Thursday, September 24, 2020

Recent Tax Court Opinions Make Key Points on S Corporations and Meals/Entertainment Deductions

Overview

Two recent Tax Court opinions provide good guidance on some important issues associated with S corporation concepts and the need to substantiate meals and entertainment expenses. 

Two recent Tax Court opinions and planning points for practitioners and taxpayers – it’s the focus of today’s post

Ownership of S Corporate Stock

General principles.  A “qualified corporation,” with the consent of all its shareholders, can elect to be treated as an S corporation for tax purposes.  Once the election is made, the entity is treated as a passthrough entity for federal income tax purposes.  I.R.C. §§1361-1366.  That means that an S corporation, unlike a C corporation pays no federal income tax at the corporate level.  Instead, a shareholder of an S corporation must report a pro rata share of the S corporation’s taxable income, losses, deductions, and credits on the shareholder’s personal return.  I.R.C. §1366(a)(1)(A); Treas. Reg. § 1.1366-1(a).  See also Gitlitz v. Comm’r, 531 U.S. 206 (2001), rev’g 182 F.3d 1143 (10th Cir. 1999)Maloof v. Comm’r, 456 F.3d 645, 647 (6th Cir. 2006). The treasury regulations further provide: “Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.”  Treas. Reg. §1.1361-1(e)(1).  In essence, whether a person is a shareholder on the date of the S election is determined by whether that person would have to report as personal income corporate profits as of the election date.  Cabintaxi Corp. v. Comm’r, 63 F.3d 614 (7th Cir. 1995); Treas. Reg. §1.1371-1(d)(1).  The answer to that question, in turn, revolves around whether the person would have been deemed a beneficial owner of the corporate shares.  See, e.g., Pahl v. Comm’r, 150 F.3d 1124; Wilson v. Comm’r, 560 F.2d 687 (5th 1977)A beneficial owner is entitled to demand from the nominal owner the dividends or any other distributions of earnings on those shares.  Id.  Beneficial ownership of corporate stock is determined by state law.  See United States v. National Bank of Commerce, 472 U.S. 713 (1985).

Nonprofit corporations.  As a general rule, a nonprofit corporation is not considered to have owners. See Farrow v. Saint Francis Medical Center, 407 S.W.3d 579 (Mo. 2013).  This is because members of a nonprofit corporation are barred from receiving residual earnings, assets or property from the corporation.  See Hansmann, “Reforming Nonprofit Corporation Law,” 129 U. Pa. L. Rev. 497 (1981); see also Austin v. Michigan Chamber of Commerce, 494 U.S. 652 (1990).

In a recent Tax Court case, Deckard v. Comm’r, 155 T.C. No. 8 (2020), the petitioner created a nonstock, nonprofit corporation in 2012 and was named as its president and one of its three directors.  However, the corporation never applied for recognition of tax-exempt status with the IRS. In late 2014, the corporation mailed Form 2553 to the IRS seeking to elect S status retroactively to its 2012 incorporation date.  The petitioner signed Form 2553 in his capacity as president.  He also signed the shareholder’s consent statement indicating that he was the sole owner of the corporation.  The corporation filed an S corporate return (Form 1120S) for tax years 2012 and 2013 on which it reported operating losses of $277,967 and $3,239 respectively, and issued Forms K-1 for the losses that flowed through to the petitioner.

In May of 2015, the petitioner filed his personal returns for 2012 and 2013.  Neither return was filed timely, and both claimed the losses that flowed through from the corporation. The IRS denied the losses on the grounds that the S-election was invalid.  The IRS also claimed that the petitioner was not a corporate shareholder.  On the latter point, the Tax Court noted that the petitioner was not a shareholder of record and the corporation was not authorized to issue stock.  In addition, there was no evidence that any stock had been issued. 

The Tax Court also pointed out that a nonprofit corporation generally does not have shareholders, is not owned by third parties and there is no interest in a nonprofit corporation that is similar to that of a for-profit corporate shareholder.  The petitioner also did not possess shareholder rights, had no ownership, had no right to profits, no dissolution rights and no right to corporate assets upon dissolution. In essence, the corporation was a state law nonprofit corporation controlled by a board of directors on which the petitioner only had one vote out of three. The Tax Court also noted that he would be bound by the form of the transaction that he chose, and he chose the nonprofit corporate form.  As a result, he had to accept the tax consequences that flowed from that choice.  Clearly, the petitioner should have filed Form 1023 to achieve tax-exempt status for the corporation. 

Meals and Entertainment

The Tax Cuts and Jobs Act (TCJA) changed the rules on deductible meals and entertainment.  For farming and operations, the tax rules governing meals often come into play at harvest.  An example would be for part-time workers that are employed at times of planting and harvest.  These part-time employees may be fed lunches on the farm.  Before 2018, meals were normally deductible to an employer at 50 percent of the cost of the meals.  But, where the meals are provided on the employer’s premises (i.e., at the farm) and for the convenience of the employer, the meals are 100 percent deductible by the employer and the employees do not have to report any of the amount of the meals as income. The 100 percent deduction is because farm workers generally work in remote areas where eating facilities are not near, and the farm employer finds it a more productive use of time to supply meals at the farm.   

Under the TCJA, the 50 percent rule still generally applies to allow an employer to deduct 50 percent of the (non-extravagant) food and beverage expenses associated with operating the business (e.g., meals consumed by employees on work travel).  I.R.C. §274(k).   But, for amounts incurred and paid after Dec. 31, 2017, and until Dec. 31, 2025, the TCJA expands the 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer.   I.R.C. §274(n)(1).  That means that the 100 percent deduction for the meals provided the part-time farm employees in the above example is reduced to 50 percent.  The 50 percent limitation remains in place through 2025 for meals (food and beverages) that aren’t “lavish or extravagant” and the taxpayer or employee of the taxpayer is present when the meal is furnished.  I.R.C. §274(k)(2).  Of course, the 50 percent cut-down can be avoided by treating the food and beverages as compensation to the employee (i.e., wages for withholding purposes). 

After 2025, none of the cost of meals is deductible.  

Through 2017, deductions for entertainment were generally disallowed unless they were directly related to the taxpayer’s business or directly preceded or followed a substantial bona fide business discussion.  In those instances, entertainment expenses were deductible at the 50 percent level. Under the TCJA, effective for tax years after 2017, no deduction is allowed for any activity that is generally considered to be entertainment, amusement, or recreation that is purchased as a business expense. Likewise, no deduction is allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes.  Similarly, no deduction is allowed associated with a facility or portion thereof used in connection with the provision of entertainment, amusement or recreation. 

Recent case.  A recent Tax Court case illustrates the necessity of carefully substantiating meal and entertainment expenses.  In Franklin v. Comr., T.C. Memo. 2020-127, the petitioner claimed deductions for meal and entertainment costs and travel expenses.  The IRS denied the deductions for lack of substantiation and the Tax Court agreed.  The Tax Court concluded that the petitioner failed to provide credible evidence that the expenses were incurred in the operation of his trade or business as I.R.C. §274(d) requires.  The Tax Court also held that the petitioner couldn’t claim a deductible loss associated with loans he made to a real estate development company, as well as a loss on computer software that he used in his real estate consulting business. 

As for the meal and travel costs, I.R.C. §274(d) disallows a deduction unless the taxpayer has substantiating records concerning the amount, time, place and business purpose for each expenditure.  Those records must be contemporaneously made.  While that doesn’t mean that a log must be created when the expenditure is incurred, it does mean that records created after-the-fact must be able to be reconstructed in a credible manner so that they are essentially the same as a contemporaneous log.  In addition, if business and personal travel is combined, the taxpayer must prove what the primary purpose of the trip is.  The Tax Court determined that neither the petitioner’s travel log nor testimony were credible.  For example, he created his travel logs created after IRS notified him that he was under audit.  That disqualified them as “adequate records” under I.R.C. §274(d).  He also failed to establish the business purpose for his travel by distinguishing personal aspects of the travel. 

As for the computer property, the Tax Court held that an associated loss wasn’t deductible because the petitioner couldn’t establish his basis in the property.  For the loans, the petitioner couldn’t establish that the debt had become worthless.  Under I.R.C. §166(a)(1), a deduction is allowed for any debt that becomes wholly worthless within the tax year.  Worthlessness is a fact-based determination.  Worthlessness cannot be established is the collateral that secures the debt has value.  These points doomed the taxpayer’s attempted deduction. 

Conclusion

These recent Tax Court cases provide some very good teaching points on some common issues.  It’s always best to learn from the mistakes of others rather than learning tough lessons first-hand.

September 24, 2020 in Income Tax | Permalink | Comments (0)

Tuesday, September 22, 2020

NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Loss of Property Rights? – Part Three

Overview

In Parts One and Two of this three-part series, I have gone through various parts of the preamble to the recently issued USDA/NRCS Final Rule involving highly erodible land and wetland.  The rule is found at 85 FR 53137 and became effective August 28, 2020.  In today’s article I conclude my discussion of the nuances of additional sections of the preamble to the Final Rule.  The question is whether, as NRCS claims, the Final Rule bring clarity to the NRCS delineation process.  Is that true?  Will the Final Rule help farmers in avoiding a violation of the rules that could cause loss of farm program benefits and additional fines and penalties?

In this concluding article on the preamble to the Final Rule, I look at more areas that are of concern to farmers and ranchers.  Part Three of the three-part series on the NRCS Final rule involving highly erodible land and wetland – it’s the topic of today’s post.

Setback Distance Concerns

In this section, the NRCS states that it is currently pursuing “improvements to the methods which are used to provide tile drainage setback distances from mapped wetlands to USDA program participants.”  That’s an interesting way to put it.  Presently, the NRCS is attempting to employ in the prairie pothole states a tripling of the calculated offset requirement where there is a preponderance of potential ground water discharge soils adjoining the farmed wetland.  This is already happening in Iowa at the state level.  There, a farmer must triple the setback or wait for the new requirements to be promulgated.  For example, a recent Iowa matter involved a 70-acre farmed wetland pothole where the adjoining common soils were classified as discharge soils.  The triple setback requirement increases the land area in which drain tile improvements cannot be made from 80 acres to more than 200 acres.  This diminishes the value and profitability of the farm substantially.

The NRCS approach basically amounts to a regulatory “land-grab” in areas where drainage tile is already in place in the existing pothole and adjoining soils.  Wetland hydrology is supposed to be determined under normal or average circumstances.  Indeed, existing regulations specify that “normal circumstances” of the land does not refer to normal climate conditions but instead refers to soil and hydrologic conditions normally present without regard to the removal of vegetation.  See, e.g., Boucher v. United States Department of Agriculture, 149 F. Supp. 3d 1045 (S.D. Ind. 2016).  While it is true that under very wet conditions these soils may experience some groundwater discharge, it is also true that under normal conditions they rarely do because existing drainage tile normally keeps the water table below the surface. 

Wetland Hydrology Indicators Section

In this section the NRCS states that the “USDA appreciates support for the changes made by the interim rule and the expressed concerns.  In response, USDA is making changes in this final rule as explained below.”  Thus, the NRCS has made material changes to the rule without inviting additional public comment.  These changes are greatly impactful in the prairie pothole states.

In a prior post, it was noted that the NRCS failed to complete the administrative procedures associated with the interim final rule that was published in September 1996.  Now NRCS asserts that the September 6, 1996 interim rule first established that “playa, pocosin, and pothole farmed wetlands and all farmed wetland pasture have required periods of inundation, ponding, or saturation.”  This is the origin of the 7-days ponding criteria - an arbitrary NRCS determination in an uncompleted interim final rule for which public comments were ignored.  The federal definition of wetland in the Clean Water Act does not have a ponding criteria.  The criteria as set forth in the 1985 Farm Bill is that a particular tract constitutes a wetland if it has (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions. In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. All three are required.  See, e.g., B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008).  However, the NRCS intends to move forward with its definition of farmed wetland based upon an incomplete interim final rule and Food Security Act Wetland Identification Procedures located in its National Food Security Act Manual, Part 514, which was not subjected to the public notice and comment procedures of the Administrative Procedure Act. 

The NRCS claims that “wetland hydrology field indicators are a valid and reliable method for the identification of wetland hydrology.”  The NRCS further asserts that “it would not be an efficient use of analytic techniques or onsite hydrology monitoring in every farmed wetland determination when other valid methods exist.  Let’s pick that claim apart.  The NRCS is claiming that its methods are valid because NRCS has made an ipse dixit determination that the methods are valid.  However, the NRCS has never monitored tests of mapped farmed wetland to determine the accuracy of its methods.

In 1991 the Congress directed the United States Environmental Protection Agency to engage the National Research Council (NRC) to review the several wetland determination methods of federal agencies.  The impetus for the report was to resolve the differences between the 1987 and 1989 federal wetland delineation manuals.  The NRC report, Wetlands Characteristics and Boundaries, was issued in 1995.   It remains the best authority on wetlands.  In Chapter 4 the NRC reviewed the NRCS standards for classes of wetland stating that, “A farmed wetland that is a playa, pothole or pocosin must be inundated for at least 7 consecutive days or saturated for at least 14 consecutive days during the growing season. Farmed wetlands that are not potholes, playas or pocosins must have a 50% chance of being seasonally flooded or ponded for at least 15 consecutive days during the growing season or for 10% of the growing season whichever is less.  NFSAM specifically acknowledges that these especially restrictive guidelines are intended to protect the unique wetland functions of potholes, playas and pocosins.”  The NRC did not endorse either the 1987 United States Army Corps of Engineer’s wetland manual or the USDA’s methodology for determining wetlands and their boundaries.

At the conclusion of Chapter 5 of the NRC report, Wetlands Characteristics and Boundaries, the NRC made 35 recommendations regarding wetland identification.  The following are applicable to the discussion of the NRCS Final Rule:

  1. If direct hydrologic evaluation is needed, as in the case of altered sites or when evidence from substrate and biota is not conclusive, the evaluation should be based on water table data or on evidence of anoxia.
  1. Guidance should be developed for assessment of hydrologic alteration.
  1. If the hydrology of a site has been altered, evidence from soils or vegetation must be used only with support from hydrologic analysis, including the characteristic frequency, duration and depth of saturation.
  1. Federal agencies that regulate wetlands should hire regulatory staff that makes up a balanced mixture of expertise in plant ecology, hydrology, and soil science.

Recommendation No. 19 is of particular importance because it says, in essence, that for possible wetland sites with altered wetland hydrology the NRCS method should not be used.  Instead, the hydrology must be proven.  Hydrology can only be done using mathematical modeling or direct observation via monitoring.  Unfortunately, in the Final Rule the NRCS takes the position that this cannot be done properly and that NRCS will simply make an off-the-cuff determination that is binding on farmers.   At a minimum, for hydrologically altered prairie potholes, the hydrology should be required to be proven before any limitations on farming activities are applied.

In the Final Rule, the NRCS issues a challenge to all farmed wetland owners in the prairie pothole states by declaring, “The final rule change brings transparency and codifies the method by which these determinations have been made since the establishment of farmed wetland and farmed wetland pasture designations, by stating that areas manipulated prior to December 23, 1985 but which retain wetland hydrology, as determined through Step 1 of the wetland determination process in Rule Section 12.30( c)(7) and application of the procedures described in Rule Section 12.31( c), meet the required hydrology criteria for playa, pocosin, and pothole farmed wetlands and farmed wetland pasture.  Both inundation and saturation criteria for pothole farmed wetlands were established in the September 6, 1996 interim rule and USDA does not agree that there is a need to modify these criteria.”

This is simply incorrect.  If this NRCS position is allowed to stand there will be very few challenges.  Instead, there will be more wetland that is erroneously mapped, and more landowners that will get caught in administrative appeals and litigation and suffer the loss of property rights. 

The 2018 Farm Bill Section

Here, the NRCS states in response to the 2018 Farm Bill that, “The December 2018 interim rule established in the wetland determination process in § 12.30(c)(7) that step 2 includes the determination of whether any exemptions apply, and no further modification in this final rule is needed in support of section 2101.”  This statement is incorrect.  Clearly, the Congress intended that a minimal effect determination be made, and that the NRCS make the determination whether or not a landowner requests that such a determination be made.

Conclusion

The Final Rule is troubling for farmers in many respects.  Perhaps the biggest is the NRCS position concerning wetland hydrology indicators for hydrologically altered wetland.  Millions of acres of these types of wetland are present in the prairie pothole states.  Also, of primary concern is the NRCS intent to triple the tile set-back requirements from the edge of farmed wetlands if the adjoining soil has groundwater discharge potential.  It is difficult to believe that NRCS hydrologists, botanists and soil scientists were meaningfully involved in the writing of the Final Rule.

Farmers beware.

September 22, 2020 in Environmental Law | Permalink | Comments (0)

Sunday, September 20, 2020

NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Loss of Property Rights? – Part Two

Overview

In Part One earlier last week, I went through part of the preamble to the recently issued USDA/NRCS Final Rule involving highly erodible land and wetland.  The rule is found at 85 FR 53137 and became effective August 28, 2020.  In today’s article I continue to work through the nuances of the various sections of the preamble to the Final Rule.  Does the Final Rule bring clarity to the NRCS delineation process?  Will it help farmers in avoiding a violation of the rules?

Picking up where I left off last time in Part One, I continue the discussion of the preamble of the NRCS Final Rule concerning the conservation provisions of the 1985 Farm Bill – it’s Part Two of a (now) Three-Part Series and is the topic of today’s post.

Certification Status of Pre-1996 Wetland Determinations Section 

In this section, the NRCS quotes the Conference Committee Report for the 1990 Farm Bill.  In that Report, the “Managers agree that the certification process is to provide farmers with certainty as to which of their lands are to be considered wetlands for purposed of Swampbuster.”  If the NRCS statement that the Final Rule is designed to bring clarity to wetland delineation is to be believed, it means one of two things.  Either this Final Rule isn’t necessary because the certification process of 30 years ago “solved” the problem, or the Final Rule is an NRCS admission that it has failed to provide clarity for 30 years.     

Since 1990, many landowners have been told that their wetland determinations made before 1996 were invalid and they requested new ones.  The new determinations resulted in more acres being determined as wetland than were designated in the original determinations.  This resulted in the loss of land use rights and the payment of penalties.  In one instance, an Iowa farmer was forced through a myriad of appeals as a result of wetland conversions done by his drainage district in the 1990s.  Following administrative appeals and court challenges (see Gunn v. United States, 118 F.3d 1233 (8th Cir. 1997), cert. den., 522 U.S. 1111 (1998)),  and after the farmer and the drainage district were forced to mitigate, an old determination surfaced showing that there actually was no wetland on his farm.  The initial determination of no wetland should have been considered certified. Will compensation be paid for the farmer’s loss of property rights?  Hardly. 

Also in this section, the NRCS responded to a comment about changing determinations based on new technology by stating that the limited circumstances where certified wetland determinations are subject to revision are:  “if the land in question has been removed from agricultural use, upon request of the USDA program participant, or when a violation of the wetland conservation provisions has occurred.”  In actual practice, this statement is incorrect.  NRCS states in its policy manual, The Food Security Act Manual, 5th Edition, that it will not make a review upon request unless it determines that there was an error.  Will the policy manual be amended to account for this statement in the Final Rule? 

Offsite Analysis of Wetland Minimal Effect Section 

In this section the NRCS notes that a comment was received claiming that the 2018 interim rule did not address the 2017 Office of the Inspector General (OIG) Audit Report entitled, “USDA Wetland Conservation Provisions in the Prairie Pothole Region.”  In this section of the preamble, the NRCS notes its disagreement with the audit and seeks to justify its conduct in the four-state prairie pothole region concerning wetland determinations from 1990-1996.  However, the NRCS response is only part of the story.  What primarily is at issue involves the concept of “minimal effect determination.”  In 1993, the Clinton administration made a policy announcement specifying that the Soil Conservation Service (SCS) was to be designated as the lead agency for determining whether agricultural land is wetland for both CWA and Swampbuster program purposes. Procedures were to be developed jointly by the SCS, U.S. Army Corps of Engineers (COE), Environmental Protection Agency (EPA) and the Fish and Wildlife Service (FWS). In addition, SCS appeal procedures were to be utilized to contest wetland determinations, and the COE, in coordination with EPA, SCS and FWS was to develop a nationwide general permit for CWA purposes for discharges associated with “minimal effects” (see 7 C.F.R. §12.31(e)(1)) and “frequently cropped with mitigation” conversions determined by SCS and FWS to qualify agricultural wetlands for exemption from Swampbuster sanctions.  The landowner is responsible for requesting such a determination and bears the burden to prove eligibility for a “minimal effects” determination. See Clark v. United States Department of Agriculture, 537 F.3d 934 (8th Cir. 2008).

In this section, the NRCS also fails to disclose that it has lost numerous court cases involving minimal effect determinations.  Without an administrative change of position, NRCS will likely lose more.  Congressional intent expressed in Conference Committee Reports dating back nearly 30 years illustrates that the Congress intended “minimal effect” determinations to be simple and widely used.  However, that has not happened.  As noted above, NRCS makes a landowner request a minimal effect determination.  That was a regulatory position staked-out by the agency in a September 17, 1987 Final Rule associated with “farmed wetland.”  If a landowner doesn’t make a request, a minimal effect determination is not made.  But, this landowner burden is not required by statute.  While the position of the NRCS in the regulation has been upheld (see the Clark case cited above), both logic and Congressional intent would seem to indicate that the NRCS should, as a matter of routine, conduct a minimal effect determination for every request for review of hydrologic manipulations.  The consequences of a landowner not requesting a minimal effect determination can be harsh – the loss of past and future farm program benefits.

PC Any Land With Pre-1985 Drainage Section 

Here, the USDA/NRCS states that “farmed wetlands” have been subject to the wetland conservation provisions since 1987 and were formally defined in regulation in 1996.  The NRCS also asserts that the Congress has not altered NRCS administration of farmed wetlands since first described in regulation. However, the NRCS comment is misleading.  A bit of history is in order.

Under the March 1986 interim rules for the wetland conservation provisions of the 1985 Farm Bill, wetland was assumed to be truly wet ground that had never been farmed. In addition, “obligation of funds” such as assessments paid to drainage districts, qualified as commenced conversions, and the FWS had no involvement in Agricultural Stabilization and Conservation Service (now Farm Service Agency (FSA)) or SCS decisions. In September of 1986, a proposal to exempt from Swampbuster all lands within drainage districts was approved by the chiefs of the ASCS, SCS, Farmers’ Home Administration, Federal Crop Insurance Corporation and the Secretary of Agriculture. However, the USDA proposal failed in the face of strong opposition from the FWS and the EPA.

The final Swampbuster rules were issued in 1987 without being subjected to the notice and comment procedures of the APA and greatly differed from the interim rules. The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion. Added were farmed wetlands, abandoned cropland, active pursuit requirements, FWS concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill). If the drainage work was not completed by December 23, 1985, a request could be made of the ASCS on or before September 19, 1988, to make a commencement determination. Drainage districts must satisfy several requirements under the “commenced conversion” rules. A project drainage plan setting forth planned drainage must be officially adopted. In addition, the district must have begun installation of drainage measures or legally committed substantial funds toward the conversion by contracting for installation or supplies.

The final rules defined “farmed wetlands” as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded.  7 C.F.R. § 12.2.  Prior converted wetlands can be farmed, but they revert to protected status once abandoned.  A prior converted wetland is a wetland that was totally drained before December 23, 1985. Under 16 U.S.C. §3801(a)(7), a “converted wetland” is defined as a wetland that is manipulated for the purpose or with the effect of making the production of an agricultural commodity possible if such production would not have been possible but for such action.  If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original drainage can be maintained.

The problem with the NRCS creation and definition of “farmed wetland” is that the law defines “converted wetland” as wetland that is dredged, drained or otherwise manipulated so as to make the production of an agricultural commodity possible where such production was not possible prior to the manipulation.  How then can farmed wetland be subject to conversion when it is, by definition, already converted?  In this section of the preamble, the NRCS claims that farmed wetland was formally defined in regulation in the September 1996 interim final rule.  However, in 1996, comments were filed with NRCS challenging the legality of subjecting farmed wetland to the wetland conservation provisions of the Farm Bill.  Under the APA the USDA was to timely respond to those comments and make appropriate revisions to the rule.  That never happened.  24 years later, the rule has not been finalized.  Now NRCS claims that the Congress has endorsed the concept.

Conclusion

What I thought would be a two-part series when I started out, will now turn into a three-part series.  In the next installment, I will continue the commentary on the preamble to the Final Rule. 

September 20, 2020 in Environmental Law | Permalink | Comments (0)

Monday, September 14, 2020

NRCS Highly Erodible Land and Wetlands Conservation Final Rule – Clearer Guidance for Farmers or Erosion of Property Rights? – Part One

Overview

The Congress, with passage of the 1985 Farm Bill, tied participation in federal farm programs to conservation requirements related to “highly erodible land” and “wetlands”  New concepts were introduced such as the Conservation Reserve Program, Sodbuster, Swampbuster, and abandoned cropland, just to name a few.  Of course, the “dirt is in the details” and that meant that terms needed to be defined so that a farmer could identify highly erodible land as well as wetland.  A farmer participating in federal farm programs must annually certify compliance with the conservation requirements, and production activities on areas that the government has identified as “protected” under the conservation rules can lead to ineligibility for farm program benefits.

The sub-agency within the United States Department of Agriculture (USDA) responsible for developing, administering and enforcing the rules for the various conservation programs is the Natural Resources Conservation Service (NRCS).  Late last month, the NRCS issued a Final Rule for both the highly erodible land and the conservation provisions of the 1985 farm bill.  85 Fed. Reg. 53137.  While the Final Rule is purportedly designed to bring clarity to the delineation process and aid farmers in avoiding farming activity that could result in farm program ineligibility, the Final rule does no such thing.  Instead, the Final rule expands the federal government’s regulatory power and diminishes landowner rights. 

The NRCS Final Rule on the conservation provisions of the 1985 Farm Bill – it’s Part One of a Two-Part Series and is the topic of today’s post.

The Basics – Delineation and Conversion 

The NRCS delineates (identifies) where highly erodible land and wetland is present so that a farmer can avoid farming activities in those areas.  As for wetland, the 1985 Farm Bill charged the Soil Conservation Service (SCS) with creating an official wetland inventory with a particular tract being classified as a wetland if it had (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions.  7 C.F.R. §12.30(c)(7).  In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. The presence of hydrophytic vegetation, by itself, is insufficient to meet the wetland hydrology requirement and the statute clearly requires the presence of all three characteristics.  See B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008). The determination of highly erodible land involves the use of an “erodibility index” for a soil based on factors such as annual rainfall, the degree to which the soil resists erosion, and the steepness of the area.  7 C.F.R. § 12.21 (a)(1)(i)-(iii).

In addition to delineating land that cannot be farmed without violating the conservation rules, the NRCS also must determine whether wetland or highly erodible land has been impermissibly “converted” from its protected status to being farmed.  But, in general, if the land at issue was converted to use in a farming operation before the 1985 Farm Bill conservation rules took effect, it will maintain its status as land that can be farmed without violating the conservation rules.  Indeed, the conference committee report a week before the 1985 Farm Bill was signed into law stated that wetland conversion was considered to be “commenced” when a person had obligated funds or begun actual modification of a wetland.

The conservation rules have been modified multiple times since their 1985 Farm Bill version.  Those modifications have largely dealt with the issues of conversion, “minimal effects,” and mitigation. 

New Rules

In late 2018, the USDA published a new interim rule concerning the conservation provisions that originated with the 1985 Farm Bill.  On August 28, 2020, those Final Rule was published.  The Final Rule adds definitions for “wetland hydrology,” “normal climatic conditions,” and “best drained condition.”  The Final Rule also modifies the manner in which the NRCS is to delineate the various types of wetland and states that wetland determinations made between 1990 and 1996 are to be “certified” such that USDA benefits will not be denied if a farmer conducts farming activities on land that is covered by such a certification.  7 C.F.R. §12.5(b)(6)(i).   

The Final Rule also says that USDA is to make a “reasonable effort” to include the “affected person” in an on-site investigation before determining that a wetland violation exists.  In addition, the Final Rule specifies that if a landowner disagrees with an “off-site” determination concerning a highly erodible soil determination, NRCS is to make a field visit (on-site) determination. 

Deeper Dive – Digging into the Final Rule

According to the NRCS the Final Rule does farmers a favor by providing clearer guidance on the determination of land subject to the conservation rules, the farming of which would disqualify the farmer from program benefits.  But, is that true?  A deeper analysis of the Final Rule portends the opposite. 

What follows is a section-by-section commentary on the Final Rule.

Summary section.  The NRCS claims that the Final Rule was prepared to clarify how the USDA delineates, determines and certifies wetlands located on subject land in a manner sufficient for making determinations of ineligibility for certain USDA program benefits.  That is a misrepresentation of the purpose of the Final Rule.  The Final Rule does not clarify as much as it alters how the NRCS makes these determinations so as to make the process more convenient for the NRCS, and making appeals from that convenient, simplified process more difficult.  The Final Rule also represents a step away from the possible (but often inconvenient) scientific determination of wetland hydrology in regularly cropped farmed wetland across the prairie pothole region (a significant portion of the northern Great Plains and north-central Iowa and south-western Minnesota).

Supplementary Information - Background section.  This section provides background information concerning highly erodible land and wetland and the charge to the USDA by the Congress as part of the 1985 Farm Bill.  The NRCS claimed in its late 2018 interim rule that its Final Rule would provide “transparency” to USDA program participants and stakeholders concerning how USDA delineates, determines, and certifies wetlands. It also claimed that it was providing information so that farmers could “better understand” actions that may result in ineligibility for USDA farm program benefits. 

However, the reality of the Final Rule is that such “transparency” and “understanding” is defined to mean that the NRCS will unilaterally decide that status of a tract based on its own determination by virtue of its best “guestimate.”  That is evidenced by the statement in this section that, as part of the wetland delineation process that a, “[w]etland hydrology determination will be made in accordance with the current Federal wetland delineation methodology in use by NRCS at the time of the determination.”  A landowner may appeal such a determination, but given the deference that courts give to administrative agencies concerning the interpretation of agency rules, succeeding in overturning such a determination will be difficult.  See Auer v. Robbins, 519 U.S. 452 (1997).

Summary of Public Comments section.  In this section, the NRCS points out that, “[o]nsite wetland determinations and aerial imagery do not constitute an unreasonable search or seizure.  Its rationale is that a wetland determination for purposes of determining eligibility in voluntary USDA programs is not part of a criminal law proceeding.

Abandonment of Farmed Wetland and Farmed Wetland Pasture section.  Here, the NRCS asserts that the Final Rule made no changes in the interim rule with respect to abandonment of farmed wetlands and farmed wetland pasture.   7 CFR §12.33(c). Abandonment applies to farmed wetland and farmed-wetland pasture when wetland conditions return after December 23, 1985, unless certain conditions are met. NRCS states that this is a part of “long-standing policy and regulation.”  Here, the NRCs stated that it was reaffirming that USDA program participants may continue to farm farmed wetlands and farmed wetland pasture under natural conditions without risk of losing their eligibility for USDA program benefits, as long as additional hydrological manipulations do not occur.

Administrative Procedure Act section.  In this section, the USDA claims that it is not required to promulgate the conservation rules contained in  7 C.F.R. part 12 pursuant to notice and comment rulemaking under the APA.   While it mentions that §1246 of the 1985 Farm Bill, as amended by the Agricultural Act of 2014, specified that the promulgation of regulations and administration of the conservation programs are to be subjected to public notice and comment, it claims that the APA requirements for notice and comment do not apply to a matter relating to public property, loans, grants, benefits, or contracts. 5 U.S.C. §553(a)(2).  Because the matters identified in the 2018 interim rule relate to USDA program grants and other benefits, the USDA claimed that notice and comment rulemaking are not required under the APA.

However, the NRCS does not explain why all the rules, practices and policies issued and implemented before 2014 were not subjected to the APA.  Similarly, the NRCS does not explain why the requirement of the 1996 Farm Bill that all changes in policies regarding highly erodible land and wetland conservation be adopted pursuant to the APA’s rulemaking and comment procedures.  Before the adoption of the Final Rule, the NRCS had acknowledged that the 1996 Farm Bill provision remains applicable by citing it in the June 2017 rulemaking for the promulgation of the State Off-Site Method (SOSM) for the prairie pothole states.  But, it should be noted, that the Iowa NRCS changed its SOSM in December of 2018 without following notice and comment procedures. 

Appeals section.  The NRCS claims in the Final Rule that it will use the delineation methodology in use at the time of a particular delineation.  But, will the states follow this approach?  For example, the Iowa NRCS has steadfastly refused to accept the application of the Soil, Plant, Atmosphere, Water (SPAW) software for wetland surface ponding hydrology even though it was and is a method accepted by the NRCS in its wetland hydrology tools.

Area of Request for Certified Wetland Determinations section.  Here, the NRCS notes that wetland determinations, delineations, and certifications may be done on a tract, field, or sub field basis.

Best Drained Condition section.  The NRCS claims that allowing the “best drained condition” of a tract is intended…” to provide clarity regarding a long-standing and practiced statutory concept that is fundamental to the identification of…” hydrologically altered farmed wetlands.  Calling this assertion a “stretch” is an understatement of substantial degree.  The phrase “best drained condition” is derived from Barthel v. United States Department of Agriculture, 181 F.3d 984 (8th Cir. 1999).   In that case, the U.S. Court of Appeals for the Eighth Circuit held that the plaintiff landowners were entitled to the historic “wetland and farming regime” of a 450-acre hay meadow irrespective of the degree of manipulation of a ditch drainage device . After more than 15 years and multiple contempt actions brought against the U.S. Secretary of Agriculture in the Barthel litigation, the NRCS finally recognized that the Barthel decision meant that it had to apply a historic drainage (i.e., “best drained condition”) test to wetland determinations, and that the focus of the analysis was not to be on the manipulation of the drainage device, but rather on the effect of the manipulation of the drainage device on the subject property.    

Under the Final Rule, the NRCS explains how “best drained condition” is to be identified.  The NRCS asserts that the decision is to be made based upon the best available evidence.  That could include remote resources such as historical aerial imagery or other historical evidence. Indeed,  this is what the NRCS does in practice.  NRCS personnel make a decide whether or not the drainage outlet (device) is in good condition by examining the available historic aerial photographs and identifying one as providing the best historic drainage.  If the existing drainage matches that historic drainage, then aerial imagery may be used.  That’s what constitutes “best available evidence.”  One of a handful of aerial photographs taken between 1935 and 1985 is picked as the best by the agency expert.  Then it is set aside never to be used again.  The agency expert then judges if the outlet is compromised. 

This is “clarity” and “transparency.”  The NRCS personnel make a judgment call about best historic drainage and the landowner must either accept or challenge it subject to a “substantial deference” standard.   This strategy allows the NRCS to playing the regulatory and judicial system to the government’s advantage rather than focusing on a serious attempt to make an accurate determination of what is the best historic drainage even though scientific methods exist to make that determination.

Conclusion

In Part Two, I will examine the remaining parts of the Final Rule and provide some concluding thoughts. 

September 14, 2020 in Environmental Law | Permalink | Comments (0)

Thursday, September 10, 2020

Ag Law and Tax in the Courtroom

Overview

In today’s post, I take a look at some recent court cases involving agricultural producers and rural landowners.

The next installment of “ag in the courtroom” – it’s the topic of today’s post.

Solar “Farm” Not a Nuisance

Yates v. United States Environmental Protection Agency, No. 6:17-cv-1819-AA, 2019 U.S. Dist. LEXIS 160799 (D. Or. Sept. 20, 2019); Yates v. United States Environmental Protection Agency, No. 6:17-cv-01819-AA, 2020 U.S. Dist. LEXIS 65949 (D. Or. Apr. 14, 2020)

A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land.  Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property.  The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.

The two primary issues at stake in any agricultural nuisance dispute are whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land.  These concepts played out in a case last year involving the construction of a “solar farm” in Oregon. 

In the Oregon case, the plaintiff owned land zoned as “Exclusive Farm Use.” The plaintiff alleged that construction of a 12-acre collection of solar panels (solar array) built on an adjacent property constituted a nuisance by interfering with her use and enjoyment of her property.  The plaintiff also claimed that the construction during the summer of 2017 caused flooding on her property. The plaintiff’s suit was against the adjacent landowner; a company that held a conditional use permit for the solar array; and the construction company. The plaintiff alleged that all three defendants were responsible for the nuisance and trespass claims. The trial court granted summary judgment to all three defendants, finding that the plaintiff failed to offer any material evidence to establish either her nuisance or trespass claim. The court held that the defendant landowner did not engage in any activity constituting a nuisance or trespass. Landowners are generally not responsible for nuisances occurring after the execution of the lease, unless the landowner knew the activity being carried on would involve an unreasonable risk causing the nuisance or had control over the activities on the land. The trial court also noted that merely because the solar company obtained the permit that ultimately allowed construction to happen did not show they had any control over the construction workers’ actions. As for the actions of the construction company, the trial court held the plaintiff failed to allege evidence of an unreasonable interference with her private use or enjoyment of her land. Although the plaintiff complained of increased traffic and leftover debris, she was unable to establish that she had to adjust any daily habits or the manner in which she enjoyed her property as a result of the construction company’s conduct. The plaintiff alleged that a ditch built between the array and her property caused flooding on her property. However, the trial court noted the plaintiff could not show that the defendant construction company built the ditch or that the ditch directly diverted water onto her property. 

In a later action solely against the county, the trial court granted the county’s motion for summary judgment on the plaintiff’s claims of negligence per se and procedural due process.  The trial court determined that the county did not violate state law (a requirement for a nuisance per se) because state law didn’t require the county to provide actual notice to the plaintiff of its permitting decision, but merely an opportunity to appeal.  The appellate court also determined that the setback requirement of state law was complied with and that the waster runoff or flooding allegedly caused by the ditch did not constitute a trespass by water. 

Recreational Use Statute Provides Landowner Protection

Nolan v. Fishman, 218 A.3d 1034 (Vt. 2019)

Many states have what is known as a recreational use statute.  Under such a statute, an owner or occupier owes no duty of care to keep the premises safe for entry or use by others for recreational purposes, or to give any warning of dangerous conditions, uses, structures, or activities to persons entering the premises for such recreational purposes. Similarly, if an owner, directly or indirectly, invites or permits any person without charge to use the property for recreational purposes, the owner does not extend any assurance the premises are safe for any purpose, confer the status of licensee or invitee on the person using the property, or assume responsibility or incur liability for any injury to persons or property caused by any act or omission of persons who are on the property.  But, if injury to recreational users is caused by the willful or malicious failure to guard or warn against a dangerous condition, use, structure, or activity, the protection of the statute is lost. Likewise, if the owner imposes a charge on the user of the property, the liability protection is lost under many state provisions.  In a 2019 case, the Vermont recreational use statute was at issue.

The facts of the Vermont case revealed that the plaintiff is the administrator of the estate of a three-year-old who drowned in a brook on the defendants’ property. The defendants are the parents of the owners of the daycare facility where the decedent had been attending when the accident occurred. The defendants’ land was connected to the daycare property, and the daycare would regularly use a small area of the defendants’ land to access a brook beach and used the defendants’ land for various outdoor activities. The defendants did not profit from the daycare and were not involved in any of the daycare’s business activities. The defendant’s land was not posted, and they had always held it open to the public for recreational use.

The plaintiff sued the defendants alleging their negligence was the direct and proximate cause of the incident. The state recreational use law encourages owners to make their land and water available to the public for no consideration for recreational uses without increasing liability potential for the owner. Under the statute, a recreational user is treated as an adult trespasser, meaning that the landowner must only avoid willfully or wantonly injuring a recreational entrant. 

The trial court found that the activities engaged in by the daycare on defendants’ land were both recreational and educational, therefore qualifying as a recreational use. However, the trial court dismissed the defendant’s motion for summary judgment because questions remained as to whether the defendants’ property was open and undeveloped land that qualified for protection under the statute. On appeal, the appellate court reversed the trial court and held that the statute applied. The appellate court held that the daycare’s use of the defendants’ property was without consideration, qualified as a recreational use, and  that the land was open and undeveloped - the general public was freely permitted to use defendants’ land, along with the daycare. Although the defendants had placed a sandbox and brook bridge on their land, the appellate court noted that the legislature had expressly stated that the presence of such objects on land would not, by itself, preclude land from being open and undeveloped. Therefore, the defendants were covered under the recreational use statute.

Tract Properly Zoned as “Residential.” 

Miller v. Scott County Board of Review, No. 19-1038, 2020 Iowa App. LEXIS 436 (Iowa Ct. App. Apr. 29, 2020)

The rural-urban fringe provides its own unique set of legal issues.  One of those, is an attempt by landowners who aren’t really farmers to qualify their small tracts as “agriculture” for purposes of achieving a lower property tax assessment.  The issue came up recently in an Iowa case.

The plaintiff, a computer services consultant, bought a 10.2-acre tract in 2008. It consisted of approximately two acres of a home and improvements; five acres of deep mud/bog; and 3.6 acres of cropland. The cropland is in a 100-year floodplain. From 2009-2011 the plaintiff grew hay on the cropland, and in 2012 and 2013 he grew corn on it. No crops were grown in 2014 due to weather, and in 2015 he grew corn and pumpkins. He challenged his 2015 property tax assessment and the 2017 assessment as inequitable and on the basis that it misclassified the property as “residential” rather than “agricultural.”

The county zoning board denied his petition and he appealed to the local trial court. At a trial court hearing the county’s assessor noted that the property had multiple uses, but that the plaintiff’s farming operation was “a secondary use.” The county did adjust the valuation downward by 16 percent and granted a “slough bill” exemption for the 2017 tax year. However, the trial court upheld the county’s designation of the property as “residential” on the basis that the plaintiff was a hobby farmer. As such, the trial court determined that the plaintiff’s property taxes should be based on a valuation amount $100,000 greater than the plaintiff desired.

On appeal, the appellate court affirmed, noting that the burden was on the plaintiff to establish the predominant agricultural use of the property. The court agreed with the trial court’s findings that the ag use of the property had never been profitable, and that if it were sold it would be marketed as a residential property rather than a farm property. Indeed, the plaintiff purchased the property as a residential property, and it is surrounded by residential housing. In addition, the largest valued asset on the property is the residence. The plaintiff also testified that he benefited from tax savings as a result of the cropping activities on his tract. He also testified to spending $90,000 for ag equipment and $55,000 to construct a barn but had farm income never exceeding $1,200 annually. That’s a classic “hobby farm” activity.

Conclusion

The legal issues involving rural landowners keep rolling in.  It’s always best to have a well-trained ag lawyer at the ready when needed. 

September 10, 2020 in Civil Liabilities, Real Property | Permalink | Comments (0)

Monday, September 7, 2020

Deducting Business Interest

Overview

The rules surrounding the limitation on deducting business interest have changed significantly for tax years beginning after 2017.  They were modified again earlier this year as part of one of the relief packages designed to deal with the 2020 self-inflicted recession related to the virus that originated in China and ultimately spread to the United States.  Guidance was then provided about the ability of some taxpayers to elect out of the limitation and making late elections.  Final and proposed regulations have also been issued as well as Frequently Asked Questions (FAQs) for determining a taxpayer’s gross receipts for purposes of the small business exception to the limitation. 

The rules on deducting business interest – it’s the topic of today’s post.

TCJA Changes

The deduction limitation.  The Tax Cuts and Jobs Act (TCJA) specified that, for tax years beginning after 2017, deductible business interest expense is limited to business interest income for the tax year plus 30 percent of the taxpayer’s adjusted taxable income (ATI) for the tax year that is not less than zeroI.R.C. §163(j).  Not relevant to farmer and ranchers, “floor plan financing interest,” is fully deductible.  That’s a “biggie” for automobile dealers.

Definitions.  Business interest is defined as the amount of interest paid or accrued on indebtedness that is included in the taxpayer’s gross income for the tax year that is properly allocable to a trade or business.  It does not include investment income within the meaning of I.R.C. §163(d).  Defining a trade or business for purposes of the determining business interest is based on the passive loss rules of I.R.C. §469I.R.C. §163(j) excludes I.R.C. §163(d) interest, which excludes trade or business interest as defined by the passive loss rules.  I.R.C. §163(j)(5). 

ATI is defined as the taxpayer’s taxable income computed without regard to any item of income, gain, deduction or loss that is not properly allocable to a trade or business; any business interest expense or business interest income; any NOL deduction and any I.R.C. §199A deduction, and (for tax years beginning before 2022) any deduction allowable for depreciation, amortization, or depletion.

Carryover.  Any disallowed amount is treated as business interest paid or accrued in the succeeding tax year.  I.R.C. §163(j)(2); Notice 2018-28.  A taxpayer is to use Form 8990 to calculate and report the deduction and the amount of disallowed business interest expense to carry forward to the next tax year.

“Small business” exception.  A “small business,” defined as a business entitled to use cash accounting (i.e., average gross receipts do not exceed $25 million (inflation-adjusted) for the three tax-year period ending with the tax year that precedes the tax year at issue) are not subject to the limitation.  I.R.C. §163(j)(3).  Thus, if average gross receipts are $25 million or less, there is no change in the rules concerning the deductibility of interest – business interest remains fully deductible.  The threshold for being able to utilize cash accounting is, for 2020, set at average gross revenue not exceeding $26 million. 

Gross receipts are defined as gross sales; investment income (regardless of whether it is earned in a business); and all amount received for services.  Treas. Reg. §1.448-1T.  The test applies to the taxpayer rather than the business.  In addition, the receipts of all persons that are treated a single employer under I.R.C. §52(a) or (b) (businesses that are under common control) or I.R.C. §414(m) or (o) (employees of an affiliated service group) are aggregated. Id. 

The threshold test applies to the taxpayer rather than the business.  That has particular implications for partnerships.  For a partnership, the business interest limitation applies at the partnership level.    Thus, a partnership treats its business interest as a non-separately computed deduction for purposes of I.R.C. §702.  Any business interest deduction that is allowed after being limited (if necessary) is combined with other non-separate deductions and income and passed through to the partners as ordinary income or loss.  I.R.C. §163(j)(4)(i).   Thus, each partner’s ATI is determined without regard to the partner’s distributive share of any of the partnership’s items of income, gain, deduction, or loss.  Stated another way, a partner’s ATI is tied to the partner’s non-partnership income and the partner’s share of any excess taxable income of the partnership.  I.R.C. §163(j)(4)(ii).  Comparable rules apply to S corporations and their shareholders.  I.R.C. §163(j)(4)(D)

Election out of the limitation.  Two types of businesses can make an irrevocable election to avoid the limitation on interest deductibility – a “real property trade or business” and a “farming business.”  For this purpose, a cash rent landlord is not engaged in a farming business.  An “electing farm business” that is barred from using cash accounting because gross revenue exceeds the threshold can elect to not be subject to the limitation on the deductibility of interest.  For this purpose, a “farm business” is defined as the trade or business of farming, including the trade or business of operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts or other crops, or ornamental trees.  An evergreen tree which is more than six years old at the time that it is severed from the roots is not treated as an ornamental tree.  I.R.C. §263A(e)(4). 

In return, such farm business must use the alternative depreciation system (ADS) on purchases of farm property with a recovery period of 10 years or more.  The use of ADS will result in the inability to take bonus depreciation on otherwise eligible assets (in accordance with I.R.C. §263A). Also, the required switch to ADS for the taxpayer’s existing property is not a change in accounting method.  It’s just a change in use.  See Rev. Proc. 2019-8, 2019-3 I.R.B.

Treas. Reg. §1.168(i)-4(d) specifies that when a business switches to a longer ADS life as the result of a change in use, the depreciation deductions beginning with the year of the change are determined as though the taxpayer originally placed the property in service with the longer recovery period and/or the slower depreciation method.  Then, the business uses the asset’s remaining basis and depreciates it via the straight-line method over the asset’s remaining life as if it had originally been placed in service with the ADS life.  See Treas. Reg. §1.168(i)-4(d)(6), Example 3.

CARES Act Changes

The Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted in late March of 2020 allows a business with gross receipts over $26 million (for 2020) to elect to increase the limitation on the deduction of interest from 30 percent of ATI to 50 percent of ATI for tax years beginning in 2019 and 2020.  A business may elect to use 2019 ATI in calculating the 2020 limitation.  If an election is made to compute the limitation using 2019 ATI for a tax year that is a short tax year, the ATI for the taxpayer’s last tax year beginning in 2019 which is substituted under the election will be equal to the amount which bears the same ratio to the ATI as the number of months in the short taxable year bears to 12. A taxpayer may elect out of the increase for any tax year beginning in 2019 or 2020.  It is an irrevocable election unless IRS consents to a revocation. 

IRS Guidance.  In Rev. Proc. 2020-22, 2020-18 I.R.B., the IRS set forth the rules for making a late election or withdrawing an election for real property trades or businesses and farming businesses.  The IRS, in the Rev. Proc, also provided guidance concerning the following:

  • The time and manner for electing out of the 50 percent of ATI limitation for tax years beginning in 2019 and 2020;
  • Using the taxpayer’s ATI for the last tax year beginning in 2019 to calculate the taxpayer’s limitation for tax year 2020; and
  • Electing out of deducting 50 percent of excess business interest expense for tax years beginning in 2020 without limitation.

A farming business that previously elected not to have the interest limitation apply, can either make a late election or elect out of the election that was previously made.  This provides flexibility and may allow the use of bonus depreciation on assets with a 10-year or longer life and MACRS depreciation. 

The 50 percent of ATI limitation does not apply to partnerships for taxable years beginning in 2019. Rather, a partner treats 50 percent of the partner’s allocable share of the partnership’s excess business interest expense for 2019 as an interest deduction in the partner’s first taxable year beginning in 2020 without limitation.  The remaining 50 percent of excess business interest from 2019 is subject to the ATI limitation as it is carried forward at the partner level.  Effective for tax years beginning after 2018, a partner may elect out of the 50% limitation.

Regulations.  In late July of 2020, the IRS issued final and proposed regulations that detail how to calculate the interest expense limitation, what constitutes “interest” for purposes of the limitation, the taxpayers that are subject to the limitation, and how the limitation applies to partnerships (among other types of taxpayers).  T.D. 9505.  In large part, the final regulations mirror the 2018 proposed regulations.  However, while the proposed regulations provided a broad definition of “business interest,” the final regulations are narrower.  The regulations are generally applicable to tax years beginning on or after November 13, 2020.

The proposed regulations issued along with the final regulations address the allocation of interest expense for passthrough entities, and propose a modification to the definition of a real property trade or business under I.R.C. §163(j)(7)(B)

FAQs.  The IRS has also posted FAQs on it website concerning the aggregation rules that apply for purposes of the gross receipts threshold.  https://www.irs.gov/newsroom/faqs-regarding-the-aggregation-rules-under-section-448c2-that-apply-to-the-section-163j-small-business-exemption#footnote-1

Conclusion

The typical farm and ranch business will have little business interest income unless sales are financed. However, livestock feedlots follow a highly leveraged business model with characteristically high levels of business interest income and expense.  The substantial majority of farming/ranching businesses will be able to elect out of the limitation and fully deduct business interest.  But the election out comes at a price.  Once again, sage tax and legal counsel is a must.

September 7, 2020 in Income Tax | Permalink | Comments (0)

Saturday, September 5, 2020

Issues With Noxious (and Other) Weeds and Seeds

Observation

A constant struggle for farmers is the battle with weeds.  Some weeds must be controlled.  Those are the ones that are listed by the state as noxious weeds.  Failure to control those can bring monetary penalties from local government officials.  Then there are non-noxious weeds that aren’t required to be controlled.  Those are a big issue when a neighbor fails to control them and their seeds drift in the wind and create a weed problem on an adjacent owner’s tract.  That can also present legal issue.  In addition, both the state and federal government have rules governing seeds designed to prevent the spread of noxious weeds.

Legal issues associated with weeds – it’s the topic of today’s post.

Federal Seed Act

Originally enacted in 1939, the Federal Seed Act (Act) (7 U.S.C. §§ 1551-1611).has two major purposes:  (1) to correct abuses in the merchandising of agricultural and vegetable seed in interstate commerce; and (2) to prevent the importation of adulterated or misbranded seed.  The Act is essentially a truth-in-labeling law that protects buyers against purchasing mislabeled or contaminated seed by imposing stringent labeling requirements under which the class and variety of seed must be specified on the label of the seed product. 

Under the Federal Seed Act, seeds are deemed to include “agricultural,” “vegetable,” or “weed” seeds.  In general, the labels must disclose the variety name and kind of seed, and the percentage by weight of each variety of seed representing over 5 percent of the total weight of the container.  Hybrid seeds must be designated, and the label must also contain the lot number, origin (state or nation) of the seed, percentage by weight of weed seeds, the kind and rate of occurrence of noxious weeds, the percentage of germination, the date of the germination test, and the date after which any inoculant used on the seeds may be ineffective.  The Act establishes seed certifying agencies that have the power officially to certify seeds as meeting purity, packaging and processing standards established by the Secretary of Agriculture.  Without certification, any representation of purity is deemed to be a false representation. 7 U.S.C. § 1562.

Violations of the Act may result in having the seed seized, and civil and criminal penalties imposed.  Any violation of the Act or rules and regulations committed with knowledge or as the result of gross negligence is considered a misdemeanor and subjects the offender to a maximum fine of $1,000 for the first offense and $2,000 for each subsequent offense.  Any other violation of the Act or rules and regulations, even though committed without knowledge or actual negligence, subjects the violator to a fine of between $25 and $500 for each violation.  Any act, omission, or failure by an officer, agent, or employee also binds the company, principal, or employer, as the case may be.  The Act does not directly create a private civil remedy for the buyer who may be harmed by a violation, but buyers may recover damages against the seed seller or distributor under general tort or contract law, or by claiming a breach of warranty.  If the problem related to the seeds stems from the failure of the producer or seller to comply with the Act, that will generally be a major factor in resolving the lawsuit.

Seed imported into the United States is also subject to inspection and sampling requirements under the Act. 7 U.S.C. § 1581.  The Collector of Customs is authorized to draw samples of all seeds and screenings so they may be tested and analyzed to insure their fitness for use in the United States.  The Act establishes requirements regarding importation of seed into the United States and when seeds may be denied entry. Certain seed which is declared to be imported for the seeding of roses is subject to the import provisions of the Act.  Seed that is adulterated or deemed to be unfit for seeding purposes may be prohibited from importation.  Unfit or adulterated seed may be cleaned or processed under the supervision of a USDA employee.  If, after careful analysis, it is determined that the clean seed meets the requirements of the Act, the seed may be admitted into the United States.

State Noxious Weed Laws

The liability of farmers and ranchers for the spread of weeds and other noxious or invasive vegetation onto adjoining land is governed by statute in almost all jurisdictions.  Noxious weed laws create a duty on the part of owners, tenants, and other possessors of land to destroy noxious weeds or otherwise prevent their spread.  A typical noxious weed statute delegates enforcement authority to state agriculture officials, as well as local boards and officials.  A typical statute defines the type of noxious weed or other vegetation subject to regulation, establishes county weed control districts, authorizes the appointment of local weed control officials and specifies their authorities and duties, prescribes the duty of landowners to destroy weeds, establishes the procedure for giving notice to offending parties, and provides local control authorities with limited enforcement powers.  Most state noxious weed statutes provide that weed control officials may assess the cost of removing weeds to the property owner rather than a tenant or other person in possession of the premises.  Some statutes also impose criminal penalties for violations.

Recovering damages against a neighbor.  Most state noxious weed laws do not permit an injured landowner to recover civil damages for the spread of weeds from an adjoining owner's property. However, this does not prevent an injured party from suing to recover damages for the defendant's negligence in allowing weeds to overspread the plaintiff's land.  For example, the South Dakota Weed Act (S.D. Codified Laws Ch. 38-22) has been held to not prohibit a private nuisance action for damages caused by a failure to control non-noxious weeds.  Collins v. Barker, 668 N.W.2d 548 (S.D. 2003). In the South Dakota case, the court held that a farmer has duty to use ordinary care in working the land.  Under the facts of the case, the plaintiff could bring a nuisance action to determine whether the defendant breached the duty of ordinary care in working Conservation Reserve Program (CRP) land.

In reality, however, obtaining a judgment may be rather difficult. An injured landowner must usually prove that the weeds were spread by the defendant's active negligence or willful conduct rather than by nature. While it may be possible for the plaintiff to prove negligence by the fact that the defendant was found guilty of violating a criminal weed control provision, there does not appear to be any authority directly on point.

An offended landowner may also be able to recover damages for the spread of noxious weeds onto their land from an adjoining landowner's premises by showing that the noxious weeds were destroyed negligently.  For example, in Kukowski v. Simonson Farm, Inc., 507 N.W.2d 68 (N.D. 1993), the court held that a farmer has a duty to exercise ordinary care when attempting to control or remove weeds.  The land at issue in the case was seeded to grass and a weed control chemical was applied.  Over the course of the growing season, a stand of Kochia and Russian thistle grew on the CRP acreage.  The landowner combined the weeds in an attempt to control the weeds.  A neighboring farmer sued alleging that the combine broke off the weeds in an unnatural manner, allowing them to blow onto their property, causing damage.  The neighbor also claimed that the use of the combine “branded” the weeds, making them readily identifiable as coming from the CRP ground.  $80,000 of damages were claimed for clean-up costs, reduced crop yields and costs for present and future weed control.  While the court noted that the common law does not hold a landowner liable for the natural spread of weeds from their property, liability can be present if weeds spread from an independent act of negligence. 

Weeds in the fence line.  For noxious weeds that are in a partition fence line, state law typically sets forth a procedure for the adjoining landowners to follow to take care of the problem.  That procedure may involve one adjoining landowner making a request of the other adjoining landowner to clear the fence line of noxious weeds.  After a set time, if the needed control hasn’t occurred, then local officials can be notified.  The local officials will come view the matter and make a determination concerning weed control.  If action is to be taken, the local officials may hire someone to control the weeds and then add the costs to the responsible landowner’s property tax bill. 

Road ditches and railroads.  Many states have law requiring counties, townships or municipalities to control noxious weeds within their jurisdiction that are growing along public roadways.  There typically is a timeframe established for the control measures to be taken.  There might also be a weed control requirement outside the specified timeframe(s) if control is necessary to minimize a public safety hazard.  If a landowner controls noxious weeds in ditches, recovery of control costs against the responsible governmental entity is possible, but only if proper procedural requirements are first followed such as providing notice and then (after a period of time without action) requesting the local court to order the governmental body to fulfill its duty. For example, in Metzger v. Horton, 2013 Ohio 2964 (Ohio Ct. App. 2013), a farmer bought a larger combine and needed trees and brush trimmed back along a road he used to get access to the land he farmed.  He requested that the township trustees trim the vegetation, but when they didn’t get the job done, he did it himself and billed the township $1,863 for his costs.  The township trustees didn’t pay the invoice and the farmer sued.  He lost.  The court held that he didn’t follow the proper procedure of seeking a court to order the township to do its job.  As such, his costs he sought reimbursement for were self-imposed. 

For noxious weeds that are growing in the right-of-way of toll-road or rail line, state law commonly specifies the company controlling the toll road (for toll roads) and the railroad company (for rail lines) is responsible for controlling noxious weeds.  If control doesn’t occur, state law typically gives the local government the ability to eliminate the weeds and sue the responsible company for the cost of control. 

Public land.  For noxious weeds on public land, state law may detail the procedure to be followed in controlling such weeds. 

Non-Noxious Weeds

Weeds that are not on a state’s (or county’s) noxious weed list also present problems.  While a farmer has a duty to control the spread of noxious weeds, as noted above, that duty doesn’t extend to non-noxious weeds absent malicious intent to injure an adjoining landowner.  For example, in Krug v. Koriel, 23 Kan. App. 2d 751, 935 P.2d 1063 (1997), the court held that there is no common law duty in Kansas to control volunteer wheat so as to prevent the spread of wheat streak mosaic virus that is caused by the wheat curl mite because volunteer wheat is not listed as a noxious weed under Kansas law.  

Controlling volunteer wheat (and grassy weeds) is a key point, there is no treatment for wheat streak mosaic virus.  This is a big issue in Kansas.  Most recent data show that the five-year average statewide loss is 1.74 percent of the Kansas wheat crop.  In 2017, the loss was estimated at $76.8 million – 5.6 percent of the statewide wheat crop.  A drought in the major wheat growing regions of Kansas in the fall of 2019 and spring of 2020 could mean that more volunteer wheat will be present in 2021 without additional control measures being taken.  Adding to the potential for more volunteer wheat in 2021 is hail damage, head scab and even waterlogged fields in late summer in some areas.  Simply planting later can be at least a partial control technique.

Conclusion

Seeds and weeds present practical and legal issues for farmers and ranchers. With respect to seeds, detailed rules apply to seed that is certified.  For weeds, it’s important to understand the types of noxious weeds in a particular state and the rules governing their control.  For, non-noxious weeds properly following protocol for their control is critical.

September 5, 2020 in Civil Liabilities | Permalink | Comments (0)

Monday, August 31, 2020

Right-To-Farm Law Headed to the SCOTUS?

Overview

Every state has enacted a right-to-farm (RTF) law that is designed to protect existing agricultural operations by giving farmers and ranchers who meet the legal requirements a defense in nuisance suits. It may not be only traditional row crop or livestock operations that are protected.  For example, the Washington statute also applies to “forest practices” which has been held to not be limited to logging activity, but include the growing of trees.  Alpental Community Club, Inc., v. Seattle Gymnastics Society, 86 P.3d 784 (Wash. Ct. App. 2004).   But, the RTF laws vary widely from state-to-state.  One such law, the Indiana version (Ind. Code §32-30-6-9), may be headed to the Supreme Court of the United States (SCOTUS).  It’s not everyday that a request is made of the SCOTUS to hear an RTF law.  What’s going on?

The Indiana RTF law and the SCOTUS – it’s the topic of today’s post.

Right-To-Farm Laws

In general.  The basic thrust of a particular state's RTF law is that it is unfair for a person to move to an agricultural area knowing the conditions which might be present and then ask a court to declare a neighboring farm a nuisance.  Thus, the basic purpose of a right-to-farm law is to create a legal and economic climate in which farm operations can be continued.  RTF laws can be an important protection for agricultural operations.  But, to be protected, an agricultural operation must satisfy the law's requirements. One such common requirement is that a protected activity must be a farming activity.  For example, in Hood River County v. Mazzara, 89 P.3d 1195 (Or. Ct. App. 2004), the state statute that protected farms against nuisance actions was held to bar a lawsuit against a farmer for noise from barking dogs. The use of dogs to protect livestock was held to be farming practice.

Types.  Right-to-farm laws are of three basic types: (1) nuisance related; (2) restrictions on local regulations of agricultural operations; and (3) zoning related.  While these categories provide a method for identifying and discussing the major features of right-to-farm laws, any particular state's right-to-farm law may contain elements of each category.

The most common type of right-to-farm law is nuisance related.  This type of statute requires that an agricultural operation will be protected only if it has been in existence for a specified period of time (usually at least one year) before the change in the surrounding area that gives rise to a nuisance claim.  See, e.g., Vicwood Meridian Partnership, et al. v. Skagit Sand and Gravel, 98 P. 3d 1277 (Wash. Ct. App. 2004).  This type of statute essentially codifies the “coming to the nuisance defense,” but does not protect agricultural operations which were a nuisance from the beginning or which are negligently or improperly run.  For example, if any state or federal permits are required to properly conduct the agricultural operation, they must be acquired as a prerequisite for protection under the statute.

Subsequent changes and the Indiana RTF law.  While right-to-farm laws try to assure the continuation of farming operations, they generally do not protect subsequent changes in a farming operation that constitute a nuisance after local development occurs nearby. See, e.g., Davis, et al. v. Taylor, et al., 132 P.3d 783 (Wash. Ct. App. 2006); Trickett v. Ochs, 838 A.2d 66 (Vt. 2003); Flansburgh v. Coffey, 370 N.W.2d 127 (Neb. 1985)If a nuisance cannot be established, however, the Indiana RTF law has been construed to bar an action when the agricultural activity on land changes in nature.  For instance, in Dalzell, et al. v. Country View Family Farms, LLC, No. 1:09-cv-1567-WTL-MJD, 2012 U.S. Dist. LEXIS 130773 (S.D. Ind. Sept. 13, 2012), the land near the plaintiffs changed hands.  The prior owner had conducted a row-crop operation on the property.  The new owner continued to raise row crops, but then got approval for a 2800-head sow confinement facility.  The defendant claimed the state (IN) right-to-farm law as a defense and sought summary judgment.  The court held that state law only allows nuisance claims when “significant change” occurs and that transition from row crops to a 2,800-head hog confinement facility did not meet the test because both are agricultural uses.  The court noted that an exception existed if the plaintiffs could prove that the hog confinement operation was being operated in a negligent manner which causes a nuisance, but the plaintiffs failed to prove that the alleged negligence was the proximate cause of the claimed nuisance.  Thus, the exception did not apply and the defendant’s motion for summary judgment was granted.  The court’s decision was affirmed on appeal.  Dalzell, et al. v. Country View Family Farms, LLC, et al., 517 Fed. Appx. 518 (7th Cir. 2013).

In another Indiana case, Parker v. Obert’s Legacy Dairy, LLC, 988 N.E.2d 319 (Ind. Ct. App. 2013), the defendant had expanded an existing dairy operation from 100 cows to 760 cows by building a new milking parlor and free-stall barn on a tract adjacent to the farmstead where the plaintiff’s family had farmed since the early 1800s.  The plaintiff sued for nuisance and the defendant asserted the state (IN) right-to-farm statute as a defense.  The court determined that the statute barred the suit.  Importantly, the court determined that the expansion of the farm did not necessarily result in the loss of the statute’s protection.  For instance, the vastly expanded dairy remained covered under the same Confined Animal Feeding Operation permit as the original farm.  In addition, the conversion of a crop field to a dairy facility was protected by the statute because both uses simply involved different forms of agriculture.  The court also noted that the Indiana statute at issue protected one farmer from suit by another farmer for nuisance if the claim involved odor and loss of property value.  Not all state statutes apply to protect farmers from nuisance suits brought by other farmers.

The Himsel Litigation

A more recent case involving the Indiana RTF law is Himsel v. Himsel, 122 N.E.3d 935 (Ind. Ct. App. 2019)I have written previously about the Himsel case here: https://lawprofessors.typepad.com/agriculturallaw/2019/05/coming-to-the-nuisance-by-staying-put-or-when-200-equals-8000.html  

The appellate court in Himsel, determined that the Indiana RTF law applied to protect the defendant because the change in the nature of the defendant’s hog operation from row crop farming to a large-scale confined animal feeding operation (CAFO) involving 8,000 hogs was “not a significant change” that would make the RTF law inapplicable.  In other words, 8,000 hogs in a confinement building raised by a contracting party that likely doesn’t make management decisions concerning the hogs, doesn’t report the associated contract income as farm income on Schedule F, and cannot pledge the hogs as loan collateral due to a lack of an ownership interest in the hogs, was somehow not significantly different from 200 hogs and 200 head of cattle raised by a farmer with associated crop ground who managed the diversified operation.  Just the sheer number of hogs alone stands out in stark contrast.  Also, unlike the Obert’s Legacy Dairy case where the expansion of the dairy farm did not require a new permit, the hog operation in Himsel required a change in the existing zoning of the tract.

The plaintiffs in Himsel, members of the same family as the defendants, were found to have essentially come to the nuisance because one of them chose to retire from farming and remain on the land that he had lived on for nearly 80 years, and the other didn’t move from the rural home they built in 1971.  An 8,000-head hog confinement operation and the presence of 3.9 million gallons of untreated hog manure was comparable to farming in this area in 1941.

The Himsel court also determined that a “taking” had not occurred because the plaintiff had not sold his home and moved away from the place where he grew up and lived all of his life, and the RTF law did not take the entire value of the plaintiff’s property away.  The appellate court, however, did not address the implications of whether its opinion essentially granted the CAFO an easement to produce odors across the plaintiffs’ property.

The appellate court declined to rehear the case (No. 18A-PL-645, 2019 Ind. App. LEXIS 314 (Ind. Ct. App. Jul. 12, 2019)), and the Indiana Supreme Court declined to review the appellate court’s decision by a single vote.  Himsel v. 4/9 Livestock, LLC, 143 N.E. 3d 950 (Ind. Sup. Ct. Feb. 20, 2020).    On July 17, 2020, a petition for certiorari was filed with the SCOTUS.

The Issue Before the SCOTUS – Unconstitutional Taking

The issue presented to the SCOUTUS is singular – whether the Indiana RTF law amounts to a taking of private property without compensation in violation of the Constitution’s Fifth Amendment. Property rights are constitutionally protected under the Fifth Amendment and cannot be taken by governmental action without payment of just compensation.  The Fifth Amendment applies to the states through the Fourteenth Amendment. What is involved in Himsel is not an outright taking of the plaintiff’s land, instead the claim is that the RTF law constitutes a regulatory taking via obnoxious odors and other environmental contamination.  I have written about regulatory takings here: https://lawprofessors.typepad.com/agriculturallaw/2019/10/regulatory-takings-pursuing-a-remedy.html But, is there any precedence for a RTF law being held unconstitutional.  There is.

State court action.  In 1998, the Iowa Supreme Court invalidated an Iowa law designed to preserve agricultural land and provide farmers protection from nuisance lawsuits. Bormann v. Board of Supervisors in and for Kossuth County, 584 N.W.2d 309 (Iowa 1998).  The Iowa law allowed counties to designate agricultural areas of at least 300 contiguous acres.  Farming operations conducted within a designated area were not subject to nuisance lawsuits if they operated properly.  The court ruled that this immunity created a property right, an easement to create odors, over land adjacent to the agricultural area’s boundary.  As a result, the court ruled the Iowa law unconstitutional because the county did not pay the neighbors who would be required to endure the odors and the neighbors could not bring a nuisance action to limit or stop odor production.  The SCOTUS declined further review.  Girres v. Bormann, 525 U.S. 1172 (1999).

In 2004, the Iowa Supreme Court addressed the constitutionality of the Iowa RTF law. Gacke v. Pork XTRA, L.L.C, 684 N.W.2d 168 (Iowa 2004).  In Gacke, the defendant built a confinement hog facility 1,300 feet to the north of the plaintiffs’ farmstead which the plaintiffs had occupied since 1974.  In the summer of 2000, the plaintiffs filed a nuisance action against the defendant claiming damages for personal injury, emotional distress and a decrease in the value of their property, and seeking a permanent injunction, compensatory and punitive damages.  The defendant raised the Iowa right-to-farm statute as a defenseThe pertinent part of the statute provides:

“An animal feeding operation…shall not be found to be a…nuisance under this chapter or under principles of common law, and the animal feeding operation shall not be found to interfere with another person’s comfortable use and enjoyment of the person’s life or property under any other cause of action.”

Importantly, the statutory protection applies regardless of whether the animal feeding operation was established (or expanded) before or after the complaining party was present in the area.  However, the protection of the statute does not apply if the animal feeding operation is not in compliance with all applicable federal and state laws for operation of the facility, or the facility unreasonably and for substantial periods of time interferes with the plaintiff’s comfortable use and enjoyment of the plaintiff’s life or property, and failed to use generally accepted best management practices. 

The plaintiffs claimed that the statute was an unconstitutional taking of their private property without just compensation in violation of both the Federal and Iowa constitutions.  The trial court agreed, determining that the value of their property had been reduced by $50,000, and that the plaintiffs should be awarded $46,500 to compensate them for their past inconvenience, emotional distress and pain and suffering. However, the court refused to award any future special or punitive damages or injunctive relief. 

On appeal, the Iowa Supreme Court held the right-to-farm law unconstitutional, but only to the extent that it denied the plaintiffs compensation for the decreased value of their property.  In essence, the Court held that the statute gave the defendant an easement to produce odors over the plaintiffs’ property, for which compensation had to be paid. 

However, in 2004, the Idaho RTF law that granted immunity from nuisance lawsuits was determined not to amount to an unconstitutional taking of property. Moon v. North Idaho Farmers Association, 140 Idaho 536, 96 P.3d 637 (2004).  That same year, the Texas Court of Appeals reached the same conclusion concerning the Texas RTF law. Barrera v. Hondo Creek Cattle Co., 132 S.W.3d 544 (Tex. App. 2004).   In 2009, the Indiana Court of Appeals, contrary to the Iowa decision in Bormann, and consistent with Barrera, held that the right to maintain a nuisance contained in the Indiana RTF law did not create an easement. Lindsey v. DeGroot, et al., 898 N.E.2d 1251 (Ind. Ct. App. 2009). 

State legislation.  In Colorado and North Carolina, the state RTF laws bar nuisance suits against “farming” operations that undergo major changes to the structure of the operation.  Colo. Rev. Stat. §35-3.5-102; N.C. Gen. Stat. Ann. §106-701(a)(1).  Utah, Nebraska and Oklahoma have built-in statutory “safe-harbors” providing protection from nuisance suits for significant changes to existing farming operations.  Utah Code Ann. §4-44-102(2); Neb. Rev. Stat. §2-4403(2); Okla. Stat. Ann. tit. 50 §1.1

Conclusion

RTF laws are a legitimate purpose of state government.  The idea of promoting animal agriculture and incentivizing multi-generational farming operations and the local communities they support via an RTF law can bear a reasonable relationship to that legitimate objective.   However,  property rights are a fundamental constitutional right.  Any law that impinges on such a right is subject to strict scrutiny.  Thus, an RTF law that grants immunity from nuisance suits when the farming operation changes materially such that it becomes, in essence, an easement to commit a nuisance impacting an existing adjacent/nearby property owner cannot withstand strict scrutiny.  However, that is only the case if the SCOTUS agrees to hear the Himsel case and decides accordingly.  If not, the “patchwork quilt” of state court opinions will continue. 

August 31, 2020 in Regulatory Law | Permalink | Comments (0)

Sunday, August 30, 2020

Tax Incentives For Exported Ag Products

Overview

The Tax Code contains two significant provisions allowing farmers to derive a tax benefit from exporting ag products.  One incentive is derived from the creation of an entity known as the Interest Charge Domestic International Sales Corporation (IC-DISC).  An IC-DISC is a tax-exempt entity that was authorized by the Congress in 1971 to provide a tax incentive to help address the U.S. trade deficit at the time.  It was restructured in 1984 into its present form.  The Tax Cuts and Jobs Act (TCJA) added another export tax incentive that can also be available to agricultural producers – the Foreign-Derived Intangible Income (FDII) deduction.  I.R.C. §250.

The IC-DISC, the FDII deduction and potential tax benefits for farmers and ranchers – it’s the topic of today’s post.

IC-DISC Basics

An IC-DISC allows a farmer that will be selling into an export market to essentially transfer income from the farmer to the tax-exempt IC-DISC via an export sales commission.  An IC-DISC can be formed and utilized by any taxpayer that manufactures, produces, grows or extracts (MPGE) property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business.  That definition certainly includes farmers.  The property to be exported is transferred to the IC-DISC which then sells the assets into an export market.

An IC-DISC has as its statutory basis I.R.C. §§991-997.  It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter.  To meet the statutory definition of an IC-DISC, the entity must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year must equal or exceed 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year.  Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year.  In addition, the corporation must make an election to be treated as an IC-DISC for the tax year.  I.R.C. §992(a)(1).

Properly structured, an IC-DISC is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at a more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1). 

“Destination test.”  As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S.  This is known as the “destination test.”  This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery.  It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold.  The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale.  Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S. 

The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing.  This is particularly the case with fruits and vegetables.  Growers can trace their products to grocery stores and other end-use foreign destinations.  The same is true for grain producers that deliver crops to export elevators.  They will likely be able to get the necessary documents showing the precise export location of their grain products. 

IC-DISC income.  The producer, manufacturer, reseller or exporter pays the IC-DISC a commission based on the amount of export sales for the year.  See Treas. Reg. §1.993-6(e)(1).  The commission paid to the IC-DISC (as a tax-exempt entity) is deductible and, as such, reduces the exporter’s taxable income by the marginal tax rate of the commission amount.  As noted, the commission is tied to the exporter’s foreign sales or foreign taxable income for the tax year, and cannot exceed either 50 percent of net income on sales of qualified export property or four percent of gross receipts from sales from sales of qualified export property. I.R.C. §994(a). Both computations can be used on the same return if there are multiple transactions and grouping of transactions are allowed.  Treas. Reg. §1.994-1(c)(7).  Thus, the taxpayer can tailor the computational method and groupings to maximize the tax benefit of the IC-DISC.     

The IC-DISC does not pay tax on the export sales because of its tax-exempt status.

The IC-DISC distributes its profits as qualified dividends to its shareholders.  Qualified dividends are taxed at preferential capital gain rates – presently anywhere from zero to 20 percent for an active farmer.

Income deferral.  Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral.  Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate.  Each shareholder does their own computation.  Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate.  Tax can be deferred on commissions on up to $10 million per year in export sales that the IC-DISC conducts. 

FDII

The FDII allows a domestic C corporation that sells into foreign markets to claim a deduction for those sales in the amount of 37.5 percent of foreign-derived intangible income.  The actual computation of the deduction is quite complex.  See I.R.C. §§250(a)(1)-(2).   With the C corporate rate currently §set at 21 percent, the FDII effectively reduces that rate to 13.125 percent through 2025.  Income qualified for the FDII deduction is that derived from the sales of property or inventory to foreign persons and for foreign use (including any lease, license, exchange or other disposition), and income derived from services to any foreign person or income from providing services with respect to property not located in the U.S.

Under proposed regulations, a business is to exclude from qualifying sales any products that are sold to a foreign customer that the taxpayer has reason to know would ultimately return to the U.S. for domestic use.  But, recently promulgated final regulations that are effective for tax years beginning on or after January 1, 2021 remove this limitation.  The final regulations also ease up on the documentation requirements concerning foreign use of property.  While specific ordering rules apply under the proposed regulations when applying the interest limitation of I.R.C. §163(j), the final regulations specify that any reasonable method can be used to order allowed deductions.  Other rules can apply when the property sold is later incorporated into another finished product, and when related parties are involved.   

Is the IC-DISC Better Than the FDII Deduction?

Which tax incentive is better depends on the taxpayer and the type of export income.  The IC-DISC applies to goods that are produced in the U.S. from U.S. materials.  Agricultural commodities meet that requirement.  There is no comparable requirement for the FDII deduction – there just has to be a sale of property to a foreign person for a foreign use.  While that can be an important distinction for many businesses, it is largely immaterial for ag businesses.  The FDII deduction also applies to a much broader range of service income than does the IC-DISC.  Again, however, that distinction is not a material one for most ag production operations.  Also, while a distributor can be used to sell ag products in the IC-DISC context, a taxpayer that sells U.S. MPGE products to a distributor who then exports the products cannot claim and FDII deduction.  Only direct sales count.  See I.R.C. §250(b)(4). 

Conclusion

The IC-DISC and the FDII deduction are designed to incentivize export sales.  Both provisions may be unheard of by many farmers and practitioners.  However, they can play a role in the overall income tax planning and business structuring process.  As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes.  In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling.  Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation.  That will please the on-farm heirs (and, likely, the parents).

The FDII deduction is only available to C corporate taxpayers, but there are no entity formation, operational and administrative costs associated with it as there are with the IC-DISC. 

Both provisions are complex and require competent tax and legal assistance to maximize their potential benefits. 

August 30, 2020 in Income Tax | Permalink | Comments (0)

Monday, August 24, 2020

Court Developments in Agricultural Law and Taxation

Overview

The cases and rulings involving agriculture keep on coming.  In today’s post, I pick out just a few involving some rather common issues.

Ag law in the courts – it’s the topic of today’s post.

Railroad Responsible For Faulty Railroad Fence 

Leslie v. BNSF Railway. Co., No. Civ. 1:16-cv-1208-JCH-JHR, 2019 U.S. Dist. LEXIS 154460 (D. N.M. Sept. 10, 2019)

Railroads are responsible for building and maintaining railroad fences.  But, the nuances of each state’s fence law involving railroads can cause some interesting arguments.  In a New Mexico case last year, the court was faced with addressing a previously unanswered application of the state fence law as applied to a railroad.   

The plaintiffs collided with a cow on a public highway.  The defendant was responsible for building and maintaining the adjacent fence along a ranch that it had a right-of-way through. The plaintiffs alleged that the railroad company negligently maintained the fence, which allowed a cow to escape onto the highway. The defendant claimed that it did not own the cow that escaped, and that the plaintiff’s theory for recovery hinged on the defendant first being found liable in an action against the owner of the livestock. The defendant removed the action from New Mexico state court to federal court and sought a judgment with respect to both of the plaintiffs’ negligence claims.

 The court interpreted the New Mexico legislature’s intent of whether the plaintiffs were a protected class under the state’s fence law and determined that the plaintiff failed to establish a negligence per se claim requiring railroads to build fence lines. The purpose of the railroad fencing portion of the fence law, the court determined, was to protect owners of livestock rather than the motoring public.  The plaintiffs’ second claim was that the defendant was per se negligent by permitting the cow to wander upon the road. The statute at issue stated that it was unlawful for “any person” to “negligently permit” livestock to wander upon any unfenced highway. The defendant argued that the term “permit” required that the negligence of the owner of the livestock must be established before liability would attach. Although the court determined that the phrase “any person” had not been construed to mean persons other than owners of livestock, it concluded that the New Mexico legislature had limited the application of similar statutes and failed to do so in this instance. According to the court, the failure to limit the statute by the state legislature meant the statute was intended to be interpreted broadly in order to protect a broader class of people.  The court held that the plaintiffs had established themselves as members of the class sought to be protected by the fence law and that the defendant had permitted the cow to wander on the road. Upon further consideration, the plaintiff must establish whether the defendant had negligently permitted the cow to wander upon the road.

Paying Principal Amount Within Redemption Period is Insufficient to Redeem Property

Sibley State Bank v. Zylstra, No. 19-0126, 2020 Iowa App. LEXIS 830 (Iowa Ct. App. Aug. 19, 2020)

When farmland is foreclosed upon, the owner is given a period of time to redeem the property by paying the price the property brought at the foreclosure sale plus costs.  But details matter.  In this case, the plaintiff purchased one of two parcels of land at a foreclosure action and another business purchased the other parcel. Under state (Iowa) law, the buyers took the property subject to the prior owner’s one-year right of redemption from the date of the sale. The prior owner assigned its redemption rights to the defendant 364 days after the foreclosure sale. The next day (the final day of the redemption period) the defendant tendered a check to the county court clerk for the principal amount of the two foreclosure bids and received a receipt from the clerk showing a “balance due” of zero.

Two days later, the plaintiff applied for a hearing on the redemption issue to refund the defendant’s check and sought a finding that no redemption had occurred because the amount tendered by the defendant did not include interest and fees. The defendant claimed that the court clerk would not tell him the exact amount that was necessary to redeem both properties upon his asking. The defendant further claimed that the clerk withheld the amount from him, and that he had acted in good faith in trying to redeem the properties by paying the full principal amount (well over $1 million). The trial court found that the defendant failed to inquire with either the bank or the bank’s attorney what the amount due for redemption would be. Additionally, the trial court held that the county clerk had no duty to the defendant to determine the redemption amount. On appeal, the defendant claimed that the trial court erred in not granting him equitable relief, and that he paid a sufficient amount to redeem at least one of the properties. The appellate court affirmed, holding that the mistake in calculating the payoff amount was the defendant’s sole fault. Further, the appellate court noted the defendant could have taken advantage of a safe harbor provision, as the redemption period was about to expire, but failed to do so. As for the defendant’s claim of partial redemption for having tendered an amount exceeding the redemption price of either property, the appellate court held that in order to redeem one tract required the defendant to specify which parcel was being redeemed. The appellate court held that an insufficient payment for redemption of two properties alone cannot result in an after-the-fact redemption of one of the properties.

A Prescriptive Easement May Be Created Over a Ditch or Waterway

Five Forks Hunting Club, LLC v. Nixon Family Partnership, No. CV-18-301, 2019 Ark. App. LEXIS 397 (Ark. Ct. App. Sept. 11, 2019)

Easement issues are frequently encountered with respect to agricultural properties.  But, is an access easement restricted to land, or can it apply to water access?  That was the issue involved in this case.

Here, the parties owned adjoining tracts that they used for duck hunting.  The plaintiff sought a declaratory judgment against the defendant, claiming that the plaintiff had the right to control the use of a ditch that the defendant had been using to gain access to the plaintiff’s land. The plaintiff had built a bridge to block the defendant’s path to their property, and in years past had obstructed the defendant’s path on separate occasions. The plaintiff claimed that the defendant merely had permissive use of the ditch, but the defendant sought a prescriptive easement over the ditch and a road that ran parallel to the ditch. The defendant would use the road to gain access to the land during dry periods and travel by boat in the ditch during times where the road was underwater. The trial court held that the defendant was able to establish an easement by prescription over the ditch by establishing that a preponderance of the evidence showed that the use of the ditch was adverse to the plaintiff and under a claim of right for the seven-year statutory period. On appeal, the appellate court noted that under Arkansas law, any vehicle needed for the operation of the easement could be driven across the servient estate. A boat could be used to access the easement therefore a prescriptive easement could be created over a ditch or waterway. The plaintiff also argued on appeal that the defendant failed to prove the necessary elements of a prescriptive easement. The plaintiff argued that the use of the ditch was not continuous or uninterrupted for the required statutory period because the ditch was not always flooded. The appellate court, however, held that mere temporary absences of a claimant do not interrupt the “continuous” requirement for a prescriptive easement. Also, the plaintiff’s attempts to obstruct the defendant’s use of the ditch occurred after the defendant had met the statutory requirement for establishing a prescriptive easement. Finally, the appellate court noted that the trial court’s decision to not limit the prescriptive easement for the ditch to a shorter route was not in error as it created no additional burden to the plaintiff landowner.

Lack of Proof for Ag Sales Tax Exemption 

Arkansas Dept. of Rev. Legal Counsel Op. No. 20200527 (Jul. 21, 2020)

In many states, personal property used in farming is exempt from sales tax.  That is the case, for example, in Arkansas.  But, it is important to be able to certify that the buyer is engaged in the trade or business of farming and that the item(s) purchased will be used in farming.  Under many state provisions, to be exempt the item(s) purchased must be used directly in farm production activities.  Indirect uses, such as an all-terrain vehicle used to spray weeds on the farm, don’t qualify.

Under the Arkansas procedure, a farmer provides a “Farm Exemption Certificate” to a seller so that the seller knows whether the sale of an item is exempt from sales tax because the buyer was engaged in farming and the item purchased would be used directly and exclusively in farming.  Here, the question was whether livestock shade systems and mower covers qualified for the exemption.  Based on the facts presented, it was determined that the taxpayer (seller) did not provide sufficient facts concerning any specific sale or transaction for a determination of exemption to be made.  However, the seller could rely on the buyer’s Certificate and could accept a certification or other information from the buyer to establish that the sale was exempt.  Alternatively, the taxpayer could accept a certification or other information that the buyer provided to establish that the sale was exempt.  Such, other information could include the buyer certifying in writing on a copy of the invoice or sales ticket that the taxpayer would retain stating that the buyer was a farmer and that the items would be used exclusively and directly in farming as a business. 

More Problems with Donated Permanent Conservation Easements

Belair Woods, LLC v. Comr., T.C. Memo. 2020-112 ; Cottonwood Place, LLC, et al. v. Comr., T.C. Memo. 2020-115

The Tax Court continues to render decisions involving claimed charitable deductions for the donation of “permanent” conservation easements.  At the National Farm Income Tax/Estate and Business Planning Conference last month in Deadwood, SD, U.S. Tax Court Judge Elizabeth Paris stated that many cases remain in the Tax Court’s pipeline yet to decide.  That vast majority of the decision so far have been decided in favor of the IRS.  Don’t expect that trend to change. 

I.R.C. §170(h)(5)(A) requires that an easement donated to a qualified organization to be “protected in perpetuity.”  Treas. Reg. §1.170A-14(g)(6) requires that the easement grant must, upon extinguishment, result in the charity receiving a proportionate part of the proceeds when the property subject to the easement is sold.  In Belair Woods, however, the deed language did not provide the charity with a proportionate part of the gross sales proceeds.  Instead, it specified that the charity would receive the extinguishment proceeds reduced by any increase in value related to improvements that the donor had placed on the property.  The deed language also required a reduction in the proceeds going to the charity by an amount paid to satisfy any and all prior claims regardless of whether a claim arose from the donor’s conduct. 

The Tax Court strictly construed the regulation and denied a charitable deduction for the donation because the grantee was not in all cases absolutely entitled to a proportionate share of the proceeds upon extinguishment sale of the property.  As such, the contribution was not protected in perpetuity.  The Tax Court noted that the improvements were part of the donation rather than the donation being restricted just to the underlying land.  The rights to construct improvements were restricted in meaningful ways by the easement, and also enhanced the property’s value.   The petitioner also claimed that the IRS had accepted deed terms comparable to the petitioner’s deed via a stipulation in a case involving a different petitioner and, as such, should be estopped from disallowing the petitioner’s deduction.  The Tax Court determined that the petitioner had failed to satisfy its burden in establishing that judicial estoppel should apply because the IRS position in the other case was merely a tactical stipulation and the case was settled. 

In Cottonwood Place, LLC, the petitioner donated a conservation easement on land to a land trust (qualified charity), reserving the right to construct limited improvements in the area subject to the easement.  The Tax Court determined that no charitable deduction was allowed because the deed language didn’t entitle the charity to a proportionate share of any easement extinguishment proceeds if a court were to extinguish the easement and order the property sold.  Thus, the language violated Treas. Reg. §1.170A-14(g)(6).  The Tax Court noted that the deed language specified that the charity’s share of such proceeds would be reduced by the value of improvements added to the property after the easement donation.  The Tax Court rejected the petitioner’s substantial compliance argument. 

Conclusion

As you can see, issues involving agricultural land and agricultural producers are prevalent.  Good legal and tax counsel is a must.  That’s what we are training at Washburn Law School in the Rural Law Program.  This week we welcome new students to the program from state across the country!

August 24, 2020 in Civil Liabilities, Income Tax, Real Property | Permalink | Comments (0)

Wednesday, August 12, 2020

Demolishing Farm Buildings and Structures – Any Tax Benefit?

Overview

The acquisition of a farm or changes in the farming business may lead to the need demolish existing buildings and structures.  Also, the recent major wind and rainstorm that stretched from Nebraska to Indiana damaged many farm buildings and structures that may now be irreparable and require demolition.  Is there any tax benefit associated with demolishing buildings and structures?  If not, perhaps it’s most economical to leave unused buildings and other improvements standing.

Tax issues associated with demolishing farm buildings and structures – it’s the topic of today’s post.

General Rules

Capitalize into land basis.  I.R.C. §280B provides that “in the case of the demolition of any structure…no deduction otherwise allowable under this chapter shall be allowed to the owner or lessee of such structure for any amount expended for such demolition, or any loss sustained on account of such demolition.”  Instead such amounts “shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.”  Thus, the amounts must be capitalized and added to the income tax basis of the land on which the building or structure was located.  Likewise, effective for tax years beginning after 1985, it became no longer possible to receive a tax deduction for the removal of trees, stumps and brush and for other expenses associated with the clearing of land to make it suitable for use in farming.  I.R.C. §182, repealed by Pub. L. 99-514, Sec. 402(a), 100 Stat. 2221 (1986).  Accordingly, the cost of removing trees and brush, capping wells and grading the land to make it suitable for farming cannot be presently deducted.  Instead, such costs are treated as development expenses (capital investment) that are added to the basis of the land. 

Use before demolishing.  If a farm building or structure is used in the taxpayer’s trade or business of farming for a period of time before being demolished, depreciation can be claimed for the period of business use.  Treas. Reg. §1.165-3.  Upon demolition, the remaining undepreciated basis of the building or structure would be added to the basis of the land along with the demolition costs.  In situations where the taxpayer purchased the property with the intent of demolishing the buildings and/or structures after using them in the taxpayer’s trade or business for a period of time, the fact that the taxpayer ultimately intended to demolish the buildings is taken into account in making an apportionment of basis between the land and the buildings under Treas. Reg. §1.167(a)-5.  Treas. Reg. §1.165-3.  In this situation, the amount allocated to the buildings/structures cannot exceed the present value of the right to receive rentals from the buildings/structures over the period of their intended use.  Id. 

Abandonment.  If the buildings and structures are simply abandoned, any remaining basis is treated as a disposition or a sale at a zero price.  That means that the remaining income tax basis becomes an ordinary loss that is reported on Form 4797.  If the abandoned buildings and structures are eventually demolished at least one year after the taxpayer ceased using them in the farm business, they have no remaining basis and only the cost of demolition would be added to the land’s basis. 

Demolition After Casualty 

As noted above, the inland hurricane that pelted parts of Iowa and Illinois with sustained winds near 100 miles-per-hour that ultimately traveled nearly 800 miles in 14 hours, created significant damage to farm structures.  When a casualty event such as this occurs, the normal capitalization rule of I.R.C. §280B does not apply when a structure that is damaged by the casualty is demolished. In Notice 90-21, 1990-1 C.B. 332, the IRS said that the capitalization rule does not apply to “amounts expended for the demolition of a structure damaged or destroyed by casualty, and to any loss sustained on account of such demolition.”  Instead, the income tax basis of the structure is reduced by the deductible casualty loss before the “loss sustained on account of” the demolition is determined.  That means for a farm building or structure destroyed in the recent inland hurricane, for example, the income tax basis in the building or structure at the time of the casualty would be deductible as a casualty loss but the cost of cleaning up the mess left behind would be capitalized into the land’s basis.  In essence, the loss sustained before demolition is not treated as being sustained “on account of” the demolition with the result that the loss isn’t disallowed by I.R.C. §280B.  It’s an “abnormal” retirement caused by the “unexpected and extraordinary obsolescence of the building.”  See, e.g., DeCou v. Comr., 103 T.C. 80 (1994); FSA 200029054 (May 23, 2000); Treas. Reg. §1.167(a)-8(a).  Conversely, if a taxpayer incurs a loss to a building or structure and decides to withdraw a building or structure from use in the trade or business and then demolish it in a later year with no tax event occurring in the interim, the demolition costs are subject to the disallowance rule of I.R.C. §280BSee, e.g., Gates v. United States, 168 F.3d 478 (3d Cir. 1998), aff’g., No. 1:CV-97-0676, 1998 U.S. Dist. LEXIS 5582 (M.D. Pa. Mar. 27, 1998).  In that situation, the taxpayer might be able to claim a casualty loss for the year in which the loss occurred (consistent with the casualty loss rules in place at the time), and if the structure is later demolished the structure’s basis must be reduced by the casualty loss that was allowed by I.R.C. §165 before the nondeductible loss sustained on account of the demolition can be determined.  Notice 90-21, 1990-1 C.B. 332.

Tangible Property Regulations

In late 2013, the IRS released final regulations providing rules regarding the treatment of materials and supplies and the capitalization of expenditures for acquiring, maintaining, or improving tangible property (the final repair regulations).  T.D. 9636 (Sept. 13, 2013).  About a year later, the IRS issued final regulations on dispositions of tangible property, including rules for general asset accounts (GAAs) (the final disposition regulations).  T.D. 9689 (Aug. 14, 2014). These regulations are generally effective for tax years beginning on or after Jan. 1, 2014. Under the regulations, a taxpayer generally must capitalize amounts paid to acquire, produce, or improve tangible property, but can expense items with a small dollar cost or short useful life. The regulations also provide a de minimis safe harbor that can be elected on a yearly basis to expense all items under a certain dollar cost.  The repair regulations also contain specific rules for determining whether an expenditure qualifies as an improvement or a betterment (essentially following established caselaw) and provide a safe harbor for amounts paid for routine property maintenance.  There is also an election that can be made to capitalize certain otherwise deductible expenses for tax purposes if they are capitalized for book purposes.

The repair/disposition regulations provide a potential opportunity for a taxpayer to continue depreciating a building/structure after demolition has occurred.  Under the regulations, a taxpayer doesn’t have to terminate a GAA upon the disposition of a building/structure.  Thus, the taxpayer that has included buildings and structures in a GAA may choose whether to continue to depreciate them when they are disposed of (e.g., demolished) or capitalize the adjusted basis into the land under I.R.C. §280B

The adjusted basis of any asset in a GAA that is disposed of is zero immediately before its disposition.  The basis associated with such an asset remains in the GAA where it will continue to depreciate.  See Treas. Reg. §§1.168(i)-1(e)(2)(i) and (iii).  Consequently, the basis of a demolished building/structure where the cost of the demolition would be subject to capitalization under I.R.C. §280B is zero and the taxpayer can continue to depreciate the basis in the GAA.  But, if only one demolished building/structure is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building/structure would, in effect, be capitalized in under I.R.C. §280B.  Likewise, the strategy doesn’t apply if the building or structure is acquired in the same year that it is demolished or if the taxpayer intended to demolish the building/structure at the time it was acquired.  See Treas. Reg. §§1.168(i)-(c)(1)(i); 1.168(i)-1(e)(3)(vii). 

The opportunity to use the technique is further limited by a requirement that the taxpayer must have elected to include the building in a General Asset Account (GAA) in the year the taxpayer placed the building/structure in service and is in compliance with the GAA rules.  The election must have been made on an original return. 

Conclusion

The inland hurricane of August 10 wreaked havoc on a great deal of agricultural assets that were in its path.  The tax rules surrounding the disposition of disaffected assets are important to understand.

August 12, 2020 in Income Tax | Permalink | Comments (0)

Monday, August 10, 2020

Exotic Game Activities and the Tax Code

Overview

Wild game “farms” are big business in the United States.  In Texas alone, in excess of four million acres are devoted to wild game farming activities.  Interest continues to grow in such activities such as the raising of captive deer, for example, often as a result of the possibility of greater profitability on fewer acres than is presently possible with raising cattle. But, how does the IRS view such activities?  Is it a “farm” for purposes of tax Code provisions that provide special tax status to “farm” businesses?

The tax treatment of wild game activities – it’s the topic of today’s post.

Definition of “Farming”

I.R.C. § 464(e) broadly defines “farming” to include the feeding, caring for and management of animals.  In addition, Treas. Reg. §1.61–4(d) defines “farm” as including stock farms and ranches owned and operated by a corporation.  For purposes of the deduction for soil and water conservation expenses, I.R.C. §175(c)(2) defines “land used in farming” to include land used for the sustenance of livestock.  Under the uniform capitalization rules, the term “farming business” includes a trade or business involving the raising, feeding, caring for, and management of animals. Treas. Reg. §1.263A–4T(c)(4)(i)(A).  For purposes of ag labor I.R.C. §3121(g)(1) includes within the meaning of “agricultural labor,” service connected with raising wildlife. Taken together, these provisions are broad enough to classify the raising of exotic and wild game as a farm.  Likewise, the tax Code defines an exotic game rancher as a “farmer.”  Work on an exotic game ranch meets the definition as agricultural labor.

1996 IRS Technical Advice

In Tech. Adv. Memo. 9615001 (Oct. 17, 1995) involved a taxpayer (an S corporation) that maintained a hunting property where deer were raised and managed for ultimate “harvest” by hunters who paid to come onto the property to hunt.  It was a “trophy deer” operation.  The taxpayer operated the activity such that each animal attained a body weight and antler size far exceeding that occurring naturally among deer of the same species.  The deer were enclosed behind a game fence and all native deer on the enclosed property were then hunted and killed.  The taxpayer bought whitetail deer from various locations in the United States, and brought them to the property where they were tagged, medically examined and treated as necessary.  The deer were then released into the enclosed property.  The taxpayer hired a genetic and nutritional consultant to help assure the economic success of the activity and to structure it as a research project to that it was in compliance with state law.  The state exercised substantial control over the activity, deeming the deer to be the state’s natural resources that could only be harvested by hunting.  The taxpayer culled the deer herd with hunts by paying hunters.  The taxpayer sought a private letter ruling which addressed the question of whether the taxpayer was a “farmer” operating a “farm for profit.” 

The IRS, in answering that question, noted that Treas. Reg. §1.162-12 does not define the terms “farmer,” “farms” or the “business of farming.”  But, the IRS referenced the Code sections discussed above and that I.R.C. §1231 property (characterizing gain or loss realized on the disposition of certain business property) includes livestock held by the taxpayer for draft, dairy or sporting purposes.  I.R.C. §1231(b)(3).  That’s virtually any mammal held for breeding or sporting purposes.    

Also, the IRS noted that Treas. Reg. §1.1231-2(a)(3) provides that for purposes of I.R.C. §1231, the term “livestock” is given a broad, rather than a narrow, interpretation and includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.  It does not include poultry, chickens, turkeys, geese, pigeons, other birds, fish, frogs, reptiles, etc.  When defining the term “gross income of farmers” the term “farm” includes stock, dairy, poultry, fruit and truck farms, as well as plantations, ranches and all other land used for farming operations.  Treas. Reg. 1.61-4(d).  The IRS also pointed out that “agricultural labor” includes services in connection with raising wildlife.  I.R.C. §3121(g)(1). 

Thus, the Code and Regulations broadly classified deer as “livestock,” a deer ranch as a “farm,” a deer rancher as a “farmer” and work on a deer ranch as agricultural labor.  Likewise, the taxpayer’s activities involving the importing, breeding, raising, feeding, protecting and harvesting the captive deer involved the operation of a farm by a farmer similar to the production of more conventional livestock such as cattle and hogs.  The Code makes no distinction as to the type of livestock or the method of harvest.  What is key are the activities the taxpayer engaged in to produce stock of marketable size and quantity.    

Thus, the IRS concluded that the taxpayer was engaged in the business of farming for purposes of Treas. Reg. §1.162-12 (deducting from gross income all amounts expended in carrying on the business of farming) if the activities were engaged in for profit. 

Depreciation

What is the appropriate depreciable recovery period of exotic game animals, including domesticated deer under the Modified Accelerated Cost Recovery System (MACRS)?  Under MACRS, cattle, sheep and goats have a five-year recovery period. Rev. Proc. 87-56, 1987-2 C.B. 647.  Breeding hogs are three-year property.  Id.  Under Rev. Proc. 87-56, 1987-2 C.B. 647, any property that is not described in an asset class or used in a described activity defaults to the seven-year classification under MACRS (12 years for alternative MACRS).  Rev. Proc. 87-56, 1987-2 C.B. 647 does not mention exotic game animals, thus the animals would be classified as seven-year property.  But, as “farm animals” and, thus, a depreciable asset used in farming, a plausible argument can be made that while they would have a recovery period of seven years, their alternative live would be ten years (rather than twelve).  Also, because there is no requirement for depreciation purposes that animals be domesticated, an argument could also be made that a five-year recovery period applies for certain types of exotic sheep and goats.  Indeed, perhaps all ruminant exotic game animals could be classified as five-year MACRS property on the basis that the livestock species in the five-year category are ruminant animals – cattle, sheep and goats.  Hogs and horses, non-ruminant animals, have different recovery periods than cattle, sheep and goats. 

Because the activity is classified as a farming activity, the fencing used in exotic game (including captive deer) activities would be an agricultural asset and classified as seven-year MACRS property.  In addition, as livestock that are tangible personal property, the game animals would qualify for expense method depreciation.  I.R.C. §179.  The same is true for qualifying costs of game fences and catch pens. 

Unanswered Question

A question that the TAM lest unanswered is whether the hunters’ activity would meet the definition of “hunting” for tax purposes.  That could have implications for the meal and entertainment rules as well as deducting travel and lodging costs. 

Conclusion

With the increase in non-traditional uses of agricultural land, the questions of whether the use of the land is a “farming activity” and the assets involved are “farming” assets has become an important question. 

August 10, 2020 in Income Tax | Permalink | Comments (0)

Wednesday, August 5, 2020

The Use of the LLC For the Farm or Ranch Business – Practical Application

Overview

Last week I wrote a two-part series on how the single-member LLC can be utilized as part of a farming or ranching business.  A large part of my focus was on the single-member LLC and what it means to be a disregarded entity.  In part two, I noted that the Tax Court has held that while a single-member LLC is a disregarded entity for federal income tax purposes, it is respected for federal estate and gift tax purposes.  As a result, valuation discounts can be available to decrease the taxable value of the owner’s interest in the single-member LLC.

In today’s post, guest author Marc Vianello, of Vianello Forensic Consulting, provides a practical application of the concepts that I discussed last week.  Many thanks to Marc for today’s article.

Single-Member LLCs – Valuation Implications

Assume that Broad Horizon Family Farms is a Kansas farming/ranching family comprised of a father, mother, son, and daughter.  The farm/ranch is operated as a unified business under the ownership of a four-partner general partnership.  As an unincorporated entity, this structure allows for four payment limitations for federal farm program payment purposes.  The partners of the partnership are four Kansas LLCs that each own an equal 25 percent interest in the partnership—no partner has control, and no family member is a partner. 

Also assume that father, mother, son, and daughter each own 100 percent of one of the four LLCs.  Each family member, therefore, owns a 100 percent interest in an LLC that owns a 25 percent interest in the partnership.  Assuming that the partnership agreement does not limit the partners’ LLC transfer rights, how does this play out for valuation purposes?

To answer that question, we need to know what the partnership owns; its expected future cash flows; and a valuation date.  For purposes of the example, assume that the valuation date is June 30, 2020, and that Broad Horizon Family Farms has the following assets and liabilities:

  • 2,000 acres of farm and ranch land with a real estate valuation of $8,000,000;
  • 200 cow/calf pairs with an auction value of $300,000;
  • $1,000,000 fair market value of equipment;
  • $700,000 of harvested grains and in on-farm storage priced at current commodity prices;
  • Cash on hand of $150,000.
  • Land debt of $3,050,000, with interest accruing at the annual rate of 6.75 percent We will assume that the partner LLCs and their individual owners have guaranteed the debt.

These assumptions result in the following partnership balance sheet stated at fair market value (not cost), and a capital structure that is approximately 30 percent debt and 70 percent equity without regard to built-in gains taxes, and  38.1 percent debt, 61.9 percent equity after deducting the taxes:

 

 Appraised Value

 Tax Basis

 Tax Rate

 After-Tax Value

 Cash

$   150,000

 n/a

 n/a

$   150,000

 Commodities

             700,000

                      -

40%

       420,000

 Cattle

              300,000

                      -

20%

      240,000

 Equipment

          1,000,000

                      -

40%

       600,000

 Land

    8,000,000

     1,000,000

20%

   6,600,000

 Total assets

$10,150,000

   

$8,010,000

         

 Debt (6.75% rate)

 3,050,000

   

       3,050,000

 Partnership equity

  7,100,000

 

  _4,960,000

 Total debt and equity

$10,150,000

   

 $8,010,000

On an asset basis, the Partnership equity might have an asset based “as if marketable” value of $4,960,000 as an operational whole, or $1,240,000 per LLC partner.  But that is not the fair market value of the LLC partner’s interest in the Partnership, because a hypothetical buyer would be buying into a partnership of which 75% ownership is held be family-related parties.  Accordingly, a minority discount is appropriate.  Let’s assume a 15 percent discount in this case, resulting in a minority discounted value of $1,054,000 per 25 percent Partnership interest.      

Now let’s make some assumptions regarding the annual operations of the Partnership.  For this discussion, we will make the simplifying assumption of constant results subject to inflationary growth of 1.25 percent annually:

  • Because the partnership is comprised of four equal partners, assume that there are no perquisites of control in the manner of operation and the handling of distributions. The projected operations are assumed to continue in all respects as in the past.
  • Father, mother, son, and daughter provide all of the labor, and work 50 hours weekly. The LLCs receive periodic distributions equal to 75 percent of book net income.  These payments total $554,344 annually ($138,586 to each partner LLC).  Let’s also assume that the LLC partners flow the payments directly through to their owners, that is, to father, mother, son, and daughter. 
  • Valuation requires that the fair market value of the work being performed by related parties be determined. Accordingly, we will assume that the labor provided by father, mother, son, and daughter could be replaced with a three-employee independent work force at an average hourly rate of $20, with each employee working a 50-hour week.  Note that the allocation of wages in the valuation scenario would not be equal; some higher paid person would be the manager, and the lowest paid worker may receive just minimum wage.  The independent work force payroll on a 50-hour week would be $156,000.
  • The farm/ranch generates $1,500,000 of annual gross revenues, which is $750 per acre.
  • Annual crop inputs are $300,000.
  • Annual animal care costs are $95,000
  • Annual other operating expenses are $160,000.
  • Annual interest of $205,875 (6.75 percent) is paid on the $3,050,000 of debt.
  • Net capital expenditures equal to 25% of book net income are incurred. This represents net capital costs of $184,781 annually, for which Section 179 deductions are assumed to be taken.
  • A 40 percent effective income tax rate is assumed to impute taxes to the Partnership. This is necessary to equate the Partnership’s income to that of a C corporation, because the cost of equity capital valuation metrics derive from publicly traded C corporations.
  • A 20 percent tax rate is assumed to calculate the effect of dividend tax avoidance by the flow through tax nature of the Partnership compared to the non-flow through nature of C corporations from which the cost of equity capital valuation metrics are derived.

These assumptions result in the below operating results.  The “adjusted” column is used for further valuation analysis.

 

 Operating Results

 

 Unadjusted

 Adjusted

     

 Gross revenues

$1,500,000

$1,500,000

     

 Wages

-

156,000

 Crop inputs

 300,000

300,000

 Animal care costs

95,000

95,000

 Other operating expenses

    160,000

    160,000

 Total operating expenses

    555,000

    711,000

     

 Operating profit

945,000

789,000

 Interest expense

   (205,875)

          0

 Book net income

739,125

 

 Net capital expenditures

(184,781)

(184,781)

 Distributions to the LLCs

   (554,344)

                  -

 Net cash flow from operations

$                -  

 604,219

 Imputed income taxes at 40%

 

   (241,688)

 Imputed after-tax cash flow to capital

 

$   362,531

If an 18 percent cost of equity is assumed as well as a forty percent tax deduction benefit for interest expense, the assumed 38.1 percent/61.9 percent debt/equity capital structure results in a weighted average cost of capital (“WACC”) of 12.688 percent.  The assumed growth rate of 1.25 percent therefore results in a capitalization rate of 11.438 percent.  Thus, we calculate a capitalized value of $3,169,478.  But because the partnership is a flow through entity, it is necessary to make another adjustment to equate it to the financial effects of a C corporation.  Assuming a 20 percent qualified dividend tax rate, the value of the avoided shareholder dividend taxes is $792,369.  Accordingly, the partnership equity might have cash flow based “as if marketable” value of $3,961,847 as an operational whole - $990,462 per 25 percent Partnership interest.  No discount for minority interest applies to this calculation. 

Imputed after-tax cash flow to capital

 

 $   362,531

 Assumed capitalization rate

 

11.438%

 Capitalized value

 

     3,169,478

 Adjustment for avoided shareholder dividend taxes

     792,369

 "As if marketable" value based on cash flow

 

$3,961,847

Valuation professionals must reconcile the “as if marketable” values of their different approaches.  It is often concluded that the value is not less than the amount that could be realized based on liquidation, but a 25 percent partner would not be able to compel liquidation.  Thus, the common conclusion is that the “as if marketable” value of a 25 percent partnership interest is $990,462 based on the partnership’s cash flow.  But this is not fair market value.  The valuation metrics derive from C corporations whose shares are traded in the public markets—they are liquid, while the 25% partnership interests held by the LLCs are not—they are illiquid.  Accordingly, a discount for lack of marketability (“DLOM”) must be subtracted from the “as if marketable” value to arrive at fair market value. 

Practitioners use a variety of tools to estimate DLOMs.  The most simplistic approaches use the average of various small published studies of the discounts reflected in the prices of (1) restricted stocks compared to their publicly traded versions; and (2) stocks sold before completion of an initial public offering (“IPO”) to their IPO prices.  Through 1988, these restricted studies a range of 30-35 percent.  The implied discounts trended downward thereafter with changes in SEC Rule 144.  The pre-IPO studies suggested larger discounts in the 40-45 percent range.  Larger databases of restricted stock and pre-IPO transactions now exist, and are used by many practitioners to estimate DLOM.  Nevertheless, relying on restricted stock and/or pre-IPO transactions for DLOM estimate is problematic and may be unreliable.  To support this see Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Chapters 3-5 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.

An alternative method of estimating an appropriate DLOM uses the VFC DLOM Calculator, which couples the time and price risks associated with marketing privately held securities to various option pricing formulae.  Unlike other methodologies, the VFC DLOM Calculator is a date specific, facts and circumstances tool supported by empirical research.  The formula most appropriate for DLOM estimation is the VFC Longstaff formula.  You can find the VFC DLOM Calculator and its supporting empirical research at https://dlomcalculator.com/

Using the partnership’s characteristics (an SIC Code range of 0100 to 0299; Asking Price of $2,000,000 to $4,000,000; 4 Employees; Annual Revenues of $1,000,000 to $2,000,000), a reasonable conclusion is that the average marketing time required by an LLC partner to sell its interest in the Partnership is 232 days, with a standard deviation of 197 days.  This compares to an average of 123 days to obtain SEC approval for a public offering by a large business in the 0000 to 0999 SIC Codes.  See Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Table 1.1 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average marketing period is between 226 and 239 days based on these statistics.

Using a selection of four publicly traded classified as “Agriculture Production – Crops” (SIC Code 0100) and “Agriculture Production – Livestock & Animal Specialties” (SIC Code 0200), the VFC DLOM Calculator tells us that the long-term average price volatility of the companies’ stocks is 38.1 percent, with a standard deviation of 59.0 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 37.3 percent and 39.0 percent using the complete set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 22.3 percent.

But there has recently been increased price volatility in the stock market because of coronavirus uncertainty.  Looking only at the 90 trading days before June 30, 2020, the VFC DLOM Calculator tells us that the average price volatility was 70.2 percent, with a standard deviation of 76.9 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 62.2 percent and 78.1 percent using the more current set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 40.3 percent.  The VFC DLOM Calculator informs us that we can be 95 percent certain that the appropriate DLOM based on the more current price data is between 35.0 percent and 45.7 percent. The economic circumstances prevailing as of June 30, 2020, counsel to this higher DLOM estimate.

Using a 40.3 percent DLOM, we might conclude that the fair market value of a 25 percent interest in the partnership held by the partner LLC is $591,306 ($990,462 x (1-.403))

 However, the family members don’t own interests in the partnership.  They instead own 100 percent interests in their respective LLCs.  What is the fair market value of these LLCs?  It’s something less than $591,306, because the LLC, too, is subject to a lack of marketability.  Additional professional consideration must be given to developing the appropriate DLOM.  For example, it may be a discount more associated with financial portfolio risks than with agriculture risks.

Conclusion

This use of the single-member LLC can be a valuable aspect of an intergenerational transfer of the farming or ranching business.  Coupled with a general partnership farming entity, the single-member LLC can also optimize receipt of federal farm program payment limitations.  Further structuring of the management form of the LLC can also bring additional income and self-employment tax savings. 

August 5, 2020 in Business Planning | Permalink | Comments (0)

Friday, July 31, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part Two)

Overview

In Part One earlier this week, I focused on the use of a single-member limited liability company (LLC) as part of the estate/business/succession plan for the farming and ranching operation.  As noted in Part One, a single-member LLC is often used to hold general partner interests in the farming general partnership so that federal farm program payments can be maximized and achieve liability protection.  Also, noted in Part One was that a single-member LLC can be a “disregarded entity.”  That means that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability.

For a single-member LLC that is a disregarded entity, what does the single-member of the LLC own?  Is it the interest in the LLC or the underlying asset(s) of the LLC?  If the entity is respected as an entity separate from its owner, can valuation discounts for the owner’s interest in the entity be achieved for federal estate and gift tax purposes?  If so, that’s a big planning (and tax saving) opportunity.

How a single-member LLC as a disregarded entity is treated for federal estate and tax purposes – it’s the topic of today’s post.

Valuation Concepts – In General

The answer to the question of what an owner of a single-member LLC owns makes a difference as far as the valuation of the interest owned is concerned because of the possible effect of valuation discounts.  Those discounts are for lack of control and minority interest.  With a single-member LLC, there is no discount for lack of control – the single-owner has full control.  But, as a privately held business, a discount for lack of marketability might be available if the LLC is respected as an entity. 

The value of an asset for federal gift and estate tax purposes is “fair market value.”  That’s defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.” Treas. Reg. §§20.2031-1(b); 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.  State law controls the determination of what has been transferred in the valuation process. 

Under the “check-the-box” regulations, a business entity that is not classified as a corporation is a “domestic eligible entity” and, without an election, is “[d]isregarded as an entity separate from its owner if it has a single owner.”  Treas. Reg. §301.7701-3(b)(1)(ii).  Under Treas. Reg. §301.7701-1(a) and 301.7701-2(c)(2), an entity with a single member is disregarded as an entity separate from its owner “for federal tax purposes.”  That definition raises two questions: 1) What does “for federal tax purposes” mean?  Does it mean federal income as well as federal transfer (estate and gift) taxes?; and 2) does it bar the use of the “willing buyer/willing seller” valuation rule?   In 2004, the IRS shed some light on the first  question when it ruled that although a disregarded entity is not recognized for federal income tax purposes, the entity exists under state law and state law controls the owner’s rights and economic interests.  Rev. Rul. 2004-88, 2004-2 C.B. 165.  In 2009, the full Tax Court answered both questions and defined the interest owned by a single-member LLC owner.

The Pierre Case

In Pierre v. Comr., 133 T.C. 24 (2009), the petitioner received a $10 million gift in 2000.  Later that year, she created a single-member LLC in accordance with New York law and transferred cash and marketable securities to it worth about $4.25 million.  She held 100% ownership of the LLC and did not file an election with Form 8823 to be treated as an association taxable as a corporation.  Thus, the LLC was a disregarded entity.  Twelve days after funding the LLC, the petitioner transferred her entire interest in the LLC to trusts established for the benefit of her son and granddaughter.  She accomplished that by gifting a 9.5 percent interest in the LLC to each trust and then by selling a 40.5 percent interest in the LLC to each trust in exchange for promissory notes with a face amount of slightly over $1 million each.  In valuing the transfers for gift tax purposes, her valuation expert applied a 30 percent discount to the value of the LLC’s underlying assets (which turned out to be 36.5% for gift tax purposes due to an error in valuing the underlying assets).  The petitioner filed a federal gift tax return (Form 709) reporting the taxable value of the gift to each trust in accordance with the valuation expert’s report.  The IRS issued a notice of deficiency on the basis that the gifts should have been treated as gifts of proportionate shares of the LLC’s assets rather than transfers of interests in the LLC.  As such, as 100% owner of the LLC’s assets, no discount was appropriate.  The IRS took the position that the entity was the check-the-box regulations meant that the LLC was to be disregarded as an entity separate from the petitioner – they were one in the same. 

The petitioner claimed that NY state property law governed for transfer tax purposes rather than federal tax law.  Under NY law, the LLC was not to be disregarded.  Rather, upon the LLC’s formation, NY law created an interest in the LLC that was distinguishable from the petitioner.  The LLC became the petitioner’s personal property that held legal title to the assets that the entity contained.  Indeed, the NY LLC statute stated that, “A member has no interest in the specific property of the limited liability company.”  N.Y. Limited Liability Company Law Section 601

The full Tax Court, in a 10-6 decision, agreed with the petitioner and determined that “for federal tax purposes” was limited to federal income tax and that the petitioner owned an interest in the LLC rather than the underlying assets of the LLC.  As such, the willing buyer/willing seller valuation test applied to valuing the transferred interests which could then carry out any applicable valuation discounts.  The Tax Court pointed out that “state law defines and federal tax law determines the tax treatment of property rights and interests.”  See also Morgan v. Comr., 309 U.S. 78 (1940); United States v. National Bank of Commerce, 472 U.S. 713 (1985); Knight v. Comr., 115 T.C. 506 (2000).  The Tax Court also concluded that the check-the-box regulations don’t define property interests.  Instead, they merely allow the election of specific tax treatment for federal tax purposes, and that the Congress did not specifically disallow valuation discounts in the context of single-member LLCs – they aren’t listed in I.R.C. §§2701-2704 along with other transactions that can’t claim valuation discounts.  Thus, the petitioner’s gift tax liability was to be determined by the value of the transferred LLC interests rather than by a hypothetical transfer of the underlying assets of the LLC. 

In a second Tax Court opinion in the case, the Tax Court noted that the petitioner made the gifts and sales on the same day.  Pierre v. Comr., T.C. Memo. 2010-106.  Thus, the court treated them as a single part-gift/part-sale transaction.  That had the effect of reducing the lack of control discount slightly (from a claimed 35 percent to 30 percent) because the combined 50% gift/sale to each transferee could block the appointment of a new manager under the LLC operating agreement.  The petitioner also couldn’t come up with any non-tax reasons for separating the transfers into gifts and sales. 

Conclusion

The Pierre case is important because, as full Tax Court opinion, it provides strong support for the proposition that the asset to be valued for transfer tax purposes is the LLC interest and not the property that the LLC holds.  Planning and valuation opportunities are possible based on that notion.  A single-member LLC holding a farmer’s general partnership interest in a farming operation can be structured to obtain valuation discounts when the interest is gifted to a member of the subsequent generation as well as at death.  That makes the cost of intergenerational transfers of farming interests less which will be even more important if the federal estate and gift tax exemption level declines from its present level.

In a post next week, the concepts discussed in this two-part series will be applied to a family farm operation engaged in an intergenerational transfer.

July 31, 2020 in Business Planning | Permalink | Comments (1)

Monday, July 27, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part 1)

Overview

In the family business planning context for a farm and ranch, the key to success is for the senior generation to clearly express goals.  Doing so assists the planning team in using entities and associated tax planning techniques to satisfy those goals.  For business transition/succession purposes, the use of the limited liability company (LLC) is one entity structure that can work in the right situation and with the right set of facts. 

Often, in agriculture, the entity that conducts the farming operations is established as a general partnership with each partner having his own single-member LLC.  This is done in order to optimize (under most farm programs) the receipt of payment limitations.  The general partnership doesn’t limit liability, but it also doesn’t limit at the entity level the number of “person” determinations for payment limitation purposes.  Limited liability for each partner is achieved via the use of the single-member LLC to hold the partnership interest.

A single-member LLC can also be a “disregarded” entity?  What does that mean?  Is the entity simply disregarded for tax purposes, or is the entity respected in ways that make a big difference from a tax and estate planning perspective?  How does it all fit together for a farming operation? 

Utilizing an LLC as part of farm/ranch business succession – it’s the topic of today’s post – Part One of a two-part series.

Business/Succession Planning Goals

I have worked with farm families on estate and business succession plans for almost 30 years.  Each situation is unique.  There is no “one size fits all.”  However, I can make an observation concerning what are typical goals of the farm or ranch family, at least from the senior generation’s perspective.  The senior generation typically wants to retain control of the operation for as long as possible.  But, along with that goal of retaining control is often the desire to transfer equity ownership in the operational entity to other family members.  Any transfer is often required to be with restrictions that bar transfer outside the family.  Limited liability is commonly desired, as is flexibility in any entity form to deal with changes in the family structure and the tax landscape.  Also, it is a common desire to minimize taxation both upon entity formation and throughout the future; maximize government payments; and create the potential for valuation discounts – both for gifted interests and for the interests retained by the parents at death.

An LLC – What is it?

An LLC is an S corporation with fewer eligibility requirements and more flexibility with regards to the capital structure.  When an LLC is taxed as a partnership, it can be more advantageous than an S corporation – debt can be included in member basis; there is more flexibility given to multiple classes of interest; and distributions are more tax advantageous.  As compared to a limited partnership, LLC members can participate in management without losing the feature of limited liability.  Thus, an LLC basically blends the advantages of both the corporate and partnership form of business.  It has the advantage of a flow-through entity with the structure of a corporation.  An LLC’s management can either be conducted by all of the members acting together or by managers that the members select.  The members can choose the management structure desired, and multiple classes of ownership are allowed.  If the LLC is classified as a partnership or sole proprietorship for tax purposes, the entity is not taxed on business income.  All items of income, loss, deduction and credit are passed through to the member(s) and taxed at the member’s individual ratesI.R.C. 704(a). 

What Does It Mean To Be a “Disregarded” Entity?

While it takes at least one member for an LLC to be formed there is no limitation on the number of members – unlike an S corporation which is limited to 100 shareholders.  I.R.C. §1361(b)(1)(A). Under what are known as the “check-the-box” regulations,” an LLC with only one member can elect to be treated for tax purposes an association taxable as a corporation or as an entity disregarded as an entity separate from its owner.  Regs. Secs. 301.7701-1, et seq.  If no election is made on Form 8832, the default rule is that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability. 

A single-member LLC is a separate entity from its owner, except when it comes to taxes.  That is a distinguishing feature from a sole proprietorship, and it protects the owner from debts and liabilities of the business.  But, both a single-member LLC and a sole proprietorship file a Schedule F (or C for non-farm businesses) to report business income and deductions.  The amounts on the Schedule are then included with the owner’s individual income tax return. 

That raises a question – for tax purposes, what does the single-member of the LLC own?  Is it an interest in the LLC or the underlying asset(s) of the LLC?  Why might that matter?

Guaranteeing debt.  Insight into precisely what a single-member LLC owner owns can be gleaned from IRS guidance on the handling of debt in a single-member LLC.  Under the “at-risk” rules of I.R.C. §465, a loss from an activity to which the rules apply are disallowed unless the taxpayer is “at risk” with respect to the activity.  A taxpayer is “at risk” with respect to an activity to the extent that the taxpayer contributes money or basis or borrows funds that are contributed to the activity, but only to the extent that the taxpayer is personally liable for repayment or to the extent of the value of collateral pledged to secure the borrowed funds.  I.R.C. §§465(b)(1)-(2).  But, what if the member of a single-member LLC that is a disregarded entity guarantees the debt?  Does that count as being “at risk” in the entity’s activity?  The Code doesn’t address the issue. The answer to that question turns on what the single member actually owns. 

In CCA 201308028 (Nov. 14, 2012), the taxpayer was the sole owner of an LLC that was treated as a disregarded entity.  The LLC owned a second LLC that was also treated as a disregarded entity.  The second LLC borrowed funds for use in its business activity.  The taxpayer, the first LLC and two S corporations that the taxpayer wholly owned guaranteed the debt.  The taxpayer also provided the lender with a commercial guarantee for the full loan amount.  The taxpayer unconditionally guaranteed the full prepayment of the loan but did not waive subrogation or reimbursement rights against the second LLC or the right of contribution from the first LLC and the two S corporations.  The IRS, following the approach of the Second, Eighth and Eleventh Circuits, determined that the taxpayer would be ultimately liable as the payor of last resort and not protected against loss and, therefore, would be “at risk” if the taxpayer did not have a right of contribution from the other co-guarantors. See  Waters v. Commissioner, 978 F.2d 1310 (2d Cir. 1992), cert. denied, 507 U.S. 1018 (1993); Young v. Commissioner, 926 F.2d 1083 (11th Cir. 1991); Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990).  It’s an “economic realities” test.  That rationale applies when a taxpayer guarantees debt of an LLC that is taxed either as a partnership or as a disregarded entity. 

The IRS followed up the CCA with A.M. 2014-3 (Aug. 27, 2013) where the IRS concluded that an LLC member that guarantees the LLC’s debt is at risk for purposes of I.R.C. §465 in the situation where the LLC is treated as a partnership or a disregarded entity.  The IRS said that a member’s guarantee of qualified non-recourse (debt whose satisfaction may be obtained on default only out of the particular collateral given and not out of the debtor's other assets) financing of an LLC increased the member’s amount at risk to the extent of the guarantee. 

With this IRS guidance in mind, transactions involving debt guarantees have more certainty.  That means that planners can structure deals in accordance with the economics of the particular situation and lender requirements. The guidance also supports the notion that a member of an LLC that is treated as a disregarded entity owns an interest in the entity rather than the underlying assets in the entity.  The entity is respected for tax purposes. 

Employment tax.  A disregarded entity is treated as a corporation for employment tax purposes.  Treas. Reg. §301.7701-2(c)(2).  Thus, the entity is responsible for paying employment taxes and any excise taxes that apply.  Consequently, a single-member LLC must have an EIN and a bank account in its name.  Self-employment tax also applies.  If a partnership owns a disregarded entity, the partners are treated as self-employed.  They are not employees of the disregarded entity.  REG-114307-15, 81 F.R. 26763 (May 4, 2016), 2016 I.R.B. 1006. 

Identification of the entity.  The IRS can require the owner of a disregarded entity to report the entity’s employer identification number (EIN) on the taxpayer’s individual return.  I.R.C. §§6011(b); 6109(b); PMTA 2016-08.  The basic requirement is that there must be sufficient information on the return so that the taxpayer is properly identified.  Because an individual taxpayer that is a member of a single-member LLC has both a social security number and an EIN, listing both numbers on the taxpayer’s return could help the IRS to cross-reference the numbers and associate correct information and returns with the taxpayer.  Including both numbers does not invalidate the return and could avoid confusion on the IRS part. 

Conclusion

In Part Two, I will explore how a single-member LLC as a disregarded entity is treated for federal estate and gift tax purposes.  If a single-member LLC is a respected entity separate from its owner, perhaps valuation discounts for entity interests can apply.  Again, the outcome of the issue turns on what the owner of the single-member LLC actually owns. 

July 27, 2020 in Business Planning | Permalink | Comments (0)

Saturday, July 25, 2020

Recent Court Developments of Interest

Overview

The court decisions of relevance to agricultural producers, rural landowners and agribusinesses keep on coming.  There never seems to be a slack time.  Today’s article focuses on some key issues involving bankruptcy, business valuation, and insurance coverage for loss of a dairy herd due to stray voltage.  More ag law court developments – that’s the topic of today’s post.

 

Court Determines Interest Rate in Chapter 12 Case

In re Key Farms, Inc., No. 19-02949-WLH12, 2020 Bankr. LEXIS 1642 (Bankr. D. Wash. Jun. 23, 2020)

 The bankrupt debtor in this case is a family farming operation engaged in apple, cherry, alfalfa, seed corn and other crop production. The parents of the family own 100 percent of the debtor. In 2014, the debtor changed its primary lender which extended a line of credit to the debtor that the father personally guaranteed and a term loan to the debtor that the father also personally guaranteed. The lender held a first-priority security interest in various real and personal property to secure loan repayment. The debtor became unable to repay the line of credit and the default caused defaults on the term loan and the guarantees. The lender sued to foreclose on its collateral and have a receiver appointed.

The debtor filed Chapter 12 bankruptcy and proposed a reorganization plan where it would continue farming during 2020-2024 in accordance with proposed budgets. The plan provided for repayment of all creditors in full, and repayment of the lender over 20 years at a 4.5 percent interest rate (prime rate of 3.25 percent plus 1.25 percent). The lender opposed plan confirmation.

In determining whether the reorganization plan was fair and equitable to the lender based on the facts, the bankruptcy court noted the father’s lengthy experience in farming and familiarity with the business and that the farm manager was experienced and professional. The court also noted that parents had extensive experience with crop insurance and that they were committing unencumbered personal assets to the plan.  In addition, the court took note of the debtor’s recent shift to more profitable crops and a demonstrated ability to manage around cash flow difficulties, and that the lender would be “meaningfully oversecured.” The court also determined that the debtor’s farming budgets appeared to be based on reasonable assumptions and forecasted consistent annual profitability. However, the court did note that the debtor had a multi-year history of operating losses in recent years; was heavily reliant on crop insurance; was engaged in an inherently risky business subject to forces beyond the debtor’s control; had no permanent long-term leases in place for the considerable amount of acreage that it leased; could not anticipate how the Chinese Virus would impact the business into the future; and proposed a lengthy post-confirmation obligation to the lender.

Accordingly, the court made an upward adjustment to the debtor’s prosed additional 1.25 percent to the prime rate by increasing it by at least 1.75 percent. The court scheduled a conference with the parties to discuss how to proceed.

 

Valuation Discount Applies to Non-Voting Interests

Grieve v. Comr., T.C. Memo. 2020-28

The petitioner was the Chairman and CEO of a company. After his wife’s death, he established two limited liability companies, with a management company controlled by his daughter as the general partner in each entity holding a 0.2 percent controlling voting manger interest and a 99.8 percent nonvoting interest in each entity held by a family trust – a grantor retained annuity trust (GRAT). The petitioner gifted the 99.8 percent interest in the two entities and filed Form 709 to report the gifts. The IRS revised the reported value of the gifts and asserted a gift tax deficiency of about $4.4 million based on a theoretical game theory construct.

According to the IRS, a hypothetical seller of the 99.8 percent nonvoting interests in the two LLCs would not sell the interests at a large discount to the net asset value (NAV), but would seek to enter into a transaction to acquire the 0.2 percent controlling voting interest from the current owner of that interest in order to obtain 100 percent ownership and eliminate the loss in value as a result of lack of control and lack of marketability. In support of this, the IRS assumed that the owner of the 99.8 percent nonvoting interest would have to pay the controlling 0.2 percent voting member a premium above their undiscounted NAV. Under traditional methodology, the IRS expert estimated that a 28 percent discount to the NAV was appropriate for the 99.8 percent nonvoting units. But, instead of accepting that level of discount, the IRS proposed that the owner of the nonvoting units would pay a portion of the dollar amount of the discount from NAV to buy the remaining 0.2 percent voting interest.

The petitioner’s expert used a standard valuation methodology to prepare valuation appraisal reports. This expert applied a lack of control discount of 13.4 percent for the gift to the GRAT and a 12.7 percent lack of control discount for the gift to the irrevocable trust. The valuation firm also applied a 25 percent discount for both gifts.

The Tax Court determined that the IRS failed to provide enough evidence for its valuation estimates. The Tax Court also rejected the IRS assumption of the impact of future events on valuation, noting that the IRS valuation expert reports lacked details on how the discounts were calculated. Thus, the Tax Court rejected the proposed valuation estimates of the IRS and accepted those of the petitioner. The result was a 35 percent discount (total) for entity-level lack of control and lack of marketability compared to a 1.4 percent discount had the IRS approach been accepted.

 

S Corporation Value Accounts for Tax on Shareholders

Kress v. United States., 327 F. Supp. 2d 731 (E.D. Wisc. 2019)

The taxpayers, a married couple, gifted minority interests of stock in their family-owned S corporation to their children and grandchildren in 2007-2009. The taxpayers paid gift tax on the transfers of about $2.4 million. The taxpayers’ appraiser valued the S corporation earnings as of the end of 2006, 2007 and 2008 as a fully tax-affected C corporation. On audit, the IRS also followed a tax-effected approach to valuation of the S corporation earnings but applied an S corporation premium (pass-through benefit) and asserted that the gifts were undervalued as a result. The IRS assessed an additional $2.2 million of federal gift tax. The taxpayers paid the additional tax and sued for a refund in 2016.

The issue was the proper valuation of the S corporation. Historically, the IRS has not allowed for tax-affected S corporation valuation based on Gross v. Comr., T.C. Memo. 1999-254; Wall v. Comr., T.C. Memo. 2001-75; Estate of Heck v. Comr., T.C. Memo. 2002-34; Estate of Adams v. Comr., T.C. Memo. 2002-80; Dallas v. Comr., T.C. Memo. 2006-212; and Estate of Gallagher v. Comr, T.C. Memo. 2011-148. The IRS also has an internal valuation guide that provides that “…no entity level tax should be applied in determining the cash flows of an electing S corporation. …the personal income taxes paid by the holder of an interest in an electing S corporation are not relevant in determining the fair market value of that interest.”

But other courts have allowed the tax impact on shareholders. See, e.g., Delaware Open MRI Radiology Associates, 898 A.2d 290 (Del. Ct. Chanc. 2006); Bernier v. Bernier, 82 Mass. App. Ct. 81 (2012).

The court accepted the tax-affect valuation but disallowed the S corporation premium that IRS asserted. The court also allowed a discount for lack of marketability between 25 percent and 27 percent depending on the year of the transfer at issue.

 

Stray Voltage Could Lead to Partial Insurance Coverage

Hastings Mutual Insurance Co. v. Mengel Dairy Farms, Inc., No. 5:19CV1728, 2020 U.S. Dist. LEXIS 87612 (N.D. Ohio May 19, 2020)

 The defendant unexpectedly had several cows and calves die and also suffered a loss of milk production and profits. The defendant filed a claimed against the plaintiff for insurance coverage for death of livestock, cost of investigation and repairs, and loss of business profits. The plaintiff investigated the claim, utilizing an electrical company to do so. The electrical company found a stray electrical current present on the property. The plaintiff then hired a fire and explosion company to investigate the property. This investigation resulted in a finding of no stray voltage on the property, but the company did express its belief that stray voltage did cause the defendant’s harm. As a result, the plaintiff paid the insurance claim for death of livestock and repairs, but not for loss of business profits.

The plaintiff then filed an action for a determination under the policy of whether loss of business profits was a covered loss. The plaintiff sought a declaratory judgment specifying that coverage for loss and damage resulting from the stray voltage was not triggered because the defendant was not subject to a “necessary suspension” of farming operations, and that the defendant’s loss or damage had to be directly caused by a “peril insured against” rather than being caused by dehydration which resulted from the cattle’s reaction to the stray voltage. The defendant filed a counterclaim for breach of contract; breach of good faith and fair dealing; and unjust enrichment. The plaintiff moved for summary judgment on the basis that the policy wasn’t triggered for lack of electrocution and that there was no suspension in the defendant’s business operations. The court determined that the policy did not define the term electrocution in the context of dairy animals. As such, the court concluded that the term could be reasonably interpreted to mean death by electrical shock or the cause of irreparable harm. As an ambiguous term, it was defined against the plaintiff and in the defendant’s favor. The court also refused to grant summary judgment on the cause of death issue. In addition, because the defendant did not cease operations, the court concluded that the policy provided no coverage for lost profits. The court also rejected the defendant’s breach of contract claim due to lack of suspending the business and rejected the good faith/fair dealing claim because mere negligence was not enough to support such a claim. The unjust enrichment claim was likewise denied.

Conclusion

The cases discussed above are all quite relevant to agricultural producers.  For those struggling financially that find themselves in a Chapter 12, the interest rate utilized in the case is of primary importance.  Many factors go into determining the rate, and farming operations can achieve a lower rate by meeting certain factors listed by the court in the decision mentioned above.  Likewise, the valuation issue is critical, particularly if the federal estate tax exemption amount were to drop.  When federal (and, possibly, state) estate tax is involved, valuation is the “game.”  Finally, in all insurance cases, the language of the policy is critical to determine coverage application.  Any ambiguous terms will be construed against the company.  In all situations, having good legal counsel is a must.

July 25, 2020 in Bankruptcy, Business Planning, Insurance | Permalink | Comments (0)

Wednesday, July 22, 2020

The Supreme Court’s DACA Opinion and the Impact on Agriculture

Overview

Last month, the U.S. Supreme Court issued its opinion in Department of Homeland Security, et al. v. Regents of the University of California, et al., 140 S. Ct. 1891 (2020) where the Court denied the U.S. Department of Homeland Security’s (DHS) revocation of the Deferred Action for Childhood Arrivals (DACA).  The Court’s decision is of prime importance to agriculture because the case involved the ability of a federal government agency to create rules that are applied with the force of law without following the notice and comment requirements of the Administrative Procedure Act.  Agricultural activities are often subjected to the rules developed by federal government agencies, making it critical that agency rules are subjected to public input before being finalized.

The Supreme Court’s DACA opinion and agriculture – it’s the topic of today’s post.

Background

The DHS started the DACA program by issuing an internal agency memorandum in 2012.  The DHS took this action after numerous bills in the Congress addressing the issue failed to pass over a number of years.  The DACA program allowed illegal aliens that were minors at the time they illegally entered the United States to apply for a renewable, two-year reprieve from deportation.  The DACA program also gave these illegal immigrants work authorizations and access to taxpayer-funded benefits such as Social Security and Medicare.  Current estimates are that between one million and two million DACA-protected illegal immigrants are eligible for benefits  In 2014, the DHS attempted to expand DACA to provide amnesty and taxpayer benefits for over four million illegal aliens, but the expansion was foreclosed by a federal courts in 2015 for providing benefits to illegal aliens without following the procedural requirements of the Administrative Procedure Act as a substantive rule and for violating the Immigration and Naturalization Act.  Texas v. United States, 809 F.3d 134 (5th Cir. 2015), aff’g., 86 F. Supp. 3d 591 (S.D. Tex. 2015)In 2016, the U.S. Supreme Court affirmed the lower court decisions.  United States v. Texas, 136 S. Ct. 2271 (2016).  Based on these court holdings and because DACA was structured similarly, the U.S. Attorney General issued an opinion that the DACA was also legally defective.  Accordingly, in June of 2017, the DHS announced via an internal agency memorandum that it would end the illegal program by no longer accepting new applications or approving renewals other than for those whose benefits would expire in the next six months.  Activist groups sued and the Supreme Court ultimately determined that the action of the DHS was improper for failing to provide sufficient policy reasons for ending DACA.  In other words, what was created with the stroke of a pen couldn’t be eliminated with a stroke of a pen. 

Administrative Procedure Act (APA)

The APA was enacted in 1946.  Pub. L. No. 79-404, 60 Stat. 237 (Jun. 11, 1946).  The APA sets forth the rules governing how federal administrative agencies are to go about developing regulations.  It also gives the federal courts oversight authority over all agency actions.  The APA has been referred to as the “Constitution” for administrative law in the United States.  A key aspect of the APA is that any substantive agency rule that will be applied against an individual or business with the force of law (e.g., affecting rights of the regulated) must be submitted for public notice and comment.  5 U.S.C. §553.  The lack of DACA being subjected to public notice and comment when it was created and the Court’s requirement that it couldn’t be removed in like fashion struck a chord with the most senior member of the Court.  Justice Thomas authored a biting dissent that directly addressed this issue.  He wrote, “Without grounding its position in either the APA or precedent, the majority declares that DHS was required to overlook DACA’s obvious legal deficiencies and provide additional policy reasons and justifications before restoring the rule of law. This holding is incorrect, and it will hamstring all future agency attempts to undo actions that exceed statutory authority.” Justice Alito joined Justice Thomas in dissent stating, “DACA presents a delicate political issue, but that is not our business. As Justice Thomas explains, DACA was unlawful from the start, and that alone is sufficient to justify its termination. But even if DACA were lawful, we would still have no basis for overturning its rescission. First, to the extent DACA represented a lawful exercise of prosecutorial discretion, its rescission represented an exercise of that same discretion, and it would therefore be unreviewable under the Administrative Procedure Act.  5 U.S.C. §701(a)(2)…. Second, to the extent we could review the rescission, it was not arbitrary and capricious.”  Justice Thomas went on to term the majority’s decision “mystifying.” 

Application to Agriculture

Farmers and ranchers often deal with the rules developed by federal (and state) administrative agencies.  Those agency rules often involve substantive rights and, as such, are subject to the notice and comment requirements of the APA.  Failure to follow the APA often results in the restriction (or outright elimination) of property rights without the necessary procedural protections the APA affords. It’s also important that when administrative agencies overstep their bounds, a change in agency leadership has the ability to swiftly rescind prior illegal actions – a point Justice Thomas made clear in his dissent. The importance of holding government agencies accountable to the requirements of the APA is illustrated below.

USDA.  The USDA has a history of being notoriously poor at complying with the APA.  Both the Farm Service Agency (FSA) and the Natural Resource Conservation Service (NRCS) issue manuals and numerous amendments containing provisions that are applied against farmers with the force of law without subjecting the provisions to the APA. The National Food Security Act Manual (NFSAM), the key publication detailing the requirements for participating in federal farm programs, is presently in its fifth edition.  Many amendments have been made to the various editions, none of which have been subjected to the APA.

The history of Swampbuster is also illustrative.  The legislation creating Swampbuster was contained in the 1985 Farm Bill.  It made no mention of farmed wetlands.  An interim agency rule in March 1986 also did not mention the concept.  However, a final rule issued in September 1987 added farmed wetland, commenced conversions and minimal effect with no opportunity for farmers, ranchers and other landowners to comment. In the mid-1990s an interim final rule was issued under the APA and comments were solicited. The rule is still in effect. It was never made a final rule and it is still in interim status 20+ years later. It has even been amended a few times. In 1996 the Congress amended the law requiring that changes to all wetland conservation and highly erodible land provisions be adopted pursuant to public review and comment. In all practicality, however, the USDA merely solicits comments and makes no revisions after comments have been made. 

As for drain maintenance, the U.S. Court of Appeals for the Eighth Circuit in Barthel v. United States Department of Agriculture, 181 F.3d 834 (8th Cir. 1999), held that a drainage device can be manipulated after December. 23, 1985, to the extent necessary to allow the best historic drainage of the affected land.  In other words, the landowner is entitled to the “wetland and farming regime” on the land irrespective of what manipulation occurs to the specific drainage device.  However, the NRCS did not respond to Barthel decision until 2015 with the issuance of state offsite methods that looked at historic photographs and supported mathematical modeling.

The Iowa Experience.  Wetland issues often interact with common farming and ranching activities.  Wetland rules come from two sources - the Clean Water Act (CWA) and the United States Department of Agriculture (USDA).  The wetland rules of the CWA have been developed by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE).  More specifically, the CWA rules are administered by the COE for the EPA. The EPA can veto COE decisions, but rarely does. That the EPA and COE comply with the APA is critical. 

For Iowa farmers, the need for government agencies to comply with the APA has been recently illustrated in several important ways. 

  • When evaluating wetland mitigation, the COE is required to consider wetland functions and societal values. For example, a nutrient removal wetland would normally be valued higher over its flooding of a channelized low value headwater stream that is only wet due to drainage from tile lines. But the COE does not administer the law in that manner.  Instead, the COE determines what mitigation is needed to offset lost stream functions. Then it decides if that mitigation satisfies societal values in its permit decision. This COE policy has been developed outside of the APA and adds cost to nutrient removal wetlands, eliminates some, and protects lower-valued common headwater streams. The public is provided no input into the process (as it would via the APA process) as to whether the flooding of headwater streams without mitigation of lost stream channel functions would be an acceptable loss in favor of the creation of highly-valued nutrient removal wetlands.
  • The COE and the Iowa Department of Natural Resources (IDNR) worked together to create an Iowa Stream Mitigation Method without observing either the state or federal APA. The COE simply used, without any formal rulemaking, the Missouri stream mitigation method (a rather strict method) in Iowa for determining mitigation needs and permits. The Iowa Department of Transportation asked the IDNR for an in-lieu fee mitigation option for stream mitigation in road projects. Ultimately, the COE adopted the IDNR’s stream mitigation method without following the Iowa APA, published it as its own, solicited comments and adopted the rule.
  • In 2017 the NRCS pursued a consistent state off-site method (SOSM) for the prairie pothole states of ND, SD, MN and IA. On June 22, 2017 the SOSM was published in the federal register and comments solicited. Iowa and MN received no comments. The SOSM endorsed the use of a water balance software called SPAW. It had been In the NRCS wetland hydrology tools manual since 1997. In late 2017, the Midwest Regional Conservationist directed all 4 pothole states to install the 2017 SOSM in their field office technical guides and to begin using them. However, in December 2018 the Iowa NRCS changed the SOSM to discourage the use of SPAW and to return to aerial photographs. This change was not subjected to public review or comment.
  • Presently, the NRCS is planning to triple the setback for new tile from a farmed wetland in soils that are classified as possible discharge soils. These soils are common. A procedure used to identify such soils was expected to be announced and subjected to public comment and review.  Instead, Iowa moved ahead in tripling the setback without public rulemaking. 

The IRS.  With respect to payments received under Conservation Reserve Program (CRP), the historic position of the IRS had been that, for a retired taxpayer who is not materially participating in the farm operations, payments received under the CRP would not be considered net income from self-employment. Priv. Ltr. Rul. 8822064 (Mar. 7, 1988).  Likewise, the IRS position has been that where the farm operator or owner is materially participating in the farm operation, CRP payments constitute receipts from farm operations includible in net earnings from self- employment.  Letter from Peter K. Scott, Associate Chief Counsel, Technical, March 10, 1987.  Thus, the IRS took the position that someone must be materially participating to cause receipt of CRP rental to constitute net earnings from self-employment. The IRS had taken the same position with respect to payments received under the precursor program to the CRP – the Soil Bank.

The IRS informally (without going through the notice and comment procedures of the APA) changed its historic position concerning the self-employment tax treatment of CRP payments in a Chief Counsel's Letter Ruling dated May 29, 2003. C.C.A. 200325002 (May 29, 2003).   In the ruling, IRS took the position directly contrary to Priv. Ltr. Rul. 8822064 and held that a landowner's activities under a CRP contract amount to material participation and the payments should be reported on Schedule F, not Schedule E or Form 4835.  That is the Chief Counsel's position for retired landowners as well as those conducting a farming business and those who are not conducting a farming business.  In late 2006, IRS issued a Notice of proposed revenue ruling essentially following the 2003 CCA letter ruling. Notice 2006-108, I.R.B. 2006-51.  After the comment period ended (during which IRS received zero public comments supporting its proposed change of position) the IRS announced that it was canceling its plans to issue a Revenue Ruling on the issue, but that it was not changing its position on the matter. However, the IRS never issued the Revenue Ruling that would have obsoleted the key Revenue Rulings from 1960s concerning the self-employment tax treatment of Soil Bank payments.  Rev. Rul. 60-32; Rev. Rul 65-149.    Ultimately, the U.S. Circuit Court of Appeals ruled against the new IRS position, noting that the IRS had said it was going to promulgate a new rule announcing its changed position on the issue, but that it failed to do so.  The court voiced its displeasure with the IRS antics in adopting a changed position that it was asserting against taxpayers by agency fiat.  Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014). 

More recently, in Feigh v. Comr., 152 T.C. No. 15 (2019), the petitioner received a Form W-2 reporting a difficulty of care payment under I.R.C. §131(c). However, such payments are excluded from income as a type of qualified foster care payment if made under a state’s foster care program. In Tech. Adv. Memo. 2010-007, the IRS took the position that the payment of a difficulty care payment to the parent of a disabled child to the parent was not excludible because the “ordinary meaning” of foster care excluded care by a biological payment. But, in Notice 2014-7, and informal IRS pronouncement that is not “substantial authority” for tax purposes and was not subjected to formal rulemaking procedures under the APA, the IRS treated the payment as nontaxable to the recipient. The petitioner did not include the payment in income but did include the amount as earned income in computing the earned income credit under I.R.C. §32 and in computing the refundable child tax credit under I.R.C. §24. The IRS position was that since the amount was not taxable under Notice 2014-7, the amount did not count as earned income for computing the credits. I.R.C. §32(c)(2)(A)(i) states that earned income includes wages, salaries, tips and other employee compensation that has been included in gross income for the tax year.

The petitioner claimed that nothing in the actual statute, I.R.C. §131, allowed the IRS to treat the payment as not includible in gross income. The court agreed, noting that the IRS position was only a Notice and not a formalized Revenue Ruling with the result that the petitioner could exclude the difficulty of care payment and obtain credits on that (untaxed) earned income. The IRS was not allowed to change the impact of the tax law without going through the proper administrative procedure. The IRS later acquiesced in result only to the Tax Court’s decision. A.O.D. 2020-20, 2020-14 IRB 558.

Conclusion

The Supreme Court’s DACA decision is a huge blow to the rule of law as applied in the context of administrative agencies, and the requirement that  agency rules applied with the force of law to farmers and ranchers (and other landowners) must be subjected to the public notice and comment requirement of the APA. 

July 22, 2020 in Regulatory Law | Permalink | Comments (0)

Wednesday, July 15, 2020

Transitioning the Farm or Ranch – Stock Redemption

Overview

A major issue for farm and ranch families that have at least one child or other heir that is interested in taking over the business after the senior generation either retires or dies, is how to transition the business to that next generation of managers/operators. 

For farming and ranching operations that operate in a corporate structure, one way to transition the business is by means of a corporate stock redemption.  What are the pros and cons of a corporate redemption?  How does it actually work mechanically?

Corporate stock redemptions – it’s the topic of today’s post.

“Retiring” the Senior Generation

Compared to a sole proprietor farming operation, the tax “hit” to a retiring owner can often be much less in the corporate structure.  When a sole proprietor retires and assets are sold, the tax consequences can be harsh.  Grain and livestock in inventory and depreciable property (other than 20-year general purpose farm buildings) are subject to ordinary income tax treatment upon sale.  In addition, any I.R.C. §1245 depreciation recapture is not eligible for the installment method of reporting.  However, the sale of corporate stock by a retiring owner is taxed at capital gain rates that are lower than the ordinary income tax rates.  That’s the case whether the stock is sold directly to the buyer or by means of a stock redemption.  In addition, the installment method of reporting the income is available allowing for income tax deferral. 

On the other end of the transaction, the next generation that is acquiring an ownership interest in the farming entity also has tax implications.  When assets are purchased directly from a sole proprietor farmer or when a partnership interest is acquired with a basis-step up election in place, enhanced tax deductions are available.  In addition, any basis that can be allocated to depreciable property results in deferred deductions.  On the other hand, the seller recognizes depreciation recapture that must be recognized at the time of sale.  See I.R.C. §1245.

One advantage of a stock redemption over a direct sale (at least to the buyer) is that a stock redemption can be used to fund the acquisition of stock with corporate earnings that are taxed at a 21 percent rate under current law. 

Advantages

The primary advantage of a corporate stock redemption is that it can remove post-tax wealth that has built up inside the corporation at a 21 percent rate.  The same is true for future wealth built up if the payout occurs by virtue of installment reporting.  In addition, interest expense is deductible inside the corporation if, for example, a member of the next generation individually buys the stock  Likewise, there is no additional payroll tax burden that would otherwise occur if a person in the subsequent generation withdrew funds from corporate earnings to acquire stock from the senior generation. 

Disadvantage

With a corporate stock redemption, there is no increase in stock basis in the hands of the acquiring next generation.  That’s the case even though the seller (senior generation) could have a large gain to report on the transaction. 

Complete Redemption

The redemption of the senior shareholder’s stock must be a complete redemption to achieve capital gain tax treatment. The redeemed shareholder’s interest in the corporation must be completely extinguished. If it is, the proceeds received by the retiring shareholder, as indicated above, are treated as capital gain.  That’s the case even if the corporation has earnings and profits what would otherwise be taxed as ordinary income if they were distributed to the retiring shareholder.  I.R.C. §302(a).  A complete redemption also eliminates characterization of the redemption as a dividend that would be taxed at ordinary income tax rates up to the amount of the earnings and profits of the corporation. 

A complete redemption is also required for the transaction to be eligible for installment reporting.  I.R.C. §302(b)(3).  To accomplish a complete redemption, the senior shareholder must agree to have no involvement in the corporation for 10 years following the transaction.  That means the former senior shareholder can’t be a consultant or an employee or a director during that time-span.  No salaries or director fees for 10 years!  However, it is permissible for the corporation to continue to employ the redeemed shareholder’s spouse and provide fringes via a lease of real estate to the corporation (and collateralization agreements) if the arrangement is structured to ensure payment on the installment note involving the redeemed stock, the employment contract for the spouse and the lease.  That is especially true if the collateralization agreements are entered into in an arms’-length transaction and is comparable to arrangements involving unrelated parties.  See, e.g., Hurst v. Comr., 124 T.C. 16 (2005).  But, it is important that the redeemed shareholder not be determined to be involved in the business via the spouse. 

As for being a consultant to the corporation, the U.S. Tax Court held in 1984 that consulting services could be provided by the redeemed shareholder occasionally and medical insurance benefits could continue without the redemption being taxed as a dividend.  Lynch v. Comr., 83 T.C. 597 (1984).  But, the IRS doesn’t like consulting arrangements involving a redeemed shareholder.  See Rev. Rul. 70-104, 1970-1 C.B. 66.  In addition, an ongoing consulting arrangement is not permissible.  Lynch v. Comr., 801 F.2d 1176 (9th Cir.1986).      

If a prohibited interest is acquired within the 10-year post transaction timeframe, the redeemed shareholder  must notify the IRS.    Indeed, the redeemed shareholder must attach an agreement to the tax return saying that such notification will be made.  I.R.C. §302(c)(2)

If the rules for a complete redemption are violated, stock basis won’t offset gain and installment sale treatment is not available.    

How is a complete stock redemption accomplished?  The rules governing a complete stock redemption are set forth in I.R.C. §302(b)(3).  As noted above, the senior generation shareholder must surrender all of his stock either all at once or in exchange for an installment note that is payable over time.  After the redemption, if the remaining shareholders are related (in accordance with family attribution rules) to the shareholder that is being bought out, the redeemed shareholder can’t have any interest in the corporation for 10 years except for an interest acquired by bequest or inheritance.  An exception from this rule, however, allows the redeemed shareholder to be a landlord or a creditor. See, e.g, Priv. Ltr. Rul. 8551014 (Sept. 19, 1985). 

A redemption can also occur in the context of an I.R.C. §1041 transaction (such as incident to a divorce or otherwise between spouses).  Prop. Treas. Reg. §1.1041-2. 

Prior Family  Transfers

Another potential “snag” in the planning process is that an “anti-abuse” rule says that  capital gain treatment is not available if there have been family transfers of stock within 10 years before  the redemption.  I.R.C. §302(c)(2)(B).  Family attribution rules of I.R.C. §318 apply to define family members in this context. The rule seems to disallow gifts to family members.  However, if tax avoidance wasn’t one of the principal purposes of the transfer, then the transfer is permissible.  Basically, it comes down to whether the taxpayer can prove a non-tax purpose for the transfer and that avoiding tax was not a principal purpose.  Thus, if the prior transfer involved, for example, a parent that owned all of the corporate stock of a family farming or ranching corporation and gifted stock to a child that was being groomed as the successor as part of the parent’s estate and succession plan, a complete stock redemption would still be available and treated favorably from a tax standpoint.  See Rev. Rul. 77-293, 1977-2 C.B. 91.

Conclusion

A stock redemption can be part of a business succession transition plan for farming and ranching corporations.  But, planning for it is a necessity to ensure that the redemption achieves the anticipated benefits.

July 15, 2020 in Business Planning | Permalink | Comments (0)

Sunday, July 12, 2020

Imputation – When Can an Agent’s Activity Count?

Overview

The tax Code often requires a taxpayer to materially participate in a farm business activity as a pre-requisite to receiving a tax benefit.  This is not an issue if the taxpayer is directly involved in the farming activity.  However, many farming activities are conducted by a tenant.  In those situations, can the landlord receive the tax benefit or benefits that might be available?  The answer is that it “depends.”  What it depends upon is the particular Code section involved and whether the conduct of the tenant can be imputed to the landlord for tax purposes.

The issue of imputation and the tax Code – it’s the topic of today’s post.

A Bit of History

In Hoffman v. Gardner, 369 F.2d 837 (8th Cir. 1966), the court acknowledged the role of an agent in meeting the material participation requirement. The plaintiff grew up on a farm in south-central Iowa.  After graduating college in 1913, he got married in 1914 and took a teaching job in Iowa almost two hours from where he grew up.  That same year he bought two farms in the Iowa county where he was from.  Two years later he moved to the St. Louis area where he continued to teach school for the next 40 years.  He and his brother-in-law managed the farms by keeping in touch with the tenants.  The brother-in-law lived near the farms.  He compensated his brother-in-law with a percentage of the farms’ income.  In 1957, a year after retiring from school teaching, the plaintiff entered into agreements with the tenants that gave him complete managerial control, subject only to the right of the tenants to make suggestions.  The agreements specified that the plaintiff would pay for all grass seed, one-half of the corn seed, one-half of the baling expense and all of the fertilizer expense.  The straw, threshed hay and stalks were to be fed to livestock on the farms.  The plaintiff was not required to pay for the oats seed or the expense of threshing.  The agreements further provided that he controlled the place and time of crop planting and crop cultivation and harvesting.  He also retained decisionmaking control over the crops to be sprayed and how they were to be tended to.  The plaintiff kept charts on his farms that detailed all types of crop and soil information, and he annually sent this information to the tenants along with information on fencing and terracing.  He consulted periodically with his brother-in-law and the tenants by telephone and letter, and occasionally spent time on the farms with his daughter during which times he would inspect the crops and walk the fields and provide crop growing advice to his brother-in-law and the tenants.  His brother-in-law inspected the farms several times monthly during the growing season and often served as a middleman between the tenants and the plaintiff in terms of conveying information about the farms. 

Also in 1957, at the age of 71, the plaintiff applied for Social Security benefits based on his self-employment earnings by virtue of his management of the farms and the conduct of his brother-in-law and the tenants.  In other words, the plaintiff claimed that he had been material participating in the operation of the farms that would entitle him to Social Security benefits.  The local Social Security Office denied the claim as did the Hearing Examiner on appeal.  The plaintiff’s request for formal review was denied, and the federal trial court also ruled against the plaintiff.  On further review, the U.S. Court of Appeals noted that the facts showed that the plaintiff was the one that made the key decisions involving the production activities on the farms.  The evidence also revealed that the plaintiff kept informed of issues that arose on the farms and educated himself by reading farm production literature and by seeking input from experts at agricultural colleges.  He also made decisions to start new farming practices and establish longer term farming practices and techniques to improve the farms’ profitability.  The appellate court also noted that the plaintiff kept close track of any new production technique or crop that was tried on the farms. 

Based on the evidence, the appellate court reversed the trial court and held that the plaintiff had materially participated in crop production and in the management of crop production on the farms.  Importantly, the appellate court determined that the plaintiff qualified for Social Security benefits based on his own material participation in the farming activities and the activities of his brother-in-law as his agent.  In other words, the brother-in-law’s activities were imputed to the plaintiff for purposes of the material participation test. 

Statutory Modification

 In 1974, the Congress amended the material participation statute to provide that the activities of an agent were thereafter to be irrelevant in determining whether the material participation requirement has been met.    Currently, I.R.C. §1402(a)(1) reads as follows:

“(a)Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss—

            (1) there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares, and including payments under section 1233(a)(2) of the Food Security Act of 1985 (16 U.S.C. 3833(a)(2)) to individuals receiving benefits under section 202 or 223 of the Social Security Act) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer; except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity;…”

For purposes of imputation, the key is the parenthetical language contained in §1402(a)(1)(A) – “…there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant).”  In addition, when read as a whole, the bar on imputation only applies when the production of agricultural or horticultural commodities is involved. 

Satisfying Material Participation

For purposes of Social Security and “net earnings from self-employment” material participation must be achieved personally when agricultural or horticultural crop production is involved.  How is that accomplished?  The IRS has offered three safe harbors and one catchall for determining whether the material participation test has been satisfied.    See Farmers Tax Guide, IRS Pub. 225, page 75 (2019).  The first test requires the landlord to satisfy any three of the following:  (1) advance, pay, or stand good for at least half of the direct costs of producing the crop; (2) furnish half of the tools, equipment and livestock used in producing the crop; (3) advise and consult with the tenant periodically; or (4)  inspect production activities periodically.  The second test requires the landlord to regularly and frequently make, or take an important part in making, management decisions substantially contributing to the success of the enterprise.  Under this test, it appears that decisions should be made throughout the year, such as when to plant, cultivate, dust, spray, or harvest; what items to buy, sell or rent; what records to keep; what reports to make; and what bills to pay and when. Establishing a lease arrangement at the beginning of the season probably will not be regarded as making management decisions.  The third test requires the landlord to work 100 hours or more over a period of five weeks or more in activities connected with producing the crop.  The fourth test requires the landlord to do things which, in total affect, show that the landlord is materially and significantly involved in the production of farm commodities.  This fourth test is the catchall that a landlord can attempt to utilize if the landlord is not able to satisfy any of the first three tests.  The litigated cases on the material participation issue have arisen primarily from this catchall provision.

Other Code Provisions

“Material participation” is required by other tax provisions which are not subject to the 1974 amendment. In other words, when the issue of material participation does not route through I.R.C. §1402, imputation is not blocked.  For example, the qualified business income deduction of I.R.C. §199A does not bar the imputation of an agent’s activity to the principal for purposes of the principal claiming the 20 percent deduction.  There is also no specific statutory bar of imputing an agent’s activity to the principal for purposes of the passive loss rules of I.R.C. §469 (although Committee Report language seems to indicate that there is a bar).

Whether the landlord materially participates in the tenant’s farming business is irrelevant for farm income averaging purposes.  I.R.C. §1301.  Thus, non-materially participating landlords are eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land.  That places a premium on written leases.

There are other sections of the Code where the imputation issue also matters.

The Type of Lease Matters

If a landowner is in the business of farming, the landowner's expenses and income are reported on Schedule F where the net income is subject to self-employment tax.  Income and expenses associated with a material participation crop share lease are reported on Schedule F.  The rental income is subject to self-employment tax and the owner is able to deduct soil and water conservation expenses attributable to the real estate, as well as qualify for the exclusion of cost-sharing payments associated with the rented real estate.  Similarly, the landlord could qualify for expense method depreciation under I.R.C. §179.  In addition, CRP payments received by a materially participating landlord are subject to self-employment tax only if there is a nexus between the CRP land and the materially participating landlord’s farming operation. The IRS continues to deliberately misstate this point in IRS Publication 225. 

A landlord who is not materially participating under a crop share lease receives the income from the lease not subject to self-employment tax.  While the landlord still qualifies for special treatment of soil and water conservation expenses and is eligible for exclusion of cost-sharing payments, and may, as noted below, be eligible for expense method depreciation, the income is to be reported on IRS Form 4835 rather than the Schedule F.

Income under a cash rent lease is income from a passive rental arrangement and is not subject to self-employment tax.  Cash rent landlords do not qualify for special treatment of soil and water conservation expenses but apparently qualify for the exclusion of cost sharing payments received from the USDA.  At least that the conclusion to be drawn from an IRS Private Letter Ruling from 1990. See, e.g., Priv. Ltr. Rul. 9014041 (Jan. 5, 1990).   In the ruling, there was no mention of the type of lease involved.   

As for expense method depreciation, the landlord must be “meaningfully participating” in the management or operations of the trade or business, (Treas. Reg. §1.179-2(c)(6)(ii)) and avoid the “noncorporate lessor” rules.  I.R.C. §179(d)(5).  Income from a cash rent lease is to be reported on the Schedule E -Supplemental Income and Loss.

Conclusion

Imputation is a key concept in several areas of farm income taxation.  It’s made trickier because sometimes it applies and sometimes it does not.  It’s all a matter of which Code section applies and how the material participation requirement is routed through the Code. 

July 12, 2020 in Income Tax | Permalink | Comments (0)

Wednesday, July 8, 2020

More Developments Concerning Conservation Easements

Overview

The U.S. Tax Court continues to issue decisions involving conservation easements.  The IRS has many of these cases in the pipeline which means that the decisions will keep on coming.  This is definitely one area of tax that has been audited heavily and it can be anticipated that the audits will continue.  I have written prior posts on the issues surrounding conservation easements.  They can be beneficial for rural landowners from a tax perspective, but the deeds granting the easement must be drafted very carefully and attention to detail is a must.

In today’s post, I look at a few recent cases and an important IRS development concerning conservation easements.

Extinguishment Regulation Upheld.

Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020); Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54

In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) the deed language violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).

The full Tax Court, agreeing with the IRS, upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5) (e.g., that the donated easement be exclusively for conservation purposes), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable. 

Charitable Deduction Denied – Bad Deed Language and Overvaluation

Plateau Holdings LLC, et al. v. Comr., T.C. Memo. 2020-93.

The petitioner, an entity, owned two parcels of rural land and donated two open-space conservation easements on the parcels to a land trust. The deeds were recorded the next day, and included language expressing an intent to ensure that the land “be retained forever in its current natural, scenic, forested and open land condition” and language preventing any use of the conserved area inconsistent with the conservation purpose. The petitioner claimed a $25.5 million charitable deduction for the donation. Eight days before the donation, an investor acquired nearly 99 percent ownership in the petitioner for less than $6 million.

The Tax Court determined that the deed language was similar to that deemed invalid in Coal Property Holdings LLC v. Comr., 153 T.C. 126 (2019) because the grantee wouldn’t receive a proportionate amount of the full sale proceeds. The Tax Court also upheld a 40 percent penalty under I.R.C. §6662(e) and I.R.C. §6662(h) for a gross misstatement of the value of the contribution. The Tax Court noted that the petitioner valued both properties well above 200 percent of market value, the cut-line for the gross misstatement penalty.  One parcel was valued a$10.9 million, or 852 percent of its correct value.  The other easement was valued at $14.5 million, or 1,031 percent of its proper value. 

Conservation Easement Not Protected In Perpetuity – The Extinguishment Issue 

Hewitt v. Comr., T.C. Memo. 2020-89.

The petitioner owned farmland and deeded a conservation easement on a portion of the property to a qualified charity as defined in I.R.C. §170(h)(3). The petitioner continued to own a large amount of agricultural land that was contiguous with the easement property, and he continued to live on the land and use it for cattle ranching. The petitioner claimed a charitable contribution deduction for the donation of $2,788,000 (the difference in the before and after easement value of the property) which was limited to $57,738 for the tax year 2012 – the year of donation. The petitioner claimed carryover deductions of $1,868,782 in 2013 and $861,480 in 2014.

The petitioner could not determine his basis in the property and, upon the advice of a CPA firm, attached a statement to Form 8283 explaining his lack of basis information. The deed stated that its purpose was to preserve and protect the scenic enjoyment of the land and that the easement would maintain the amount and diversity of natural habitats, protect scenic views from the roads, and restrict the construction of buildings and other structures as well as native vegetation, changes to the habitat and the exploration of minerals, oil, gas or other materials. The petitioner reserved the right to locate five one-acre homesites with one dwelling on each homesite. The deed did not designate the locations of the homesites but required the petitioner to notify the charity when he desired to designate a homesite. The charity could withhold building approval if it determined that the proposed location was inconsistent with or impaired the easement’s purposes.

The deed provided for the allocation of proceeds from an involuntary extinguishment by valuing the easement at that time by multiplying the then fair market value of the property unencumbered by the easement (less any increase in value after the date of the grant attributable to improvements) by the ratio of the value of the easement at the time of the grant to the value of the property, without deduction for the value of the easement at the time of the grant. The deed also stated that the ratio of the value of the easement to the value of the property unencumbered by the easement was to remain constant. The charity drafted the deed and a CPA firm reviewed it and advised the petitioner that it complied with the applicable law and regulations, and that he would be entitled to a substantial tax deduction.

The IRS denied the carryover deductions for lack of substantiation and assessed a 40 percent penalty under I.R.C. §6662(h) for gross valuation misstatement and, alternatively, a 20 percent penalty for negligence or disregard of the regulations or substantial understatement of tax. The petitioner bought additional land that he held through pass-through entities that would then grant easements. The petitioner recognized gain of over $3.5 million on the sale of interests in the entities to investors who then claimed shares in the easement deductions. The IRS claimed that these entities overvalued the easements for purposes of the deductions. Individuals in the CPA firm invested in the entities and claimed easement deductions. The Tax Court determined that the deed language violated the perpetuity requirement of I.R.C. §170 because of the stipulation that the charity’s share of proceeds on extinguishment would be reduced by improvements made to the land after the easement grant. The Tax Court did not uphold the penalties. 

Conservation Easement Doomed by Bad Deed Language

Woodland Property Holdings, LLC v. Comr., T.C. Memo. 2020-55

The petitioner donated a conservation easement to a qualified charity. The deed conveying the property contained a judicial extinguishment provision stating that the easement gave rise to a vested property right in the donee, the value of which "shall remain constant." The value of the donee's property right was defined as the difference between (a) the fair market value (FMV) of the conservation area as if unburdened by the easement and (b) the FMV of the conservation area as burdened by the easement, with both values being "determined as of the date of this Conservation Easement." The IRS took the position that the language failed to satisfy the "in perpetuity" requirement for such gifts. The petitioner pointed to the following deed language for support of the his position that the perpetuity requirement was satisfied:  "If any provision of this Conservation Easement is found to be ambiguous, an interpretation consistent with its purposes that would render the provision valid should be favored over any interpretation that would render it invalid."

The Tax Court, however, held that the provision did not help the taxpayer because it was a cure only for ambiguous provisions and the deed was unambiguous in limiting the donee's vested property right. In addition, the Tax Court noted that a statement from the donee organization that the easement be in full compliance with the tax law was immaterial. 

Conservation Easement Deduction Allowed At Reduced Amount. 

Johnson v. Comr., T.C. Memo. 2020-79

The petitioner is the president of a west-central Colorado company that manufactures and sells disposable ink pans for printing presses. He purchased a ranch in 2002 for 200,000 and carved out a permanent conservation easement that he donated to the Colorado Open Lands, a qualified charity. He made the donation in 2007. The easement encumbered 116.14 acres along with the water rights, leaving the remaining five acres unencumbered. The easement restricted the encumbered area from being subdivided, used as a feedlot, or used for commercial activities. It also restricted all construction within the encumbered area except for five acres that was designated a “building envelope”. The deed limited constructed floor space inside the building envelope to 6,000 square feet for single residential improvements and a cumulative maximum of 30,000 square feet for all improvements.

On his return for 2007, the petitioner claimed a $610,000 charitable contribution deduction for the donated easement, with carryover amounts deducted in future years. He also claimed certain farm-related expenses. The IRS denied the carryover charitable deductions in three carryover years on the basis that he had already deducted more than the easement’s value for previous tax years. The petitioner and the IRS agreed that the property’s highest and best use was for farming and a residence. The petitioner’s valuation expert used a quantitative approach by taking comparable sales adjusted by time between the time of those easement donations and when the petitioner donated his easement. The petitioner’s expert then adjusted for nearness of the encumbered property to town and size. He then factored in irrigation, topography and improvements to arrive at the value of the property before the easement. The expert did not have many post-donation comparable sales to work with in arriving at the value of the petitioner’s property after the easement donation.

The valuation expert for the IRS used the qualitative approach. By comparing several characteristics for each comparable, including market conditions at the time of sale, location/access, size, aesthetic appeal, zoning, and available utilities, to evaluate the relative superiority, inferiority, or similarity of each comparable to the ranch. The expert then evaluated the overall comparability of each property to the ranch.

The Tax Court preferred the approach of the petitioner’s expert, due to the IRS’s expert ignoring the quantitative factors. However, the Tax Court adjusted the value arrived at by the petitioner’s expert. Post-encumbrance nearby comparable sales were lacking, the Tax Court rejected both experts’ post-encumbrance direct comparable sales analyses. By ignoring an outlier from both of the experts, the parties were only two percent apart on value. The Tax Court split the difference between the parties and added it to the pre-easement value as adjusted to arrive at the easement’s value. Thus, the Tax Court allowed a $373,000 deduction for the easement. The Tax Court also disallowed various farming expense deductions including travel-related expenses due to the lack of substantiation. 

Conclusion

The saga of claimed charitable deductions for donated conservation easements will continue.  It seems that nothing generates more Tax Court litigation than a Code provision that the IRS despises.

July 8, 2020 in Income Tax | Permalink | Comments (0)