations on Auer deference for future cases. I say “appear” because the Court created a new multi-part test for review of agency action that could prove difficult for lower courts to apply and relatively easy for administrative agencies to skirt. According to the Court, a court that reviews agency action is to review the regulatory language at issue to determine whether the regulation is ambiguous. If it is, the court is to then apply Auer deference in determining whether the agency reached a reasonable conclusion resulting from the agency’s careful consideration and expertise after giving affected parties reasonable notice of the agency’s interpretation. From agriculture’s perspective, it was hoped that the Court would jettison Auer deference. That would have been the approach of Justice Gorsuch who would have eliminated the binding agency deference of Auer.
So, the battle between agriculture and administrative agencies will continue on numerous fronts, and the arguments over the reasonableness of agency interpretations will continue with the courts largely deferring to agency determinations. While there might be a dent in Auer deference, it still is a very functional defense to agency action.
The Equal Access to Justice Act (EAJA) (5 U.S.C. §§504 (2008); 28 U.S.C. §2412(d)(2)(A)) provides that a party who prevails administratively against government action can recover fees and expenses if the administrative officer determines that the government’s position was not substantially justified. However, the USDA’s longstanding position is that the EAJA does not apply to administrative hearings before the USDA’s National Appeals Division (NAD) because NAD proceedings are not adversarial adjudications that are held “under” the APA. But, the United States Court of Appeals for the Eighth Circuit rejected the USDA’s position in 1997. Lane v. United States Department of Agriculture, 120 F.3d 106 (8th Cir. 1997). The Ninth Circuit ruled similarly in 2007. Aageson Grain and Cattle, et al. v. United States Department of Agriculture, 500 F.3d 1038 (9th Cir. 2007). The Seventh Circuit ruled likewise in 2008. Five Points Road Venture, et al. v. Johanns, 542 F.3d 1121 (7th Cir. 2008).
Dealing with administrative agencies is a reality for the typical farmer or rancher. While ag didn’t get the clear victory it sought in Kisor, perhaps it’s a baby-step in the right direction. Only time will tell.
Tuesday, June 25, 2019
Last year, the U.S. Supreme Court decided South Dakota v. Wayfair, 138 S. Ct. 2080 (2018), upholding South Dakota’s ability to collect taxes from online sales by sellers with no physical presence in the state. That decision was the latest development in the Court’s 50 years of precedent on the issue. Based on that opinion, some states with an income tax took an aggressive stance against trust beneficiaries residing in their states. These states claimed that Wayfair meant that the mere presence in the state of a trust beneficiary allowed the state to tax the beneficiary’s trust income. North Carolina was one of those states.
The Supreme Court unanimously rejected North Carolina’s position. In so holding, the Court outlined Due Process limitations that apply to a state’s ability to tax.
The limitations on a state’s taxing authority – that’s the topic of today’s post.
The “Nexus” Requirement
In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in Quill Corporation v. North Dakota, 504, U.S. 298 (1992), the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. That’s what got North Carolina (and some other states) excited – the ability to tax trust income on the basis that a beneficiary’s presence in the state satisfied the nexus requirement. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain – fair apportionment; no discrimination against interstate commerce, and; fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – limited application (based on transactions or dollars of sales); not retroactive; the state was a member of the Streamlined Sales and Use Tax Agreement; the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
Taxing an Out-Of-State Trust?
In the North Carolina case, the trust at issue was a revocable living trust created in 1992 with a situs of New York. The primary beneficiaries were the settlor’s descendants. None of the descendants lived in North Carolina at the time of the trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at that time. The trustee was replaced in 2005 with a successor trustee who resided in Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the accumulated trust income, that was distributed to the beneficiaries, including the non-North Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2, which assesses tax on the amount of taxable income of the estate or trust that is for the benefit of a North Carolina resident, was unconstitutional on Due Process and Commerce Clause grounds. The defendant denied the claim, and the hearing officer later dismissed the case for lack of jurisdiction.
The trial court dismissed the request for injunctive relief with respect to the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The trial court then granted summary judgment for the trust on the constitutional claim and ordered the defendant to refund the taxes paid on its accumulated income.
On appeal, the appellate court affirmed. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 248 N.C. 212, 789 S.E.2d 645 (N.C. Ct. App. 2016). The appellate court determined that the trust failed to have sufficient minimum contacts (as required by the Due Process Clause) with North Carolina to subject the trust to North Carolina income tax. The court cited both International Shoe Co. v. Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to support its position on this point. The trust did not have any physical presence in the state during the tax years at issue, contained no North Carolina property or investments, had no trust records that were created or kept in North Carolina, and the place of trust administration was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional.
On further review, the state Supreme Court affirmed. Kimberley Rice Kaestner Trust 1992 Family Trust v. North Carolina Department of Revenue, 371 N.C. 133, 814 S.E.2d 43 (N.C. Sup. Ct. 2018). The state Supreme Court noted that a key to the case was that the trust beneficiary did not receive trust distributions during the years at issue. As such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.
The North Carolina Supreme Court’s decision was delivered 13 days before the U.S. Supreme Wayfair decision, and was based on the controlling U.S. Supreme Court decision at that time – Quill. Consequently, the North Carolina Department of Revenue, based on Wayfair, sought U.S. Supreme Court review. On January 11, 2019, the U.S. Supreme Court agreed to hear the case. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, 139 S. Ct. 915 (2019).
U.S. Supreme Court Decision
In a unanimous decision, the U.S. Supreme Court affirmed, holding that the North Carolina law violated Due Process. North Carolina Department of Revenue v. Kimberley Rice Kaestner Trust 1992 Family Trust, No. 18-457, 2019 U.S. LEXIS 4198 (U.S. Sup. Ct. Jun. 21, 2019). The Court noted that a taxpayer must have “some minimum connection” with the state, and that a rational relationship must exist between the income the state wants to tax and the state. There must be a fiscal relationship to benefits that the state provides. That’s a Due Process limitation. As applied to a trust, and based on Brooke v. Norfolk (cited above), the Court seemed to suggest that whether a trust beneficiary’s in-state contacts are relevant on the nexus question is tied to whether the beneficiary has a “right to control, possess, enjoy or receive trust assets.” Applying that rationale to the trust at issue, the court determined there was an insufficient nexus between the North Carolina beneficiary and the state for the state to have jurisdiction to tax the trust. The beneficiary never received an income distribution from the trust for the years at issue and didn’t have a right to demand trust distributions and had no power of assignment. It was the trustee, under the terms of the trust, that had the sole discretion over distributions. Indeed, the trust assets could ultimately end up in the hands of other beneficiaries. But, the Court did not foreclose the ability of a state to tax trust income where the trust gives the resident beneficiary a certain right to trust income.
Implications. The Court’s decision does leave in its wake considerations for drafters of trust instruments. For starters, a purely discretionary trust (e.g., a trust giving the trustee sole discretion over trust distributions) can bar a state from taxing a beneficiary’s income distribution. That’s especially true when combined with “spendthrift” language that bars the beneficiary from assigning their beneficial interest in the trust. This type of trust language typically works well when there is a need to place limitations on a beneficiary’s rights and access to trust assets. While the Court didn’t address the impact of a giving a beneficiary a power of appointment over trust assets in a discretionary trust, it would seem that if such a power is present and exercised, the state would have the ability to tax the beneficiary at least in the year the power is exercised.
The facts of the case indicated that the beneficiary had the right to receive either a share or all of the trust assets upon reaching a particular age, but the right was contingent. What if the trust language had made the future right not contingent? Would the Court have concluded that a state has the ability to tax the beneficiary then?
The Court also pointed out that nexus means something different depending on whether it is being applied to the grantor/settlor of the trust, the trustee or a beneficiary. A resident trustee satisfies the nexus requirement as does a resident grantor/settlor (with respect to a revocable trust). But, does that mean that a trust grantor/settlor can be taxed based solely on having created the trust in that particular state? Maybe that challenge will be forthcoming in the future.
State taxation of trusts varies greatly from state to state in those states that have a state income tax. A trust’s situs in a state certainly permits that state to subject the trust to the state’s income tax as a resident. But, a trust may be tied to a state in other ways via a grantor, trustee, assets, or a beneficiary. In addition, whether a trust is a revocable or irrevocable trust can make a difference. For instance, the Illinois definition of “resident” includes “an irrevocable trust the grantor of which was domiciled in this State at the time such trust became irrevocable.” 35 ILCS/1501(A)(20)(D); see also, Linn v. Department of Revenue, 2 N.E.3d 1203 (Ill. Ct. App. 2013). Indeed, a trust may have multiples states asserting tax on the trust’s income.
However, due process requires that before a state can tax a trust’s income, the trust must have a substantial enough connection (e.g., nexus) with the state. In addition, while a trust could be subject to state income tax based on its residency, the trust has grantors and trustees and beneficiaries and assets that can all be located in different states – and can move from state-to-state (at least to a degree). That last point makes the Court’s decision relevant even to those practitioners in states without an individual income tax.
Friday, June 21, 2019
It has taken the IRS and the Treasury almost 18 months to issue proposed regulations on how the new Qualified Business Income Deduction (QBID) works with respect to qualified agricultural cooperatives and their patrons. For background information on the QBID see https://lawprofessors.typepad.com/agriculturallaw/2018/01/the-qualified-business-income-qbi-deduction-what-a-mess.html Of course, the Congress didn’t help anything when the Tax Cuts and Jobs Act was passed by including a special deal for cooperatives that private grain elevators couldn’t avail themselves of. That got “fixed” in late March of 2018, but by that time the air and water in D.C. had become so polluted over the cooperative issue that I was told personally by Senator Grassley not to anticipate any proposed regulations until the middle of 2019. For commentary on the “fix” see https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified-business-income-deduction.html The Senator was spot- on with that prediction.
Now that we have the proposed regulations, this will be a topic that will be addressed at the 2019 Summer National Farm Income Tax and Estate/Business Planning Seminar in Steamboat Springs, Colorado on August 13-14. That event is sponsored by Washburn University School of Law, the Department of Ag Econ at Kansas St. University and WealthCounsel. You can attend either in person or online. Registration information is available here: http://washburnlaw.edu/employers/cle/farmandranchtaxregister.html
A brief summary of the cooperative QBID regulations – that’s the topic of today’s post.
No Deduction for a Cooperative
Under I.R.C. §199A(a), a taxpayer is eligible for up to a 20 percent QBI deduction (QBID) attributable to qualified business income (QBI) derived from a domestic business that is other than a C corporation. Trusts and estates are eligible for the deduction. But, the QBID does not apply to wage income or to C corporate income. A cooperative is deemed to be a C corporation for federal income tax purposes and, thus, cannot claim a QBID. But, a cooperative determines its taxable income after the deduction for patronage dividend distributions and the like. I authored a BNA Tax Management Portfolio several years ago on cooperative taxation and noted there that such distributions are not taxed at the cooperative level. Instead, the distributions are taxed at the patron level. All cooperatives can deduct patronage distributions; exempt cooperatives can also deduct non-patronage distributions. I.R.C. §1382(c).
While a C corporation cannot utilize the QBID, I.R.C. §199A has a special rule for patrons that receive patronage dividends – they aren’t treated as an exclusion to the patron’s QBI. I.R.C. §199A(c)(3)(B)(ii). In addition, the Treasury has said that for purposes of the trade or business test of I.R.C. §162 (a pre-requisite for QBI), the income is tested at the trade or business level where the income is generated. T.D. 9847, Feb. 12, 2019. This all means that the QBID, if any, is at the patron level and not the cooperative level.
Special Rule for Patrons
As noted, I.R.C. §199A has special rules for patrons of ag cooperatives. These rules stem from the fact that farmers often do business with agricultural (or horticultural) cooperative. A farmer patron could have QBI that is not tied to patronage with a cooperative and QBI that is tied to patronage with a cooperative.
What are “patronage dividends”? Patronage dividends include money, property, qualified written notices of allocations, qualified per-unit retain certificates for which a cooperative receives a deduction under I.R.C. §1382(b), nonpatronage distributions paid in money, property, qualified written notices of allocation, as well as money or property paid in redemption of a nonqualified written notice of allocation for which an exempt cooperative receives a deduction under I.R.C. §1382(c)(2). But, dividends on capital stock are not included in QBI. Prop. Treas. Reg. §1.199A-7(c)(1).
Under Prop. Treas. Reg. §1.199A-7(c), patronage dividends or similar payments may be included in the patron’s QBI to the extent that these payments: (i) are related to the patron’s trade or business; (ii) are qualified items of income, gain, deduction, or loss at the cooperative’s trade or business level; and (iii) are not income from a specified service trade or business (SSTB) (as defined in I.R.C. §199A(d)(2)) at the cooperative level. But, they are only included in the patron’s income if the cooperative provides the required information to the patron concerning the payments. Prop. Treas. Reg. §199A-7(c)(2).
The patron’s QBID. The amount of a patron’s deduction that can be passed through to the patron is limited to the portion of the patron’s deduction that is allowed with respect to qualified production activities income to which the qualified payments (patronage dividends and per unit retains) made to the patron are attributable. I.R.C. §199A(g)(2)(E). In other words, the distribution must be of tax items that are allocable to the cooperative’s trade or business on behalf of or with a patron. The cooperative makes this determination in accordance with Treas. Reg. §1.199A-3(b). This is, essentially, the domestic production activities deduction computation of former I.R.C. §199, except that account is taken for non-patronage income not being part of the computation.
Note. There is a four-step process for computing the patron’s QBID: 1) separate patronage and non-patronage gross receipts (and associated deductions); 2) limit the patronage gross receipts to those that are domestic production gross receipts (likely no reduction here); 3) determine qualified production activities income from the domestic, patronage-sourced gross receipts; 4) apply a formula reduction (explained below). Prop. Treas. Reg. §1.199A-8(b).
As noted, the farmer-patron must reduce the “patron’s QBID” by a formula that is the lesser of 9 percent of QBI that relates to qualified payments from the cooperative, or 50 percent of the patron’s W-2 wages paid that are allocable to the qualified payments from the cooperative. I.R.C. §199A(b)(7)(A)-(B). In Notice 2019-27, 2019-16 IRB, the IRS set forth various methods for calculating W-2 wages for purposes of computing the patron’s QBID. See also Prop. Treas. Reg. §1.199A-11.
Because the test is the “lesser of,” a patron that doesn’t pay qualified W-2 wages has no reduction. Remember, however, under I.R.C. §199A(b)(4) and Prop. Treas. Reg. §1.199A-11(b)(1), wages paid in-kind to agricultural labor are not “qualified wages” but wages paid to children under age 18 by their parents are. For background information on that point, see https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html
Note. I.R.C. §199A(b)(7) requires the formula reduction even if the cooperative doesn’t pass through any of the I.R.C. §199A(g) deduction (the deduction for a patron) to the patron for a particular tax year. If the patron has more than a single business, QBI must be allocated among those businesses. Treas. Reg. §1.199A-3(b)(5). Uncertainty remains, however, as to how the formula reduction functions in the context of an aggregation election. For example, if an aggregation election is made to aggregate rental income with income from the farming operation, must an allocation be made of a portion of the rental income as part of the formula reduction?
The formula reduction applies to the portion of a patron’s QBI that relates to qualified payments from a cooperative. If the patron has negative QBI that is associated with business done with the cooperative, the 9 percent amount will always be lower than the W-2 wage amount. Based on the draft form 8995-A, the QBID is to be increased by 9 percent of the AGI amount.
An optional safe harbor allocation method exists for patrons under the applicable threshold of I.R.C. §199A(e)(2) ($160,700 single/$321,400 MFJ for 2019) to determine the reduction. Under the safe harbor, a patron must allocate the aggregate business expenses and W-2 wages ratably between qualified payments and other gross receipts to determine QBI. Prop. Treas. Reg. §1.199A-7(f)(2)(ii). Thus, the amount of deductions apportioned to determine QBI allocable to qualified payments must be equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments.
Note. The proposed regulations attempting to illustrate the calculation only mention gross receipts from grain sales. There is no mention of gross receipts from farm equipment, for example. Based on the language of Prop. Treas. Reg. §1.199A-7(f)(2)(ii), gross receipts from the sale of equipment and machinery should be included in the calculation and the farmer would have to allocate gross receipts from equipment sales between patronage and non-patronage income. Indeed, in prior years, depreciation may have been allocated between patronage and non-patronage income. Likewise, the example doesn't address how government payments received upon sale of grain are to be allocated.
The example contained in the Proposed Regulations not only utilizes an apparently unstated “reasonable method of allocation,” but uses an allocation of W-2 wage expense that doesn’t match the total expense allocation. That will have to be cleaned up in the final regulations. The example, as written, does not meet the requirement of the regulations to “clearly reflect income” without an explanation of how the cost allocation has been accomplished. A taxpayer using the approach of the example would certainly fail the requirement of the regulations upon audit.
This all means that the patron must know the qualified payments from the cooperative that were allocable to the patron that were used in computing the deduction for the patron at the cooperative level that could be passed through to the patron. This information is contained on Form 1099-PATR.
A higher income patron that receives patronage dividends (or similar payments) from a cooperative and is conducting a trade or business might be subject to the W-2 wages and “unadjusted basis immediately after acquisition” (UBIA) limitation. See https://lawprofessors.typepad.com/agriculturallaw/2018/08/qualified-business-income-deduction-proposed-regulations.html for a discussion of the limitation. In that instance, the patron is to calculate the W-2 wage and UBIA limitations without regard to the cooperative’s W-2 or UBIA amounts. Prop. Treas. Reg. §1.199A-7(e)(2). That means that the cooperative does not allocate its W-2 wages or UBIA to patrons. Id. Instead, a patron allocates (by election) W-2 wages and UBIA between patronage and non-patronage income using any reasonable method based on all the facts and circumstances that clearly reflects the income and expense of each trade or business. Prop. Treas. Reg. §1.199A-7(f)(2)(i). An example of an allocation might be by the number of bushels of grain that the patron sells during the year to various buyers – cooperatives and non-cooperatives. But, once an election is made with respect to an allocation approach, it applies to all subsequent years.
The patron’s QBID that is passed through from the cooperative (which is not limited by W-2 wages at the patron level) is limited to the patron’s taxable income taking into account the non-patron QBID which is limited to 20 percent of taxable income not counting net capital gains. Any unused patron-QBID is simply lost – there is not carryover or carryback provision that applies.
Identification by the cooperative. A cooperative must identify the amount of a patron’s deduction that it is passing through to a patron in a notice that is mailed to the patron via Form 1099-PATR during the “applicable payment period” – no later than the 15th day of the ninth month following the close of the cooperative’s tax year. I.R.C. §199A(g)(2)(A); Prop. Treas. Reg. §1.199A-8(d)(3); I.R.C. §1382(d).
A patron uses the information that the cooperative reports to determine the patron’s QBID. If the information isn’t received on or before the Form 1099-PATR due date, no distributions from the cooperative will count towards the patron’s QBI if the lack of reporting occurs after June 19, 2019. Prop. Treas. Reg. §1.199A-7(c)(3); Prop. Treas. Reg. §1.199A-7(d)(3).
Note. The Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as patronage and nonpatronage distributions.
Is the Patron’s Business an SSTB? The proposed regulations indicate that a patron must determine whether the trades or businesses it directly conducts are specified service trades or businesses (SSTBs). Prop. Treas. Reg. §1.199A-7(d)(2). Why? Because the cooperative must report to the patron the amount of tax items from an SSTB that the cooperative directly conducts (based on the application of the gross receipts de minimis rule of Tress. Reg. §1.199A-5(c)(1)) that is used to determine if a trade or business is an SSTB. The patron is to then determine if the distribution from the cooperative can be included in the patron’s QBI (based on the patron’s taxable income and the phase-in range and threshold that applies to an SSTB). The cooperative must report to the patron the amount of SSTB income, gain, deduction, and loss in distributions that is qualified with respect to any SSTB directly conducted by the cooperative on an attachment to or on the Form 1099-PATR (or any successor form) that the cooperative issues to the patron, unless otherwise provided by the instructions to the Form.
Note. Again, the Preamble to the proposed regulations states that these rules apply to both exempt and nonexempt cooperatives as well as to patronage and non-patronage distributions.
Waiting well over a year for draft proposed regulations on the cooperative QBID issue has created many hassles for taxpayers, preparers and tax software companies for the 2018 tax season (which is still ongoing in many respects). The proposed regulations can be relied upon until final regulations are published. Written comments on the proposed regulations are due within 60 days of publication of the proposed regulations in the Federal Register – approximately August 17, 2019. Hard copy submissions of comments can be sent to: CC:PA:LPD:PR (REG-118425-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044.
Wednesday, June 19, 2019
Especially with respect to fruit and vegetable crops, seasonal ag workers are vital – particularly during harvest. But is a seasonal ag worker an employee or an independent contractor? What are the factors for determining the proper classification? Why does classification matter? Actually, it matters for several important reasons including withholding of income tax and the filing of the proper tax forms; whether minimum wage requirements apply; and applicable penalties for a misclassification.
During this spring’s academic semester at the law school, my students in agricultural law were required to write a paper on a particular ag law topic. Today’s post features the work of one of those students - Rebecca Bergkamp. Rebecca graduated last month, is presently preparing for the Bar exam, and will then join the Hinkle Law Firm in Wichita, Kansas. She is well-trained to enter the practice world to begin assisting agricultural clients (among others) with their legal issues.
The proper classification of seasonal ag workers – that’s the topic of today’s post.
Rules Governing Classification of Workers
Under the Fair Labor Standards Act (FLSA), a worker is presumed to be an employee, unless the worker is specifically classified as an independent contractor. The term “employee” is very expansive and means any individual employed by an employer. 29 U.S.C. §203(e)(1). This includes individuals who might not normally qualify as an “employee” under traditional agency principles. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 112 S. Ct. 1344, 1350 (1992). Likewise, a contractual designation between a farmer and the worker that the worker is an independent contractor is not controlling for purposes of determining whether that worker is an employee or independent contractor. Rutherford Food Corp. v. McComb, 331 U.S. 722, 67 S. Ct. 1473, 1476-77 (1947). Moreover, the subjective intentions of the parties are not controlling in determining whether an employer-employee relationship exists; it does not matter whether the parties had any intention of creating an employment relationship. Brennan v. Partida, 492 F.2d 707, 709 (5th Cir. 1974).
Factors for Consideration
So how is it determined whether an ag worker is an employee or a independent contractor? An “economic realities” test is often used. Under this test, the courts look to various factors in assessing the economic realities of the situation to determine whether an individual is an employee, or an independent contractor. Those factors are: (1) the nature and degree of the worker’s control of the manner in which the work is to be performed (the less control the worker has, the more likely the worker is an employee); (2) the worker’s opportunity for profit or loss depending upon his or her managerial skill (the less opportunity, the more likely the worker is an employee); (3) the degree of the worker’s own investment in equipment or materials required for the work or employment of other workers (the greater degree, the more likely the worker is an independent contractor); (4) whether the service rendered requires a special skill, (if so, the more likely is independent contractor classification); (5) the degree of permanency and duration of the working relationship of the parties (the longer and more permanent the relationship, the more likely employee classification will be); and (6) the extent to which the services rendered are an "integral part" of the business (the greater the extent, the more likely is employee status). No single factor is determinative. See, e.g., Blair v. Transam Trucking, Inc., 309 F. Supp. 3d 977, 1002 (D. Kan. 2018); Real v. Driscoll Strawberry Associates, Inc., 603 F.2d 748 (9th Cir. 1979); In re Kokesch, 411 N.W.2d 559 (Minn. Ct. App. 1987); Mendez v. Brady, 618 F. Supp. 579 (W.D. Mich. 1985); Tobin v. Cherry River Boom & Lumber Co., 102 F. Supp. 763 (S.D. W. Va. 1952).
Although a farmer may have to classify many of its workers as employees due to the application of the economic realities test, a farmer is not required to classify immediate family members as employees. For the purposes of agriculture, the term “employee” does not include workers who are a parent, spouse, child, or other immediate family members. 29 U.S.C. §203(e)(3). This is an important exception for many family farming operations.
Why Classification Matters
There are various reasons for classifying a worker either as an employee or as an independent contractor.
- For many farmers, it’s simply easier to classify seasonal workers as independent contractors and pay them with a checks and issue Forms 1099 at year end. In addition, independent contractors are responsible for paying both the employer and employee portion of Social Security and Medicare taxes.
- For tax years beginning after 2017, the Tax Cuts and Jobs Act (TCJA) provides for a 20 percent deduction for the “qualified business income” of an independent contractor that is other than a C corporation. Wages of an employee don’t qualify.
- The staffing flexibly of independent contractors can be very beneficial and, if the farming operation is in a state that has at-will employment, employees can terminate the working relationship at any time for any reason. In contrast, an independent contractor’s ability to terminate a working relationship with a farmer is governed by a contract that the parties have negotiated.
- If a worker is an employee, the farmer-employer, has greater control over how, when, and which projects are completed at any given time. But, the use of an independent contractor provides the farm operation the flexibility of being able to acquire talent for a specific period of time without having to maintain an ongoing commitment, financial or otherwise.
What About Minimum Wage and Overtime Pay Requirements?
If a worker is an “employee,” the FLSA requires agricultural employers who use 500 “man-days” or more of “agricultural labor” in any calendar quarter of a particular year to pay the agricultural minimum wage to certain agricultural employees in the following calendar year. 29 CFR § 780.305. Man-days are those days during which an employee performs any agricultural labor for not less than one hour. The man-days of all agricultural employees count in the 500 man-days test, except those generated by members of an incorporated employer's immediate family. 29 U.S.C. § 203(e)(3). Five hundred man-days is roughly equivalent to seven workers working five and one-half days per week for thirteen weeks (5.5 x 7 x 13 = 501 man-days). Under the FLSA, “agriculture” is defined broadly. See 29 U.S.C. § 203(f). For related entities, where not all of the entities involve an agricultural trade or business, the question is whether the business operations are so intertwined that they constitute a single agricultural enterprise that is exempt from the minimum wage rules. See, e.g., Ares v. Manuel Diaz Farms, Inc., 318 F.3d 1054 (11th Cir. 2003).
Other agricultural exceptions from the minimum wage requirement include persons that are: (1) members of the employer's immediate family, unless the farm is incorporated; (2) local hand-harvest, piece-rate workers who come to the farm from their permanent residences each day, but only if such workers were employed less than 13 weeks in agriculture in the preceding year; (3) children age 16 and under whose parents are migrant workers, and who are employed as hand-harvest piece-rate workers on the same farm as their parents, provided that they receive the same piece-rate as other workers; and (4) employees engaged in range production of livestock. 29 U.S.C. § 213(a)(6). A higher monthly wage rate applies to a “ranch hand” who does not work in a remote location and works regular hours. See, e.g., Mencia v. Allred, 808 F.3d 463 (10th Cir. 2015).
If a worker is classified as an “employee,” the FLSA requires payment of at least one and one-half times an employee’s regular rate for work over 40 hours in a week. However, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. § 213(b)(12). Again, for this purpose, “agriculture” is defined broadly, and the 500 man-days test is not relevant. There are also certain workers that are exempt from being paid for hours worked that exceed 40 hours in a week. Included in this category are those “executive” workers whose primary duties are supervisory, and the worker supervises two or more employees. Also included are workers that fall in the “administrative” category who provide non-manual work related to the management of the business. Also exempt are those workers defined as “professional” whose job is education-based and requires advanced knowledge. Many larger farming and ranching operations have employees that will fit in at least one of these three categories.
Income Tax Withholding
For employees, the employer must withhold federal (and state) income tax. The withholding of tax from an individual’s wages is “treatment” of the individual as an employee. See, e.g., Priv. Ltr. Rul. 8323004 (Feb. 21, 1983). Also, it’s not possible to retroactively change the “treatment” of the workers as employees by filing Forms 941c (the Form for correcting withholding information) and requesting a refund of FICA taxes. Even assuming the farmer could do so, the farmer would be prevented from claiming workers as nonemployees for years he did not file the proper federal information tax returns. Likewise, “Section 530 relief” is not available to those taxpayers who did treat workers as employees by filing Forms 943 and withholding FICA taxes. It also doesn’t apply to those who treated workers as employees as a result of past audits.
One of the biggest risks in hiring “independent contractors” is misclassification because it can result in violations of wage, tax, and employment laws. Penalties can also be imposed for failing to timely deposit payroll taxes. Fines from the U.S. Department of Labor (DOL), IRS, and state agencies could total thousands of dollars. Farmers can be held responsible for paying back-taxes and interest on employee’s wages as well as FICA taxes that were not originally withheld. Failure to make these payments can result in additional fines. If the misclassification is found to be intentional, criminal penalties can apply. In addition, for employees, an employer must keep Form I-9 on record for each employee to establish employment eligibility.
Careful thought must be given to the proper classification of ag workers. The issue is particularly acute with respect to seasonal ag workers. Misclassifying can lead to serious consequences.
Monday, June 17, 2019
Eminent domain is the power of a state to take private property for public use consistent with the state’s constitution. In many states, the power has been legislatively delegated to municipalities, government subdivisions, as well as private persons and private corporations. Sometimes, the exercise of eminent domain intersects with agriculture, particularly when a pipeline is being put in or a wind energy company wants to erect industrial wind towers and landowners object.
How broad is the power of eminent domain? How do the federal and state constitutions protect private property? What does “public use” mean? Can a private company exercise eminent domain?
The exercise of eminent domain at the state level and the impact on agriculture – that’s the focus of today’s post.
The Power to “Take” Property
The power to “take” private property for public use (or for a public purpose) without the owner's consent is an inherent power of the federal and state government. However, the United States Constitution limits the government's eminent domain power by requiring federal and state governments to pay for what is “taken.” U.S. Const. 5th Amend. The “takings” clause of the Fifth Amendment has been held to apply to the states since 1897. Chicago, Burlington and Quincy Railroad Co., v. Chicago, 166 U.S. 226 (1897).
The Fifth Amendment states in part “...nor shall private property be taken for public use without just compensation.” Just compensation” equals fair market value, generally in cash. For partial takings, “severance damages” may be awarded in addition to compensation for the part taken. See, e.g., Sharp v. United States, 191 U.S. 341 (1903). The clause has two prohibitions: (1) all takings must be for public use; and (2) even takings that are for public use must be accompanied by compensation.
What Does “Public Use” Mean?
Historically, the “public use” requirement operated as a major constraint on government action. For many years, the requirement was understood to mean that if property was to be taken, it had to be used by the public – the fact that the taking was “beneficial” was not enough. Eventually, however, courts concluded that a wide range of uses could serve the public even if the public did not, in fact, have possession. Indeed, so many exceptions were eventually built into the general rule of “use by the public” that the rule itself was abandoned. In 1954 and again in 1984, the U.S. Supreme Court demonstrated its willingness to define expansively “public use,” and confirmed the ability of a state to use eminent domain power to transfer property outright to a private party, so long as the exercise of the eminent domain power was rationally related to a conceivable public purpose.
In recent years, however, state courts have split on the issue of whether the government’s eminent domain power can be exercised to take private homes and businesses for the development of larger businesses by private companies. The argument is that the larger businesses enhance “economic development” that increases jobs and tax revenue in the area and that this satisfies the Fifth Amendment’s “public use” requirement. However, in Bailey v. Myers, 206 Ariz. 224, 76 P.3d 898 (Ariz. Ct. App. 2003), the court determined that the condemnation of private property for redevelopment and sale to private parties was unconstitutional because the proposed use of the property was not public. Similarly, the Michigan Supreme Court has ruled that the exercise of the eminent domain power is proper only if (1) the private entities involved are public utilities that operate highways, railroads, canals, power lines, gas pipelines, and other instrumentalities of commerce; (2) the property remains under the supervision or control of a governmental entity; or (3) the public concern is accomplished by the condemnation itself (i.e., blighted housing has become a threat to public health and safety). County of Wayne v. Hathcock, 684 N.W.2d 765 (Mich. 2004).
In 2005, the Supreme Court clarified the difference among the states by again ruling that the eminent domain power can be exercised on behalf of a private party for economic development that benefits the public by increasing jobs and the tax base in the area. Kelo, et al. v. City of New London, 545 U.S. 469 (2005). Thus, if the exercise of eminent domain for a private party is done in conjunction with a development plan and does not involve obvious corruption, the taking will be allowed (and compensation will have to be paid). While the Supreme Court’s Kelo decision was a landmark one, the Court clearly deferred to states on the issue. At the federal level, if the condemnation of property is rationally related to a legitimate purpose of government (rather low hurdle to overcome) the taking will be approved. But, any particular state could restrict the exercise of eminent domain on behalf of private parties if they so desired.
In the wake of Kelo, several states either amended the state statutory process for proceedings involving condemnation of private property, or have amended the state constitution. Shortly after the Kelo decision, the Ohio Supreme Court has held that a taking providing nothing other than an economic benefit violates the Ohio constitution. City of Norwood v. Horney, 853 N.E.2d 1115 (Ohio 2006). The Ohio Supreme Court has previously held that Ohio landowners have a property interest in the groundwater underlying their land such that governmental interference with that right can constitute a taking. McNamara v. City of Rittman, 838 N.E .2d 640 (Ohio 2005).
What Does “Property” Mean?
The term “property” in the context of eminent domain, connotes all types of ownership interests – fee simple; partial interests; future interests; surface interests and even, perhaps, sub-surface interests. For example, in The Edwards Aquifer Authority, et al. v. Day, et al. 369 S.W.3d 814 (Tex. Sup. Ct. 2012), the Texas Supreme Court unanimously held, on the basis of oil and gas law, that landownership in TX includes interests in in-place groundwater. As such, water cannot be taken for public use without adequate compensation guaranteed by Article I, Section 17(a) of the TX Constitution. In the case, the plaintiffs were farmers that sought permit to pump underground water for crop irrigation purposes. The underground water at issue was located in the Edwards Aquifer and the plaintiffs' land was situated entirely within the boundaries of the aquifer. A permit was granted, but water usage under the permit was limited to 14 acre-feet of water rather than 700 acre-feet that was sought because the plaintiffs could not establish "historical use." The Court determined that the plaintiff's practice of issuing permits based on historical use was an unjustified departure from the Texas Water Code permitting factors.
Recent Case – The Dakota Access Pipeline
A recent opinion issued by the Iowa Supreme Court involving a pipeline seeking to exercise eminent domain, illustrates the intersection of the concept with agriculture. In Puntenney, et al. v. Iowa Utilities Board, No. 17–0423, 2019 Iowa Sup. LEXIS 69 (Iowa Sup. Ct. May 31, 2019), the Court was faced with the Dakota Access Pipeline that sought to use eminent domain against farmland owners so that its pipeline could be completed. The pipeline was piping oil from the oil fields of northwest North Dakota to southern Illinois. In 2014, the pipeline company filed documents with the Iowa Utilities Board (IUB) signifying its intent to lay a pipeline. The pipeline would traverse Iowa from the northwest corner to the southeast corner of the state, passing through eighteen counties over approximately 343 miles. At the end of 2014, the pipeline company held meetings in all eighteen counties.
In 2015, the pipeline company petitioned the IUB to start construction and sought “the use of the right of eminent domain for securing right of way for the proposed pipeline project” due to several landowners in the path of the pipeline refusing to grant an easement. The pipeline asserted such authority as a “common carrier” (a public or private entity that carries goods or people). In November and December of 2015, the IUB held hearings on the petition. Hundreds of people were present to give testimony for both sides. On March 10, 2016, the IUB issued a 159-page final decision and order. This order found that the pipeline would promote the public convenience and necessity, involve a capital investment in Iowa of $1.35 billion, and generate $33 million in Iowa sales tax during construction and $30 million in property tax in 2017. The order also noted that the pipeline had utilized a software program to lay the pipeline’s path to avoid critical areas, and that state law gave the pipeline the power to exercise eminent domain where necessary. After the IUB’s issuance of the order, several motions for clarification and rehearing were filed, which the IUB denied. Numerous parties sought judicial review of the order, and the parties were consolidated into a single case. On February 15, 2017, the trial court denied the petitions for judicial review.
On further review, Iowa Supreme Court addressed numerous issues. The Court determined that the Iowa Chapter of the Sierra Club had standing under state law on behalf of its affected members. Those members, the Court noted under Iowa law, did not need to be landowners, just aggrieved or adversely affected by “agency action.” On the legal issues, the Court looked at the standing of the parties. While the pipeline had already largely been constructed, the Court determined that the matter was not moot because the IUB retained the authority to impose other “terms, conditions, and restrictions” in the petitioners’ favor. On the IUB’s authority to issue a construction permit to the pipeline company based on the promotion of public convenience and necessity, the Court determined that the IUB’s decision to grant the permit was not “[b]ased upon an irrational, illogical, or wholly unjustifiable application of law” and its factual determinations were supported by “substantial evidence.” The Court noted that the evidence showed that the pipeline would reduce oil transport costs which would provide a lower price for petroleum products; transport oil more safely than rail; and provide secondary economic benefits to the citizens of Iowa. However, the Court did conclude that private economic development, by itself, is not a valid “public use.” Thus, the Court rejected the U.S. Supreme Court’s holding in Kelo - joining Illinois, Michigan, Ohio and Oklahoma. The Court also did not find any violation of the statutory limit on the use of eminent domain with respect to farmland because the pipeline company was a common carrier under the IUB’s jurisdiction – an entity not statutorily limited on the use of eminent domain on farmland. Thus, the Iowa Constitutional provision on the use of eminent domain was not violated, nor was the Fifth Amendment of the U.S. Constitution. The Court also upheld the IUB’s determination that the pipeline route was proper and need not be rerouted based on speculative surface development, but did conclude that the pipeline be laid under existing field drainage tile where necessary.
The use of eminent domain at the state level and taking of private property at the federal level is a significant concern for many farmers and ranchers. Certainly, the government must pay for what it takes (the issue of compensation is a topic for another day), but the extent to which a public use must be present is a key issue. The recent Iowa decision sheds some light on the question – at least in Iowa.
Thursday, June 13, 2019
Weather conditions in the Midwest and the crop-growing regions of the Great Plains have made it likely that prevented planting payments will be utilized by a greater percentage of impacted farmers this summer. If that happens, what are the regulatory and legal rules that kick-in that the recipient-farmer becomes subject to?
Prevented Planting Payments
The crop insurance final planting dates for corn have passed, but many areas of the soybean growing region (basically south of Minnesota and east of Nebraska) still have final planting dates for soybeans that remain but will expire soon. A farmer must weigh options of changing crops, planting soybeans or simply not planting at all. The economics of the situation will dictate the outcome. Crop insurance companies can provide guidance on eligible acres and production practices and the applicable rules for prevented planting payments. It’s also important to know what neighboring farmers are doing. Being the only farmer in a particular area to utilize prevented planting payments is not a good thing. If that happens, crop insurance adjusters and underwriters may could suddenly become reluctant to allowing payment on the claim.
Legal and Regulatory Matters
The governing statute on prevented planting payments is 7 U.S.C. §1508a. The language contained in that statute defines such things as “first crop,” “second crop,” and “replanted crop.” It then lays out the options that a producer has when a “first crop” is lost and what the rules are when a “second crop” is planted. Also, specified is the effect on actual production history and the area conditions that are required for payment. Also, detailed are the exceptions for established double cropping practices, among other things.
As with participation in any federal government farm program, the participating farmer becomes subject to the regulatory and legal framework of the particular program. That means that any dispute must be appealed to a final decision through the administrative process before redress can be available in the judicial system. Failure to preserve the administrative record can result in a court being unable to provide a remedy even though it may be clear that the farmer should prevail. That’s not a good position to be in.
Recent Prevented Planting Court Decisions
It is common for a prevented planting dispute to end up in arbitration. Two recent federal court opinions have concerned the operation of the arbitration process with respect to prevented planting payments.
A case from Nebraska involved the statutory time limit for the notice of application to vacate a crop insurance arbitration award and whether that statutory time limit could be waived. In Karo v. NAU Country. Ins. Co., 901 N.W.2d 689, 297 Neb. 798 (2017), the plaintiffs farmed together in Holt County, Nebraska. They each obtained federally reinsured crop insurance policies that the defendant serviced. In 2012, the plaintiffs submitted “prevented planting” claims under their crop insurance policies, claiming they were unable to plant corn on certain acres due to wet conditions. The defendant denied the plaintiffs’ prevented planting claims, finding that excessive moisture was not general to the surrounding area and did not prevent other producers from planting acres with similar characteristics. Pursuant to the mandatory arbitration clause in the policies, the parties submitted their disputes to binding arbitration.
The arbitrator issued a final arbitration award in favor of the defendant on January 21, 2014. On May 15, 2014, the plaintiffs filed a petition for judicial review in the Holt County District Court seeking to vacate the arbitration award under §10 of the Federal Arbitration Act (FAA) which provides “the district court wherein the award was made may make an order vacating the award upon the application of any party to the arbitration. . . where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.” The district court granted the plaintiffs’ summary judgment motion and vacated the arbitration award finding that the arbitrator exceeded his powers and manifestly disregarded the law.
The defendant appealed, but failed to note in the appeal that the plaintiffs did not meet the three-month time limit for appealing. Consequently, because the defendant did not raise the issue of the violation of the three-month limit, the appellate court had to determine whether the time limit was jurisdictional in nature and, thus, could not be waived even if the parties do not raise the issue. According to the U.S. Supreme Court, absent such a clear statement, the restriction should be treated as non-jurisdictional in character. Section 9 of the FAA which enumerates the notice requirements for judicial confirmation expressly states that after service of proper notice “the court shall have jurisdiction over the adverse parties to the arbitration.” Consequently, the appellate court determined that this was a clear indication that Congress intended the statutory requirements for service notice of an application for expedited judicial review under the FAA to be jurisdictional in nature. The appellate court held that although different timeframes apply for serving notice under section 9 and section 12 of the FAA, there is no difference in the mandatory process by which the adverse party must be served with notice and no difference in the practical purpose for requiring such notice. Thus, it would make little sense for Congress to give clear jurisdictional weight to service notice in one context but not the other.
In addition, the appellate court saw no indication in the statute that Congress intended the notice requirements for expedited judicial review to be jurisdictional when a party seeks judicial confirmation, but not jurisdictional when a party seeks judicial vacatur or modification. Consequently, the court determined that whether an arbitrating party is applying for judicial review to confirm and award under section 9 or to vacate or modify an award under section 10 and 11, Congress intended that party’s failure to serve notice of the application within the mandatory time limits, would have jurisdictional consequences. Because the appellate court concluded that the three-month requirement is jurisdictional in nature and the plaintiffs failed to comply with the three-month requirement the district court did not have authority under the FAA to vacate the arbitration award. Because the district court didn’t have jurisdiction to enter a judgment vacating the arbitration award under the FAA, the district court’s judgment was void. That meant that the appeal from the district court’s judgment didn’t confer any appellate jurisdiction on the appellate court – the Nebraska Supreme Court. The district court’s judgment was vacated and the appeal was dismissed for lack of jurisdiction.
In a more recent case from North Carolina, an arbitrator’s award was vacated. In Williamson Farm v. Diversified Crop Insurance Services, No. 5:17-cv-513-D, 2018 U.S. Dist. LEXIS 49249 (E.D. N.C. Mar. 26, 2018), the plaintiff, a farming partnership, bought crop insurance from the defendant for the 2013 crop year. The plaintiff intended to buy full crop coverage on all planted acres, and the defendant’s agents represented that the coverage purchased was full coverage. The plaintiff incurred a loss on one parcel, and was prevented from planting on two other tracts. The plaintiff filed claims for the losses under the policy and the defendant denied coverage on the basis that one tract on which the claim was made was listed under the policy as being in a different county and the tracts on which the plaintiff was prevented from planting crops were improperly claimed on an Farm Service Agency report. The defendant conceded that the errors were the fault of the defendant’s agents.
The plaintiff sought arbitration pursuant to the policy and was awarded coverage on the claims and treble damages. The arbitrator’s award was based on legal theories of negligence, breach of fiduciary duty, constructive fraud and violation of state (NC) law. The defendant challenged the arbitrator’s award as beyond the scope and authority of the arbitrator insomuch as the arbitrator engaged in interpreting the meaning, scope and applicability of the crop insurance policy at issue rather than obtaining an interpretation from the Federal Crop Insurance Corporation (FCIC).
The court agreed, noting that 7 U.S.C. §1506(l) pre-empts the arbitrator’s award unless FCIC procedures had been followed. The court also noted that the treble damages were based on the arbitrator finding a violation of NC law involving unfair and deceptive trade practices without first seeking a ruling from the FCIC. Accordingly, the court vacated the award as being beyond the arbitrator’s authority. On appeal, the U.S. Court of Appeals for the Fourth Circuit affirmed. Williamson Farm v. Diversified Crop Ins. Services, 917 F.3d 247 (4th Cir. 2019).
The decision whether to plant a crop or simply file for prevented planting payments is an important one. In that decisionmaking process will be included the notion that this spring’s second round of market facilitation payments can only be received if a crop is planted. That’s a key point. But, once a claim is filed, the regulatory and administrative process kicks-in. Those rules can be complex and confusing. Another good reason to have an attorney specially trained in agricultural law matters at your side.
Tuesday, June 11, 2019
The organization of the farming business is important to those farm and ranch families that are wanting to transition the business to the next generation. Other families don’t have heirs that are interested in continuing the family business. For them organizational issues are important from a present tax and farm program payment limitation standpoint (perhaps), but not necessarily that critical for future business succession.
In today’ post, I take a look at some recent developments relevant to entity structuring. These developments point out just a couple of the various issues that can arise in different settings.
S Corporation Basis Required to Deduct Losses
An S corporation shareholder reports corporate income or loss on their personal income tax return for the year in which the corporate year ends. I.R.C. §1366(a). Losses or deductions passed through to the shareholder first reduce stock basis. After stock basis has been reduced to zero, remaining loss amounts are applied against debt basis. I.R.C. §1367(b)(2)(A). In a year where losses decrease stock and debt basis to zero, the losses can be deducted only if the shareholder increases basis before the end of the corporation’s tax year.
One way to increase basis is to lend money to the S corporation. But, the loan transaction must be structured properly for a basis increase to result. For example, in In Litwin v. United States, 983 F.2d 997 (10th Cir. 1993), the court allowed the principal shareholder and principal investor in a Kansas corporation involved in the provision and installation of certain fuel systems for motor vehicles a bad debt deduction for amounts loaned to the corporation. Why? Because the shareholder’s loan was tied to his desire to remain a shareholder/employee and he personally guaranteed the large loans that exceeded his investment. In other words, he was at-risk and his business motives outweighed his investment motives.
But, a couple of recent developments reveal the wrong way to structure loan transactions if a basis increase is desired. In Messina v. Comr., T.C. Memo. 2017-213, the petitioners, a married couple, formed an investment advisory firm. They also each owned 40 percent of the outstanding stock of an S corporation. The S corporation subsequently became the 100 percent owner of another business that elected to be a qualified subchapter S subsidiary (QSUB). The QSUB borrowed money from an unrelated third party to finance the acquisition of another business. The petitioners then formed another S corporation that they were the sole owners of. They then used that second S corporation to buy the debt of the QSUB. The petitioners claimed that they could use the QSUB debt that the second S corporation held to increase their tax basis in the first S corporation so that they could deduct losses that passed through to them from the first S corporation. The petitioners claimed that the second S corporation was to be ignored because it was merely acting as an agent or conduit of the petitioners (an incorporated pocketbook of the petitioners). Thus, the petitioners claimed that they had made an actual economic outlay with respect to the acquisition of the QSUB debt to their financial detriment. As such, the petitioners claimed that the second S corporation should be ignored, and its debt actually ran directly between the first S corporation and its shareholders, of which they owned (combined) 80 percent.
The IRS disallowed the loss deduction due to insufficient basis and the Tax Court agreed. The Tax Court determined that there was no evidence to support the claim that the second S corporation was operating as the petitioners’ incorporated pocketbook. The Tax Court noted that the second S corporation had no purpose other than to acquire the debt of the QSUB, and the petitioners did not use the second S corporation to pay their expenses of the expenses of the first S corporation. There also was no evidence that the second S corporation was the petitioners’ agent because the corporation operated in its own name and for its own account. The Tax Court also held that the petitioners had not made any economic outlay except to the second S corporation. As such, the second S corporation could not be ignored, and the petitioners could not use its debt to increase their tax basis. The Tax Court noted that 2014 IRS final regulations and I.R.C. §1366(d)(1)(B) require that shareholder loans must run directly between the S corporation and the shareholder.
More recently, another court determined that an S corporation shareholder failed to achieve a basis increase on loan transaction. In Meruelo v. Comr., No. 18-11909, 2019 U.S. App. LEXIS 13305 (11th Cir. May 6, 2019), the taxpayer was a shareholder in an S corporation that bought a condominium complex in a bankruptcy sale. To fund its operations, the S corporation accepted funds from numerous related entities. Ultimately, lenders foreclosed on the complex, triggering a large loss which flowed through to the taxpayer. The taxpayer deducted the loss, claiming that the amounts that the related entities advanced created stock basis (debt basis) allowing the deduction. The IRS disallowed the deduction and he Tax Court agreed. The appellate court affirmed on the grounds that the advances were not back-to-back loans, either in form or in substance. In addition, the related entities were not “incorporated pocketbooks” of the taxpayer. There was no economic outlay by the taxpayer that would constitute basis. There also was no contemporaneous documentation supporting the notion that the loans between the taxpayer and the related entities were back-to-back loans (e.g., amounts loaned to a shareholder who then loans the funds to the taxpayer), and an accountant’s year-end reclassification of the transfers was not persuasive. While the taxpayer owned many of the related entities, they acted as business entities that both disbursed and distributed funds for the S corporation’s business expenses. The appellate court noted the lack of caselaw supporting the notion that a group of non-wholly owned entities that both receive and disburse funds can be an incorporated pocketbook. To generate basis, the appellate court noted, a loan must run directly between an S corporation and the shareholder.
The Peril of the Boilerplate
The use of standard, boilerplate, drafting language is common. However, there rarely are situations where “one-size-fits-all” language in documents such as wills, trusts, and formative documents for business entities will work in all situations. That point was clear in another recent development.
In a recent IRS Private Letter Ruling (directed to a specific taxpayer upon the taxpayer’s request), a multi-member LLC elected to be treated for tax purposes as an S corporation. Later, the shareholders entered into an operating agreement that governed the rights of shareholders. Section 10 of the agreement provided that, “Upon dissolution…the proceeds from the liquidation of the Company’s assets shall be distributed…to the Members in accordance with their respective positive Capital Account Balances; and, the balance, if any, to the Members in accordance with their respective Percentage interests.” The language is “boilerplate” and was intended to meet the substantial economic effect provisions of Treas. Reg. §1.704-1(b)(1) and protect special allocations of the partnership.
Unfortunately, the language did not require that the distributions be equal to a “per share” basis in all situations. Instead, they could be disproportionate upon liquidation to the extent of differences in their capital accounts at the time of liquidation. That proved to be a problem. The LLC engaged in a reorganization and sought a ruling on whether the language created a second class of stock that would terminate the S election. The IRS determined that the fact that the rights were not strictly proportionate created more than a single class of stock in violation of I.R.C. §1362(b)(1)(D) and terminated the S election as of the date of the adoption of the operating agreement. However, the IRS determined that the termination was inadvertent, and the S status of the LLC was restored retroactively. Priv. Ltr. Rul. 201918004 (Nov. 15, 2018).
Trusts – Is the End in Sight?
When does a trust end? Either by its terms or when there is no longer any purpose for it. Those are two common ways for a trust to end. This was an issue in a recent case from Wyoming. In re Redland Family Trust, 2019 WY 17 (2019), involved a family trust. The case had been before the Wyoming Supreme Court on multiple occasions. The trust was created in 1989 and amended in 1995. The amendment provided for the appointment of a successor trustee; always required the service of two trustees; created a marital trust for the survivor of the settlors; and revised the buyout provision. The grantors and their five children made contributions to the trust. Upon the death of one of the grantors in 2007 one of the children was appointed as co-trustee. Ligation arose when the surviving grantor’s property was not conveyed to the trust and then again involving removal of the trustees, and an appointed trustee moved to have the trust terminated due to the administrative difficulties to administer, family dysfunction, and because the trust no longer served its purpose. The defendants, (including the co-trustee that resigned) asserted that termination was moot and moved to have the new co-trustee removed. The trial court did not remove the co-trustee and found that the trust was still valid. The trial court found that the co-trustee did not violate any fiduciary duties and that the defendants failed to show gross and willful misconduct to justify her removal. Further the trial court found that the co-trustee’s claims that the trust was invalid should have been raised in the original trust challenge. The trial court determined that the primary reason for the trust (to keep the lands and leases together for the Redland family) had not been frustrated and that the trust remained administratively functional and was not "unlawful, contrary to public policy, or impossible.
On appeal, the Wyoming Supreme Court affirmed. The Court determined that the trust still had a purpose - to keep the ranch holdings together to conduct business. Even though the other purpose of minimizing tax consequences had failed, consolidation of ranch holdings remained a legitimate purpose. The Court also determined that the co-trustee did not violate her fiduciary duties, her duties of impartiality or loyalty, and that her actions did not amount to gross and willful misconduct. In addition, the Court found that the duty of impartiality did not require the trustee to treat all beneficiaries fairly, but simply to act in the best interest of the beneficiaries and equally defend the intentions of the settlors. While the Court could find no precedent with respect to the duty of loyalty the Court held that merely seeking termination of the trust was not a breach of loyalty. In addition, the Court determined that hostility between parties did not warrant removal.
There are various ways to structure business arrangements. Not every structure is right for each family situation, but there’s a unique business plan that will do well for you – once you figure out what your goals and objectives are and have a solid understanding of your factual setting. But, peril lurks. Today’s post examined just a couple of the issues that can arise. Make sure to have good planners assisting.
Friday, June 7, 2019
Is a farmer that raises an ag commodity (or commodities) under a production contract engaged in the trade or business of farming or a rental activity? Is the farmer engaged in both activities with respect to the same contract? Self-employment tax is imposed on a taxpayer’s trade or business income, but not on rental income. Are there components of both in a contract production setting?
The self-employment tax treatment of contract production income – that’s the topic of today’s post.
There has been a dramatic increase in the contract production of agricultural products of the past 50 years. According to the USDA, as of 2017, 34 percent of U.S. farm output is produced under contract. https://www.ers.usda.gov/webdocs/publications/90985/eib-203.pdf?v=9520.4 That’s up from 12 percent in 1969. Over the past 20 years, the average has been 37 percent. Id. The percentage exceeds 50 percent for peanuts, tobacco (presently 90 percent), sugarbeets, hogs and poultry/eggs. Id. There are billions of dollars associated with ag production contracts annually.
There are two basic types of contracts involving the production of agricultural commodities. For crop farms, marketing contracts predominate. Under a marketing contract, the farmer retains ownership of the commodity while the commodity is being raised. The contract is entered into before harvest and establishes a price for a certain amount of commodity to be sold along with delivery date(s). This could also be termed a “forward” contract, and it may contain a payment or pricing clause that would make it a deferred contract for tax purposes. The other type of contract is a production contract. With this type of contract, the contracting firm owns the ag commodity during the production process, and the farmer is paid a fee for services rendered under the contract. The contract will set forth each party’s responsibilities with respect to the provision of inputs and services. Production contracts predominate in the poultry and hog industries.
The Self-Employment Tax Issue
Definition of self-employment income. I.R.C. §1402(a) of the Code, defines “net earnings from self-employment” as “the gross income derived by an individual from any trade or business carried on by such individual…”. Is an ag producer raising a commodity or commodities under a production contract engaged in a “trade or business.” If so, self-employment tax is owed on the contract income. Conversely, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. To date, the IRS hasn’t pushed the employer/employee line of argument. However, the same cannot be said for the self-employment tax issue.
In Gill v. Comr., T.C. Memo. 1995-328, a farmer who contracted with a poultry supplier to raise poultry flocks in barns constructed on the farmer's property, but leased to the supplier, was liable for self-employment tax on payments received under the contract from the supplier because the farmer materially participated in raising the poultry That determination was made based on the services that the farmer was required to provide under the contract. They were extensive. Likewise, in Schmidt v. Comr., T.C. Memo. 1997-41, a dairy farmer who contracted with a vegetable cannery to raise beets on a portion of his farm was also found liable for self-employment tax on the contract payments. The contract required the farmer to supply the labor and equipment to produce the beets.
Exception for “rents.” I.R.C. §1402(a)(1) specifies that “there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares.” That’s an important exception in the ag production contract setting. When an ag production contract also involves the rental of a building (particularly in livestock production settings), if the contract is structured properly the portion of the contract payment attributable to the building should not be subject to self-employment tax. If the contract calls for two separate checks to be issued to the producer (one for building rent and another for services rendered) the tax reporting is simplified – Schedule E for the building rent and Schedule F for the contract services payment. But, if a single check is issued the tax reporting is more difficult. In that situation, the producer will need supporting documentation and evidence of fair rental rates for comparable buildings as well as evidence supporting reasonable labor rates to be able to separate out the building rent portion from the services. Doing so will minimize self-employment tax.
What about W-2 wage income? As noted above, if the producer is merely an employee of the supplier under the contract, the supplier must withhold taxes on wages paid, and there is liability for Social Security and, perhaps, federal unemployment tax on both the producer and the supplier. That’s not likely to be the case – ag production (and marketing) contracts commonly recite that an employment relationship is not created. Even if there is no specific contract clause stating that the producer is not an employee, the typical contract language and producer requirements would likely not create one. In addition, the definition of self-employment income focuses on income derived from a “trade or business” that a taxpayer engages in on a regular and continuous basis. That is different than the definition of “wages” under I.R.C. §3121 which defines “wages” as “remuneration for employment.” I.R.C. §3121(a). In other words, the presence of an employer/employee relationship is the key. In contract production settings that is not present.
What about “nexus”? Income is self-employment taxable if there is a connection or “nexus” between the income a taxpayer receives, and the taxpayer’s conduct of a trade or business based on all of the facts and circumstances. See, e.g., Newberry v. Comr., 76 T.C 441 (1981); Groetzinger v. Comr., 480 U.S. 23 (1987). In an ag contract production situation, that would be broad enough to subject all of the contract income to self-employment tax. That’s where the real estate rental exception of I.R.C. §1402(a)(1) comes into play. That exception effectively severs the “nexus” with respect to building rents. Without that exception the nexus test has a broad application. See, e.g., Slaughter v. Comr., T.C. Memo. 2019-65.
Many ag products are produced via contract. The rental real estate exception can play an important role in minimizing self-employment tax. Proper structuring of the production arrangement economically and careful drafting of the contract for tax purposes can lead to a more profitable venture for the producer.
Wednesday, June 5, 2019
Centuries ago, the seas were viewed as the common property of everyone - they weren’t subject to private use and ownership. This concept was later adopted in English law, the Magna Carta, and became part of the common (non-statutory) law in the United States. Over the years, the doctrine has been primarily applied to access to the seashore and intertidal waters, but it can also be applied with respect to natural resources. A recent case involving seaweed involved the application of the public trust doctrine.
The public trust doctrine and the right to harvest seaweed – that’s the topic of today’s post.
The U.S. Supreme Court’s first application of the public trust doctrine was in 1842 in Martin v. Lessee of Waddell, 41 U.S.367 (1842). In the case, the issue was who had the right to submerged land and oyster harvesting off the coast of New Jersey. The Court, largely based on the language in the charter granted by the King to a Duke to establish a colony and for policy and economic reasons, determined that the land area in issue belonged to the state of New Jersey for the benefit of the people of the state. The Court dealt with the issue again in 1892 in a case involving a railroad that had been granted a large amount of the Chicago harbor. Illinois Central Railroad Company v. Illinois, 146 U.S. 387 (1892). The Court determined that the government cannot alienate (interfere with) the public’s right to access land under waters that are navigable in fact except for situations where the land involved wouldn’t interfere with the public’s ability to access the water or impair navigation.
As generally applied in the United States (although there are differences among the states), an oceanfront property owner can exclude the public below the mean high tide (water) line. See e.g., Gunderson v. State, 90 N.E. 3d 1171 (Ind. 2018). That’s the line of intersection of the land with the water's surface at the maximum height reached by a rising tide (e.g., high water mark). Basically, it’s the debris line or the line where you would find fine shells. However, traceable to the mid-1600s, Massachusetts and Maine recognize private property rights to the mean low tide line even though they do allow the public to have access to the shore between the low and high tide lines for "fishing, fowling and navigation. In addition, in Maine, the public can cross private shoreline property for scuba diving purposes. McGarvey v. Whittredge, 28 A.3d 620 (Me. 2011).
Other applications of the public trust doctrine involve the preservation of oil resources, fish stocks and crustacean beds. Also, many lakes and navigable streams are maintained via the public trust doctrine for purposes of drinking water and recreation.
The public trust doctrine was invoked recently in a Maine case. In Ross v. Acadian Seaplants, Ltd., 2019 ME 45 (2019), the defendants harvest rockweed with skiffs in the intertidal zones of Maine. Rockweed is a perennial plant that attaches to the rocks in the intertidal zones. Rockweed regulates the temperature of the area where it is located and is home to many organisms. Commercially, rockweed is used for fertilizer and feed. To harvest Rockweed, the defendant uses skiffs, rakes, and watercraft without physically stepping foot on the intertidal zone. The defendant annually harvests the statutory maximum 17 percent of eligible harvestable rockweed biomass in Cobscook Bay. The plaintiff, an intertidal landowner, sued seeking (1) a declaratory judgment that the plaintiff is the exclusive owner of the rockweed growing on and affixed to his intertidal property; and (2) injunctive relief that would prohibit the defendant from harvesting rockweed from the plaintiff’s intertidal land without his permission. The defendant sought a judgment declaring that harvesting rockweed from the intertidal water is a public right as a form of "fishing" and "navigation" within the meaning of the Colonial Ordinance. The trial court granted summary judgment for the plaintiff on the declaratory judgment claim, and on the defendants’ counterclaim. The trial court denied the defendant’s counterclaim.
On appeal, the state Supreme Court affirmed, holding that rockweed that is attached to and growing on rocks in the intertidal zone is private property owned by the adjacent landowner. The Court noted that the English common law tradition vested both “title” to and “dominion” over the intertidal zone in the crown. While title belonged to the crown, however, it was held subject to the public’s rights of “navigation,” “commerce,” and “fishing.” After the American colonies gained independence, the ownership of intertidal land devolved to the particular state where the intertidal area was located. See, e.g., Phillips Petroleum Co. v. Mississippi, 484 U.S. 469 (1988). But, the Court noted the uniqueness of rockweed. It takes specialized equipment and skills to harvest it, and harvesting didn’t “look like” the usual activities in the water of fishing and navigation. Instead, it was more like the other uses in the intertidal zone that have been held to be outside the public trust doctrine. Thus, the Court concluded that the harvesting of rockweed was not within the collection of rights held by the State for use by its citizens – the public couldn’t engage in rockweed harvest as a matter of right. The Court stated that, "rockweed in the intertidal zone belongs to the upland property owner and therefore is not public property, is not held in trust by the State for public use, and cannot be harvested by members of the public as a matter of right."
The application of the public trust doctrine has the potential to be quite broad. Environmental activists and others opposed to various agricultural activities often attempt to get courts to apply the doctrine in an expansive manner well beyond public access to that of preservation in general. The potential application of the doctrine can be rather expansive – nonpoint source pollution from farm field runoff; wetlands; dry sand areas; cattle ranching in areas of the West, etc. See, e.g., Mathews v. Bay Head Improvement Association, 471 A.2d 355 (N.J. 1984). The issue is acute in California where a private party can bring an independent action against a state agency under the public trust doctrine when that agency allegedly doesn’t follow the public trust in the conduct of its duties. See Citizens for Biological Diversity, Inc. v. FPL Group, Inc., 83 Cal. Rptr. 3d 588 (Cal Ct. App. 2008); San Francisco Baykeeper, Inc. v. State Lands Commission, 29 Cal. App. 5th 562, 240 Cal. Rptr. 3d 510 (2018).
In the recent Maine case, the public trust doctrine was not used to unnecessarily erode private property rights. The Court balanced the public’s rights against those of private property owners. It wasn’t enough for the plaintiff to simply assert the public trust doctrine.
Maybe there’s hope that the public trust doctrine will be properly balanced against the rights of private landowners. The recent Maine case weighs in on that side of the scale.
Monday, June 3, 2019
Earlier this spring I devoted two blog posts to the topic of cost segregation studies. In those, I mentioned that the purpose of such a study is to generate greater depreciation deductions by parsing out tangible personal property (that is depreciated over a shorter recovery period) from real estate when depreciable real estate is acquired in a transaction. But, one of the downsides of separating out tangible personal property from the real estate is the possibility of recapture – that dirty word in tax.
Cost segregation and the potential for recapture – that’s the topic of today’s post. I would also like to acknowledge Ken Wright’s assistance with today’s post. Ken is a lawyer in Chesterfield, MO and a lecturer on tax and estate planning topics. He brought to my attention the very real problem of recapture when a cost segregation study has been utilized and provided commentary for today’s post.
Cost Segregation Study - Why Do It?
According to the American Society of Cost Segregation Professionals, a cost segregation is "the process of identifying property components that are considered "personal property" or "land improvements" under the federal tax code." Cost segregation is the engineering and accounting process of identifying those items of personal property that are contained within real property, and separating out the items of personal property for MACRS purposes. Land is not depreciable, but structures associated with land are. From a depreciation standpoint, that means that there may be opportunities to allocate costs to personal property or land improvements that are depreciable.
A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate). In tax lingo, a cost segregation study often results in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period. See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property). That is what generates larger depreciation deductions in any particular tax year.
The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on commercial and business property (including property found on a farm or ranch), and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets. These changes make it more likely that a cost segregation study will provide additional tax benefits.
Potential Recapture Issue
When a component of I.R.C. §1250 property is reclassified as I.R.C. §1245 property, the total depreciation allowable on the reclassified item is the same. The benefit comes from the present value of the tax savings resulting from the acceleration of the depreciation deduction. However, depreciation recapture can occur on disposition. Depreciation on an I.R.C. §1245 asset is subject to ordinary income recapture in accordance with I.R.C. §1245 and is ineligible for long-term capital gain treatment under I.R.C. §1231. The impact of this result depends on the particular taxpayer’s marginal tax bracket at the time the recaptured amount is taxed. If the item of property had not been reclassified, gain on it would have been subject to a maximum rate of 25 percent as unrecaptured I.R.C. §1250 depreciation. Thus, the ordinary income penalty could be de minimis or it could be as much as 37 percent for individuals (but only 21% for C corporations).
The recapture issue may be more problematic if the disposition of the reclassified asset is via installment sale, like-kind exchange or involuntary conversion. Although gain from a sale of I.R.C. §1231 property can be reported on the installment basis, installment reporting is not permitted for I.R.C.§1245 depreciation recapture. Instead, all I.R.C. §1245 recapture is treated as cash received in the year of sale and must be reported. IRC § 453(i). The taxpayer’s basis in the property for purposes of calculating the gross profit ratio (part of the procedure for computing taxable gain on an installment sale transaction) is then increased by the amount of depreciation recapture and any remaining gain is taxed each year using the recomputed gross profit ratio.
Care should be taken in an installment sale transaction by a taxpayer who has reclassified a significant portion of a property’s basis as I.R.C. §1245 tangible personal property to get enough cash down to pay the tax liability resulting from the recapture along with any first-year payments. (This may also lead to some creative purchase price allocations in sales contracts.)
Ordinary income recapture under I.R.C.§1245 applies to any disposition of I.R.C. §1245 property notwithstanding any other provision of the Code unless there is an express exception contained in I.R.C. §1245. I.R.C. § 1245(a)(1). I.R.C. §1245(b)(4) provides a limited exception from the recapture rules for like-kind exchanges under I.R.C. §1031 and involuntary conversions under I.R.C. §1033. Under the exceptions, if property is disposed of and there is nonrecognition of gain under I.R.C. §1031 or I.R.C. §1033, then the amount of gain to be taken into account under I.R.C. §1245 by the seller is not to exceed the sum of the amount of gain recognized on the disposition determined without regard to I.R.C. §1245 (effectively boot received under I.R.C. §1031 and proceeds not reinvested under §1033), plus the fair market value of any property that is received and which is not I.R.C. §1245 property and has not already been taken into account as gain.
The application of the application rules in the event a portion of the real property is reclassified as §1245 property is illustrated by the following example that is based on Treas. Reg. §1.1245-4(d)(5).
Sam Sung owns I.R.C. §1245 property, with an adjusted basis of $100,000 and a recomputed basis of $116,000. The property is destroyed by fire and Sam receives $117,000 of insurance proceeds that triggers $16,000 of recapture.
Sam uses $105,000 of the proceeds to purchase I.R.C. §1245 property similar or related in service or use to his original property, and $9,000 of the proceeds to purchase stock in the acquisition of control of a corporation owning property similar or related in service or use to Sam’s original property. Both acquisitions qualify under the involuntary conversion rules. Sam properly elects to limit recognition of gain to the amount by which the amount realized from the involuntary conversion exceeds the cost of the stock and other property acquired to replace the converted property.
Since $3,000 of the gain is recognized (without regard to the I.R.C. §1245 recapture rules) under the involuntary conversion rules for failure to purchase sufficient replacement property (that is, $117,000 minus $114,000), and since the stock purchased for $9,000 is not I.R.C. §1245 property and was not taken into account in determining the gain under the involuntary conversion rules, the amount of the gain taken into account as I.R.C. §1245 recapture is limited to $12,000 (that is, $3,000 plus $9,000).
If, instead of purchasing $9,000 in stock, Sam purchases $9,000 worth of property which is I.R.C. §1245 property similar or related in use to the destroyed property, the recapture amount would be limited to $3,000. The result would have been the same had the transaction been structured as an I.R.C. §1031 exchange.
As noted above, a building containing items that have been reclassified as I.R.C. §1245 tangible personal property for MACRS purposes as the result of a cost segregation study does not change the classification of the property for purposes of the like-kind exchange provisions of I.R.C. §1031 or the involuntary conversion rules of I.R.C. §1033. Consider the following example:
Ray Ovac reclassifies 25 percent of the basis of items in a building as being 7-year MACRS property and claims accelerated depreciation. All of the items are otherwise structural components of the building and therefore classified as real property under state law. Ray later trades the building and associated land in a like-kind exchange for unimproved land. For purposes of applying the like-kind exchange rules of I.R.C. §1031, Ray is treated as having traded real property for real property. Ray will recognize gain under I.R.C. §1245, however, unless the FMV of the 25 percent of the basis that was reclassified as I.R.C. §1245 property is replaced by an equal or greater FMV of I.R.C. §1245 property. The point of this is to ensure that the I.R.C. §1245 recapture carries over to the replacement I.R.C. §1245 property and is not subsumed by the replacement I.R.C. §1250 property.
The recapture potential as the result of a cost segregation study should always be kept in mind.
Thursday, May 30, 2019
During the significant economic downturn of early 2008 that continued through mid-2009 and then turned into an anemic recovery until 2017, foreign investors sought U.S. farmland as an alternative to stocks. This has caused concern in some corners of ag. It’s an issue of national security – potentially disloyal parties should not be owning the U.S. real estate food base. As of the end of 2016, the USDA reported that foreign individuals and entities held interests in 28.3 million acres of U.S. agricultural land. That amounts to 2.2 percent of all privately held U.S. ag land and about one percent of all U.S. land. This has also raised questions about whether there are laws are on the books that might protect American soil from being owned by foreign persons and interests.
Foreign ownership of agricultural land – that’s the topic of today’s post.
Under the English common law, aliens could not acquire title to land except with the King's approval. The common law rule existed in England until it was abolished by statute in 1870. However, by that time, the notion of limiting alien ownership of agricultural land was well imbedded in United States jurisprudence. In the 1970s, the issue of foreign investment in and ownership of agricultural land received additional attention because of several large purchases by foreigners and the suspicion that the build-up in liquidity in the oil exporting countries would likely lead to more land purchases by nonresident aliens. The lack of data concerning the number of acres actually owned by foreigners contributed to fears that foreign ownership was an important and rapidly spreading phenomenon.
In 1978, the Congress enacted the Agricultural Foreign Investment Disclosure Act (AFIDA). 7 U.S.C. 3501 et seq. Under AFIDA, the USDA obtains information on U.S. agricultural holdings of foreign individuals and businesses. In essence, AFIDA is a reporting statute rather than a regulatory statute. The information provided in reports by the AFIDA helps serve as the basis for any future action Congress may take in establishing direct controls or limits on foreign investment in agricultural land and provides useful information to states considering limitations on foreign investment. The Act requires that foreign persons report to the Secretary of Agriculture their agricultural land holdings or acquisitions. The Secretary assembles and analyzes the information contained in the report, passes it on the respective states for their action and reports periodically to the Congress and the President.
AFIDA requires reports in four situations: (1) when a foreign person “acquires or transfers any interest, other than a security” in agricultural land; (2) when any interest in agricultural land, except a security interest, is held by any foreign person on the day before the effective date of the Act; (3) when a nonforeign owner of agricultural land subsequently becomes a foreign person; and (4) when nonagricultural land owned by a foreign person subsequently becomes agricultural land.
AFIDA defines “agricultural land” as “any land located in one or more states and used for agricultural, forestry, or timber production purposes...”. 7 U.S.C. § 3508(1). The regulations define agricultural land as “land in the United States which is currently used for, or if currently idle, land last used within the past five years, for farming, ranching, or timber production, except land not exceeding ten acres in the aggregate, if the annual gross receipts from the sale of the farm, ranch, or timber products produced thereon do not exceed $1,000. 7 C.F.R. § 781.2(b).
The reporting provisions of the AFIDA require the disclosure of considerable information regarding both the land and the reporting party. Individuals who are not U.S. citizens, and have purchased or sold agricultural land must report the transaction to the USDA’s FSA with 90 days of the closing. The information must be reported on Form FSA-153, and failure to do so can result in civil penalties of up to 25 percent of the fair market value of the property. The information to be disclosed includes: (1) the legal name and address of the foreign person; (2) the citizenship of the foreign person, if an individual; (3) if the foreign person is not an individual or government, the nature of the legal entity holding the interest, the country in which the foreign person is created or organized, and the principal place of business; (4) the type of interest in agricultural land that the person acquired or transferred; (5) the legal description and acreage of the agricultural land; (6) the purchase price paid, or other consideration given, for such interest; (7) the agricultural purposes for which the agricultural land is being used and for which the foreign person intends to use the agricultural property; and (8) such other information as the Secretary of Agriculture may require by regulation. 7 U.S.C. § 3501(a)(9).
While federal law requires informational reporting, some states have enacted statutes designed to restrict alien ownership of real property. The state laws are generally of three types: (1) outright restrictions on the acquisition of certain types of property; (2) limitations on the total amount of land that can be acquired; and (3) limitations on the length of time property can be held. Acquisition restrictions are common in the agricultural context, with the restriction generally applying only to the acquisition of farmland, as defined by the law. Exceptions are common for the acquisition of land for conversion to non-agricultural purposes, land acquired by devise or descent, and land acquired through collection of debts or enforcement of liens or mortgages. Acreage restrictions allow foreign investment, but place a premium on having an effective method of discovering and preventing multiple acquisition by the same individuals through the use of various investment vehicles. Time restrictions generally do not apply to voluntary acquisition of the land by foreign investors, but are associated with involuntary acquisitions. Some states require the disclosure of information concerning the land acquired and the investors.
Currently, thirty states restrict agricultural land acquisition by aliens. Consider the following three states as examples of states that have more restrictive provisions:
- Iowa - Presently, Iowa has the most restrictive limitation on nonresident alien ownership of any state in the United States. Iowa Code §9I. The Iowa restriction provides that a “nonresident alien, foreign business, or foreign government, or an agent, trustee or fiduciary thereof, shall not purchase or otherwise acquire agricultural land in this state.” A major exception exists that allows restricted parties to acquire up to 320 acres of agricultural land for “an immediate or pending use other than farming” if the conversion is completed within five years, and annual reports on the progress of the conversion are made. In addition, during the five-year period, the land can only be farmed on lease to a family farm, a family farm corporation, or an authorized farm corporation. The Iowa law also provides that agricultural land acquired by nonresident aliens by devise or descent must be divested within two years. However, if the land is acquired by devise or descent from another nonresident alien, it need not be divested, unless the nonresident alien originally acquired the land in the six months preceding enactment of the law.
- Under the Minnesota law, no natural person (unless a United States citizen or a permanent resident alien of the United States) can acquire, directly or indirectly, any interest in agricultural land, including leaseholds. Minn. Stat. Ann. § 500.221.1. Foreign corporations cannot, either directly or indirectly, acquire or obtain any interest in title to agricultural land unless at least 80 percent of each class of stock issued and outstanding or 80 percent of the ultimate beneficial interest of the entity is held, directly or indirectly, by United States citizens or permanent resident aliens. Land can be acquired by devise, inheritance, as security for indebtedness, by process of law in the collection of debts, or by enforcement of a lien, but land acquired in these fashions must be divested within three years of acquisition. Similarly, land or interests acquired in connection with mining and mineral processing operations are permissible but, pending development for mining purposes, the land can only be used for farming on lease to a family farm, family farm corporation or authorized farm corporation. Another exception exists for agricultural land operated for research or experimental purpose if the total acreage does not exceed that held on May 27, 1977.
- Missouri law prohibits aliens and foreign businesses from acquiring by grant, purchase, devise or descent, agricultural land in the state. Mo. Rev. Stat. §§ 442.560-442.592. Under the legislation, “alien” is defined as any person who is not a citizen of the United States and who is not a resident of the United States or its holdings. Mo. Rev. Stat. § 442.566(2). A “foreign business” is defined as “any business entity whether or not incorporated, including but not limited to corporations, partnerships, limited partnerships, and associations in which a controlling interest is owned by aliens.” Mo. Rev. Stat. § 442.566(4). Agricultural land is defined as any tract consisting of more than five acres whether inside or outside the corporate limits of any municipality, which is capable of supporting an agricultural enterprise including production of agricultural crops, livestock, poultry and dairy products. Farm leasehold interests of ten years or longer or a lease renewable at the lessee's option for greater than ten years are treated as the acquisition of agricultural land. An exception exists for agricultural land acquired for immediate or potential use in non-farming purposes, but the exception is limited to that amount of land necessary for the nonfarm business operation. While the nonfarm activity is being developed, the land may only be farmed under lease to a family farm unit, family farm corporation, or a registered alien or foreign business. The Missouri legislation also contains a reporting requirement requiring any foreign person holding any interest (other than a security interest) in agricultural land to submit a detailed report to the Director of Agriculture within 60 days, except for land used for the production of energy-related minerals. The information required to be submitted includes the name and address of the foreign person, the citizenship of foreign individuals, the type of interest in acquired land held or transferred, a legal description of the land, the purchase price or consideration paid or received, information concerning transferees, and the declaration of the type of agricultural activity engaged in or the nonfarm purpose for which the land was acquired. Failure to file a required report is subject to civil fine.
Other states that restrict foreign interests in ag land in one form or another (some restrictions are very minor) are: Alabama, Alaska, Arkansas, California, Georgia, Hawaii, Idaho, Illinois, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Mississippi, Nebraska, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, Virginia, Washington, Wisconsin and Wyoming.
While there is no bar on foreign ownership of agricultural land at the federal level, a majority of states have some sort of restriction. In many of these states, those restrictions are minor. The states with the most extensive restrictions tend to be in the center of the country. Other states have no restrictions at all or place the same restrictions on foreign individuals or entities as they do domestic ones.
Tuesday, May 28, 2019
Last week the USDA announced a second round of Market Facilitation Program (MFP) payments would be forthcoming. This is a support program in a long line of federal government support programs for farmers going back decades. Some farmers will pledge these payments to lenders as collateral for loans. That raises important questions – how are MFP payments classified from a secured transactions perspective? Are they “proceeds” of crops? In ag, “proceeds” can take many forms. Where do MFP payments fit, and what must a lender do to secure its interest in the payments?
Lenders’ rights in MFP payments – that’s the topic of today’s post.
MFP Payments – In General
The MFP is a USDA federal farm program that the Farm Service Agency (FSA) administers. The MFP provides “payments to farmers with commodities that have been significantly impacted by actions of foreign governments resulting in the loss of traditional exports.” 83 Fed. Reg. 169, p. 44173 (Aug. 20, 2018). In 2018, the first round of MFP payments was authorized. Those payments were paid for various crops as an advance payment of 50 percent of a producer’s final production times a rate for each crop or commodity. The MFP payment rate was $1.65/bu. for certified 2018 soybean production; $.86/bu. for sorghum; $.14/bu. for wheat; $.12/hundredweight for dairy; and $8/head for pork – just to name a few of the commodities that were covered by the program. There was a separate $125,000 payment limit that applied for the 2018 MFP payments, but they were subject to the $900,000 AGI limitation.
Now, the USDA has announced a 2019 MFP payment. This payment will be based on a per-acre payment tied to the county where the producer’s particular farm is located. But, to be eligible for an MFP payment, a producer must actually plant crops. Another form of payments – prevented planting payments – will be available under the rules applicable to that program for producers that aren’t able to plant due to weather-related conditions. Whether there will be a separate $125,000 payment limitation for the 2019 MFP payment remains to be determined. If not, larger farming operations where the operating entity limits liability will be subject to a single $125,000 payment limit for all payments, including the MFP payment. In addition, the $900,000 AGI limitation is waived for producers with at least 75 percent of their AGI from farming.
MFP payments are not deferable for income tax purposes as are crop insurance payments that are paid for actual physical destruction to the taxpayer’s crops. Instead, MFP payments are for lost profit rather than to compensate a producer for physical damage or destruction to crop, or the inability to plant (the requirement for deferability under I.R.C. §451(f)). Because they are intended to compensate a farmer for lost profits, they are included in gross income in accordance with I.R.C. §61(a). See also Rev. Rul. 73-408, 1973-2 C.B. 15; Rev. Rul. 68-44, 1968-1 C.B. 191. They are also similar to counter-cyclical and price-loss payments authorized under prior Farm Bills which a farmer/recipient had to include in gross income. MFP payments must included in net earnings from self-employment and, thus, subject to self-employment tax because they are tied to earnings derived by a farmer from the farming business. See, e.g., Ray v. Comr., T.C. Memo. 1996-436; IRS Legal Advice to Program Managers, PMTA-2018-21 (Dec. 10, 2018).
MFP Payments As Loan Collateral
The security interest created by a security agreement is a relatively durable lien. The collateral may change form as the production process unfolds. Fertilizer and seed become growing crops, animals are fattened and sold, and equipment is replaced. The lien follows the changing collateral, and in the end, may attach to the proceeds from the sales of products (at least up to ten days after the debtor receives the proceeds).
The “proceeds” issue. What are “proceeds” of crops or livestock? In ag, “proceeds” can take the form of crop insurance payments, prevented planting payments, storage payments, disaster relief payments, and other types of government payments. State law interpretations of Article 9 of the Uniform Commercial Code (UCC) can differ, but Article 9 provides an extensive and careful coverage for security interests in proceeds. Proceeds are generally defined as whatever is received upon the sale, trade-in or other disposition of the collateral covered by the security agreement. Revised UCC § 9-102(a)(64)(A). “Proceeds” also includes whatever is distributed or collected on account of collateral. But, a disposition is not necessarily required. See, e.g., Western Farm Service v. Olsen, 90 P.3d 1053 (Wash. 2004), rev’g, 59 P.3d 93 (Wash. Ct. App. 2003).
The general intent of Article 9 is to give the secured party with a security interest in collateral a similar security in anything which the debtor received from third parties in exchange for that collateral. No specific reference to proceeds is required in the security agreement. UCC §9-203. Indeed, the attachment of a security interest in collateral automatically gives the secured party an interest in the proceeds if they are identifiable. UCC § 9-203(f).
As noted above, in ag settings, “proceeds” of crops or livestock can take several forms. These can include federal farm program deficiency payments, storage payments, diversion payments, disaster relief payments, insurance payments for destroyed crops, Conservation Reserve Program payments and dairy herd termination program payments, among other forms. See, e.g., FMB-First Michigan Bank v. Van Rhee, 681 F. Supp. 1264 (W.D. Mich. 1987). This is significant in agriculture because of the magnitude of the payments. In fact, in debt enforcement or liquidation settings, the federal payments are often the primary or only form of money remaining for creditors to reach. However, it should be noted that at least two courts have held that the Federal Crop Insurance Act (FCIA) preempts UCC Article 9. Thus, according to these courts, the exclusive method for a creditor to obtain a lien in undisclosed proceeds is through the FCIA authorized assignment process. In re Duckworth, No. 10-83603, 2012 Bankr. LEXIS 1219 (C.D. Ill. Mar. 22, 2012); In re Cook, 169 F.3d 271 (5th Cir. 1999).
In general, for governmental agricultural payments to qualify as proceeds, three conditions must be met: (1) the crop must have been planted; (2) the crop must have been lost or destroyed; and (3) the government payment being claimed must have been received by the producer for the lost or destroyed crop. See, e.g., In re Schmaling, 783 F.2d 680 (7th Cir. 1986); ConAgra, Inc. v. Farmers State Bank, 602 N.W. 2d 390 (Mich. Ct. App. 1999). Thus, the majority of courts hold that if deficiency payments are made to supplement a planted crop's depressed market price, they are proceeds. Other courts have held that deficiency payments are not proceeds primarily because the payments are made regardless of whether the farmer harvests or sells a crop. See, e.g., In re Hunerdosse, 85 B.R. 999 (Bankr. S.D. Iowa 1988); In re Kruger, 78 B.R. 538 (Bankr. N.D. Ill. 1987); In re Kingsley, 865 F.2d 975 (8th Cir. 1989). Similarly, government payments received for the inability to produce crops have been determined to not be proceeds. See, e.g., In re Schmitz, 270 F.3d 1254 (9th Cir. 2001). The courts seem to distinguish between payments that replace lost crops (or their markets) and payments that are paid in substitution of a crop. The former constitutes “proceeds” of crops and the later are general intangibles. See, e.g., In re Mattick, 45 B.R. 615 (Bankr. Minn. 1985).
What about MFP payments? Given the regulatory definition of MFP payments noted above, they are supplemental payments to farmers based (at least for 2018) on certified crop production. Presently, there aren’t any reported court decisions on the issue of what the method is to properly perfect an interest in MFP payments. But, logic indicates that MFP payments are intended to serve as a substitute for what would have been crop proceeds if it were not for conduct by foreign governments. Thus, perhaps a strong argument can be made that MFP payments are like disaster relief payments. Disaster relief payments have been held to be “proceeds” of crops (or livestock). See, e.g., In re Nivens, 22 B.R. 287 (Bankr. N.D. Tex. 1982). Thus, if a lender holds a perfected security in the crops (or farm products) “and proceeds thereof” of a farm debtor, the perfected security interest would include the MFP payments. But, is a mere reference in a security agreement/financing statement to “government payments or programs” of the farm debtor enough to cause the security interest to attach and become enforceable in MFP payments? Without a specific reference to the debtor’s crops or farm products, maybe not.
Does a statutory lien extend to MFP payments? Probably not. Lien statutes are typically tied to a specific crop that crop inputs and related services benefitted. Thus, a properly perfected secured creditor in proceeds of crops would beat out a lien creditor with respect to MFP payments. However, the precise answer to this issue is dependent on the particular state lien statute at issue and court opinions in that particular state construing the reach of the lien. Also, it’s important to note that rules for the 2018 MFP payment allowed a landlord operating under a crop-share lease to submit a separate MFP application for the landlord’s share of the crop irrespective of whether the landlord has a landlord’s lien that would beat out a secured creditor.
The FSA is also not subject to state central filing rules or direct notice provisions. Those rules provide relief to a lender in the event a buyer of a crop that serves as loan collateral fails to issue a jointly payable check to the farmer and the lender. This is an important point for lenders to understand. With respect to the 2018 MFP payments, the FSA was encouraging the amounts to be direct deposited into the farmer’s operating account. If the lender is other than the depository bank, the payments could become subject to a prior perfected security interest of the bank upon deposit. The banks interest will beat out the lender holding an interest in the debtor’s farm products and proceeds thereof.
MFP payments raise some important questions from a lending standpoint. Regardless of the classification of farm program payments that a jurisdiction adopts, a creditor must always comply with applicable UCC requirements for the creation, attachment, and perfection of a security interest in the payments. In any event, however, the most effective manner for a creditor to perfect a claim against a farmer's federal farm program payments is to include specific references to federal farm program benefits (and comparable benefits such as the MFP program payments) in the lender’s blanket security agreement. A lender should also closely pay attention to the status of a borrower’s MFP application and require that any payments be direct deposited into the debtor’s account with the lender (if there is such an account). But, the advice remains for lenders drafting documents designed to take an interest in farm program benefits: 1) the security agreement must “reasonably identify” the collateral and; 2) the collateral must be sufficiently identified in the financing statement.
Another good question is whether the differences in the MFP program between 2018 and 2019 make a material difference on the “proceeds” issue. While the 2019 payment is tied to the county where the producer’s farm is located, the rule appears to require the producer to actually plant crops to receive a payment. From a lending and security perspective, that could be a key point.
Friday, May 24, 2019
During life, many farmers and ranchers are focused on building their asset base, making sure that the business transitions successfully to the next generation, and preserving enough assets for the next generation’s success. Historically, farm and ranch families haven’t widely used life insurance, but it can play an important role in estate, business and succession planning. It can also help protect a spouse (and dependents, if any) against a substantial drop in income upon the death of the farm operator. It can also provide post-death liquidity and fund the buy-out of non-farm heirs.
Planning with life insurance for farmers and ranchers – that’s the topic of today’s post.
A primary purpose of life insurance during the life of the insured farm operator is to provide for the family in the event of death. In that sense, life insurance can provide the necessary capital to build an estate. But, it can also protect income and capital of the farming or ranching business which could be threatened by the operator’s death. Selling off farm assets, including land, to pay debts after the operator’s death will threaten continuity of the business. Life insurance is a means of providing the necessary liquidity to protect against the liquidation of operating assets.
Unfortunately, my experience has been that many legal and tax professionals often overlook the usefulness of insurance as part of the overall plan. This can leave a gaping hole in the estate and business plan that otherwise need not be there. The result is that many farm and ranch families may feel that “the land is my life insurance.” But, what if funds are needed to be unexpected expenses at death? What about debt levels that have increased in recent years? Is it really good to have to liquidate a tract or tracts of land to pay off expenses associated with death and retire burdensome debt?
So how can life insurance be utilized effectively during life? That depends on the economic position of the operator, the asset value of the operation and the legal and tax rules surrounding the ownership of life insurance. Of course, the cost of life insurance must be weighed against options for accumulating funds for use post-death. Also, consideration must be given to the amount of insurance needed, the type of life insurance that will fit the particular situation, and who the insured(s) will be.
From an economic standpoint, life insurance tends to provide a lower return on investment than other alternative capital investments for a farmer or rancher. It’s also susceptible to inflation (not much of an issue in recent years) because of the potentially long time before there is a payout under the policy. But, also from an economic standpoint, life insurance proceeds are generally not included in the beneficiary’s gross income. I.R.C. §101(a)(1).
For younger farmers and ranchers, premium payments can be reduced by putting a term policy in place to cover the beneficiary’s premature death. The term policy can later be converted to a permanent policy. That’s a key point. The use of and plan for life insurance is not static. Life insurance wanes in importance as a mechanism to help build wealth as the farm operation matures and becomes more financially successful and stable. The usage and type of life insurance will change over the life cycle of the farm or ranch business.
From a tax standpoint, life insurance proceeds are included in the insured’s gross estate if the proceeds are received by or for the benefit of the estate. As such, they are potentially subject to federal estate tax. However, the current $11.4 million exemption equivalent of the unified credit (per person) takes federal estate tax off the table for the vast majority of farming and ranching estates. In addition, if the proceeds are payable to the estate, they also become subject to creditors’ claims as well as probate and estate administration costs. If the beneficiary is legally obligated to use the proceeds for the benefit of the estate, the proceeds are included in the estate regardless of whether the estate is the named beneficiary. It makes no difference who took the policy out or who paid the premiums. But, the proceeds are included in the decedent’s gross estate only to the extent they are actually used to discharge claims. See, e.g., Hooper v. Comr., 41 B.T.A. 114 (1940); Estate of Rohnert v. Comr., 40 B.T.A. 1319 (1939); Prichard v. United States, 255 F. Supp. 552 (5th Cir. 1966).
But, there is a possible way to have the funds available to cover the obligations of the decedent’s estate without having the insurance proceeds being included in the estate. That can be accomplished by authorizing the beneficiary to pay charges against the estate or by authorizing the trustee of a life insurance trust to use the proceeds to pay the estate’s obligations, buy the assets of the estate at their fair market value, or make loans to the estate. Treas. Reg. §20.2042-1(b)(1). In that situation, the proceeds aren’t included in the decedent’s estate because there is no legal obligation (i.e., duty) of the beneficiary (or trustee if the policy is held in trust) to use the proceeds to pay the claims of the decedent’s estate. See, e.g., Estate of Wade v. Comr., 47 B.T.A. 21 (1942). However, achieving this result requires careful drafting of policy ownership language along with the description of how the policy proceeds can be used to avoid an IRS claim that the decedent retained “incidents of ownership” over the policy at the time of death. I.R.C. §2042. In addition, the policy holder’s death within three years of transferring the policy can cause inclusion of the policy proceeds in the decedent’s estate. I.R.C. §2035.
Other Uses of Life Insurance
Loan security. Life insurance can be pledged as security for a loan. This means that a farmer or rancher can use it as collateral for buying additional assets to be used in the business. In this event, the full amount of the policy proceeds will be included in the decedent’s gross estate, but the estate can deduct any outstanding amount that is owed to the creditor, including accrued interest. It makes no difference whether the creditor actually uses the insurance proceeds to pay the outstanding debt.
Funding a buy-sell agreement. For those farming and ranching operations where the desire is that the business continue into subsequent generations as a viable economic unit, ensuring that sufficient liquid funds are available to pay costs associated with death is vitally important to help ease the transition from one generation to the next. Having liquid funds can also be key to buying out non-farm heirs so that they do not acquire ownership interests in the daily operational aspects of the business. Few things can destroy a successful generational transition of a farming or ranching business more effectively than a sharing of managerial control of the business between the on-farm and off-farm heirs. Life insurance proceeds can be used fund a buy-out of the off-farm heirs. How is this accomplished? For example, an on-farm heir of the farm operator could buy a life insurance policy on the life of the operator. The policy could name the on-farm heir as the beneficiary such that when the operator dies the proceeds would be payable to the on-farm heir. The on-farm can then use the proceeds to buy-out the interests of the off-farm heirs. In addition, the policy proceeds would be excluded from the operator’s estate.
There are other approaches to the addressing the transition of the farming/ranching business. Of course, one way to approach the on-farm/off-farm heir situation is for the parents’ estate plans to favor the on-farm heirs as the successor-operators. But, this can lead to family conflict if the younger generation perceives the parents’ estate plans as unfair. Whether this point matters to the parents is up to them to decide. Another approach is to leave property equally to the on-farm and the off-farm heirs. But, this approach splits farm ownership between multiple children and their families and can result in none of the families being able to derive sufficient income from their particular ownership interest. This causes the ownership interest to be viewed as a “dead” asset. Remember, off-farm heirs often prefer cash as their inheritance. Sentimental ownership of part of the family farming or ranching operation may last for a while, but it tends to not to be a long-term feeling for various reasons. Sooner or later a sale of the interest will be desired, real estate will be partitioned and the future of the family farming operation will be destroyed. A life insurance funded buy-out can be a means to avoiding these problems.
Today’s post merely introduced the concept of integrating life insurance in the estate/business plan of a farmer or rancher. Other considerations involving life insurance include a determination of the appropriate type of life insurance to be purchased, the provisions to be included in a life insurance contract, and the estate tax treatment of life insurance. Ownership planning is also necessary. As you can see, it gets complex rather quickly. However, the use of life insurance as part of an estate plan can be quite beneficial.