Friday, July 3, 2020
In the context of Chapter 12 (farm) bankruptcy, unless a secured creditor agrees otherwise, the creditor is entitled to receive the value, as of the effective date of the plan, equal to the allowed amount of the claim. Thus, after a secured debt is written down to the fair market value of the collateral, with the amount of the debt in excess of the collateral value treated as unsecured debt which is generally discharged if not paid during the term of the plan, the creditor is entitled to the present value of the amount of the secured claim if the payments are stretched over a period of years.
What does “present value” mean? It means that a dollar in hand today is worth more than a dollar to be received at some time in the future. It also means that an interest rate will be attached to that deferred income. But, what interest rate will make a creditor whole? A recent decision involving a farming operation in the state of Washington is a good illustration of how courts address the issue.
“Cramdown” and Present Value
When a farmer files a Chapter 12 bankruptcy, the law allows the “cramdown” of a secured creditor if the farmer reorganization plan provides that the secured creditor gets to retain the lien that secures the claim and the value, as of the effective date of the plan, of property to be distributed by the trustee or the debtor under the plan on account of the claim is not less than the allowed amount of the claim. 11 U.S.C. §1225(a)(5)(B)(i)-(ii). The real issue is what “not less than the allowed amount of the claim” means. That’s particularly true when the rule is applied in the context of cash payments that are to be made in the future. In that instance, a value must be derived as of the plan’s effective date, that is discounted to present value. Present value is the discounted value of a stream of expected future incomes. That stream of income received in the future is discounted back to present value by a discount rate.
The determination of present value is highly sensitive to the discount rate, which is commonly expressed in terms of an interest rate. Several different approaches have been used in Chapter 12 bankruptcy cases (and nearly identical situations in Chapters 11 and 13 cases) to determine the discount rate. Those approaches include the contract rate – the interest rate used in the debt obligation giving rise to the allowed claim; the legal rate in the particular jurisdiction; the rate on unpaid federal tax; the federal civil judgment rate; the rate based on expert testimony; a rate tied to the lender’s cost of funds; and the market rate for similar loans.
Supreme Court Decision
In 2004, the U.S. Supreme Court, in, addressed the issue in the context of a Chapter 13 case that has since been held applicable in Chapter 12 cases. Till v. SCS Credit Corporation, 541 U.S. 465 (2004). In Till, the debtor owed $4,000 on a truck at the time of filing Chapter 13. The debtor proposed to pay the creditor over time with the payments subject to a 9.5 percent annual interest rate. That rate was slightly higher than the average loan rate to account for the additional risk that the debtor might default. The creditor, however, argued that it was entitled to a 21 percent rate of interest to ensure that the payments equaled the “total present value” or were “not less than the [claim’s] allowed amount.” The bankruptcy court disagreed, but the district court reversed and imposed the 21 percent rate. The United States Court of Appeals for the Seventh Circuit held that the 21 percent rate was “probably” correct, but that the parties could introduce additional concerning the appropriate interest rate.
On further review by the U.S. Supreme Court, the Court held that the proper interest rate was 9.5 percent. That rate, the Court noted, was derived from a modification of the average national loan rate to account for the risk that the debtor would default. The Court’s opinion has been held to be applicable in Chapter 12 cases. See, e.g., In re Torelli, 338 B.R. 390 (Bankr. E.D. Ark. 2006); In re Wilson, No. 05-65161-12, 2007 Bankr. LEXIS 359 (Bankr. D. Mont. Feb. 7, 2007); In re Woods, 465 B.R. 196 (B.A.P. 10th Cir. 2012). The Court rejected the coerced loan, presumptive contract rate and cost of funds approaches to determining the appropriate interest rate, noting that each of the approaches was “complicated, impose[d] significant evidentiary costs, and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments ha[d] the required present value.” A plurality of the Court explained that these difficulties were not present with the formula approach. The Court opined that the formula approach requires that the bankruptcy court determine the appropriate interest rate by starting with the national prime rate and then make an adjustment to reflect the risk of nonpayment by the debtor. While the Court noted that courts using the formula approach have typically added 1 percent to 3 percent to the prime rate as a reflection of the risk of nonpayment, the Court did not adopt a specific percentage range for risk adjustment.
Since the Supreme Court’s Till decision, the lower courts have decided many cases in which they have attempted to apply the Till approach. Indeed, the Circuit Courts have split on whether the appropriate interest rate for determining present value should be the market rate or a rate based on a formula. For example, in a relatively recent Circuit Court case on the issue, the Second Circuit held that a market rate of interest should be utilized if an efficient market existed in which the rate could be determined. In re MPM Silicones, L.L.C., No. 15-1682(l), 2017 U.S. App. LEXIS 20596 (2nd Cir. Oct. 20, 2017). In the case, the debtor filed Chapter 11 and proposed a reorganization plan that gave first-lien holders an option to receive immediate payment without any additional “make-whole” premium, or the present value of their claims by utilizing an interest rate based on a formula that resulted in a rate below the market rate. The bankruptcy court confirmed the plan, utilizing the formula approach of Till. The federal district court affirmed. On further review, the appellate court reversed noting that Till had not conclusively specified the use of the formula approach in a Chapter 11 case. The appellate court remanded the case to the bankruptcy court for a determination of whether an efficient market rate could be determined based on the facts of the case.
Recent Washington Case
A recent case from the state of Washington is a good illustration of how a court can use the Till opinion to fashion an interest rate suitable to the debtor’s particular farming operation. In In re Key Farms, Inc., No. 19-02949-WLH12, 2020 Bankr. LEXIS 1642 (Bankr. D. Wash. Jun. 23, 2020), the debtor was a family farming operation engaged in apple, cherry, alfalfa, seed corn and other crop production. The parents of the family owned 100 percent of the debtor, the farming entity. 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 then filed Chapter 12 bankruptcy and proposed a reorganization plan where it would continue farming under 2020-2024 in accordance with proposed budgets through 2024. The plan provided for repayment of all creditors in full. The plan proposed to repay then 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. A primary issue was what an appropriate cramdown interest rate would be.
The court looked at the unique features of the debtor to set the rate. Indeed, in determining whether the reorganization plan was fair and equitable to the lender based on the facts, the 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 the parents had extensive experience with crop insurance and that they were committing unencumbered personal assets to the reorganization plan. The court also noted the debtor’s shift in recent years to more profitable crops, 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 (30 years) to the lender. Accordingly, the court made an upward adjustment to the debtor’s proposed 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.
The interest rate issue is an important one in reorganization bankruptcy. the market rate, as applied to an ag bankruptcy, does seem to recognize that farm and ranch businesses are subject to substantial risks and uncertainties from changes in price and from weather, disease and other factors. Those risks are different depending on the type of agricultural business the debtor operates. A market rate of interest would is reflective of those factors.
Tuesday, June 30, 2020
The Paycheck Protection Program (PPP) was enacted into law in late March and has now been statutorily modified by the Paycheck Protection Program Flexibility Act (PPFA). It is designed to provide short-term financial relief to qualified businesses that have been negatively impacted by the action of state Governors in response to the virus. The Small Business Administration (SBA) administers the law.
The Premium Assistance Tax Credit (PATC) is a refundable credit designed to offset the higher cost of health insurance triggered by Obamacare for eligible individuals and families that acquire health insurance purchased through the Health Insurance Marketplace. In recent days important developments have involved the PATC.
Prior posts have discussed various aspect of the PPP, particularly as applied to farm and ranch businesses. In today’s post I take a brief look at a couple of PPP court developments and key information involving the PATC. Recent developments of the PPP and the PATC – it’s the topic of today’s post.
PPP Court Developments
Maine case. The SBA has promulgated a rule taking the position that an individual PPP applicant that is in bankruptcy is ineligible for PPP funds. Also, if the applicant is an entity and a majority owner is in bankruptcy, the SBA also denies PPP eligibility to the entity. In recent days, two more courts have addressed various aspects of the SBA position.
In a recent case from Maine, the plaintiff had filed Chapter 11 and sought approval of a disclosure describing its Chapter 11 plan. The statement acknowledged the problems the virus presented to its business, but assured creditors that the plan was feasible. The plaintiff continued to project that its business would be viable and would continue in business and meet plan obligations. The statement also described a general effort to get assistance, but did not suggest any likelihood of suffering immediate and irreparable harm in the form of ceasing business if access to the PPP were denied. The plaintiff’s statement also pointed to a forecasted ability to weather the current economic problems after July 2020 and into 2022, even without receipt of funds under the PPP.
The court noted the devoid record of any showing of projected receipts and disbursements and determined that it didn’t have enough information to determine if the state Governor’s conduct seriously impaired the plaintiff’s financial projections. The court denied the temporary restraining order (TRO). In re Breda, No. 20-1008, 2020 Bankr. LEXIS 1246 (Bankr. D. Me. May 11, 2020). In a later proceeding the plaintiff claimed that the defendant violated the anti-discrimination provisions of 11 U.S.C. §525. The court granted the defendant’s motion to dismiss. In re Breda, No. 18-10140, 2020 Bankr. LEXIS 1626 (Bankr. D. Me. Jun. 22, 2020).
Fifth Circuit case. As noted above, the SBA created a regulation with respect to eligibility for the PPP that makes an applicant ineligible to receive program funds if the applicant is a debtor in a bankruptcy proceeding. 85 Fed. Reg. 23, 450 (Apr. 28, 2020). In In re Hidalgo County Emergency Service Foundation v. Carranza, No. 20-40368, 2020 U.S. App. LEXIS 19400 (5th Cir. Jun. 22, 2020), the debtor was in Chapter 11 bankruptcy and was denied PPP funds. The debtor claimed that such denial violated the anti-discrimination provisions of 11 U.S.C. §525(a) which bars discrimination based on bankruptcy status in certain situations. The debtor also claimed that the regulation was arbitrary and capricious and an abuse of the SBA’s discretion.
The bankruptcy court agreed and issued a preliminary injunction mandating that the SBA handle the debtor’s PPP application without considering that the debtor was in bankruptcy. The district court stayed the injunction and certified the case for direct appeal to the appellate court. On further review, the appellate court vacated the preliminary injunction noting that federal law prohibits injunctive relief against the SBA.
Premium Assistance Tax Credit
The IRS recently proposed regulations clarify that the reduction of the personal exemption deduction to zero for tax years beginning after 2017 and before 2026 does not affect an individual taxpayer’s ability to claim the PATC. The regulations essentially adopt the guidance set forth in Notice 2018-84. The proposed regulations apply to tax years ending after the date the regulations are finalized as published in the Federal Register. Taxpayers can rely on the proposed regulations for tax years beginning after 2017 and before 2026 that end on or before the date the Treasury decision adopting the regulations as final regulations is published in the Federal Register. Prop. Treas. Reg. 124810-19.
On another angle, the self-employed health insurance deduction may allow for a PATC. In Abrego, et ux. v. Comr., T.C. Memo. 2020-87, the petitioners, a married couple, received an advance premium assistance tax credit under I.R.C. §36B to help offset the higher cost of health insurance acquired through the Health Insurance Marketplace as a result of Obamacare. The advance credit was received for a tax year during which the wife worked as a housekeeper and the husband worked as a driver for a transport company. The husband also operated his own tax return preparation business. The IRS determined that the entire advanced credit had to be paid back based on the petitioners’ actual income for the year as reported on the tax return.
The Tax Court held that the repayment amount was capped under I.R.C. §36B(f)(2) when taking into account the partial self-employment health insurance deduction that lowered the petitioners’ “household income” to just under 400 percent of the federal poverty line. Thus, the petitioners were eligible for some advance credit amount under I.R.C. §36B(b)(2) rather than being completely ineligible.
These are just a small sample of what’s been happening in the courts that might impact a client’s return. Unfortunately, it’s still tax season. Fortunately, the IRS has announced that the end of tax season won’t be postponed again. You can sign up for two days of continuing education on these and other topics at the National Farm Income Tax & Estate and Business Planning Conference in Deadwood, SD on July 20-21. You may either attend in-person or online. For more information click here: https://washburnlaw.edu/employers/cle/farmandranchtax.html
Saturday, June 27, 2020
Either as part of an estate plan or for purposes of setting up another person in business or for other reasons, a gift might be made. But when is a transfer of funds really a gift? Why does it matter? The recipient doesn’t have to report into income gifted amounts. If the amount transferred is not really a gift, then it’s income to the recipient. When large amounts are involved, the distinction is of utmost importance.
When is a transfer of funds a gift? It’s the topic of today’s blog article
Definition of a “Gift”
Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded. I.R.C. §61(a). However, gross income does not include the value of property that is acquired by gift. I.R.C. §102(a). In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses. As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent. That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction. A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc. Detached and disinterested generosity is the key. If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity. Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.
Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift. A common law gift requires only a voluntary transfer without consideration. If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard. That’s an easier standard to satisfy than the Code definition set forth in Duberstein.
The recent Tax Court case of Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes. The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings. The company would buy structured payments from lottery winners and resell the payments to investors. The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s. Their business relationship lasted until 2007.
In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets. An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future. In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean. The petitioner was the beneficiary of the trust along with his son. In 2007, the petitioner established another trust in the Bahamas to hold business assets. From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000. Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean island and still others went to the petitioner’s business. The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income. The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts. The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person. A CPA prepared the Form 3520 for the necessary years. The petitioner never reported any of the transfers from Mr. Haring as taxable income.
The petitioner was audited for tax years 2005-2007. The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency.
The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income. They were not gifts. The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers. The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence. However, Mr. Haring never appeared at trial and didn’t provide testimony. Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony. The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests. He even formed a trust in Liechtenstein for Mr. Haring in 2000. Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000. That loan was paid off in 2007. Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees. He later liquidated his interest for $255 million.
The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number. He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes. The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner. The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account. That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts.
The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses. The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.” There was no supporting documentary evidence. In addition, the attorney represented both Mr. Haring and the petitioner. The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.” The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner. Thus, the note carried little weight in determining whether the transfers were gifts.
The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity. The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity. The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor. That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee.
The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b).
The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity. The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift. The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into. When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must. The income tax consequences from being wrong are enormous.
Wednesday, June 24, 2020
When a farmer or rancher dies, often left behind are assets that are unique to agriculture. For tax purposes, these assets present unique valuation issues. For practitioners handling ag estates, it’s important to get values correct for federal estate tax purposes and/or a county inheritance tax worksheet. What are the basics tenets of valuing these unique farm and ranch items? This was an issue that Don Kelley, who I started out my practice career out with in North Platte, NE, wrote about in his two-volume treatise, Estate Planning for Farmers and Ranchers, and his other two-volume set, Farm Business Organizations. Don recently turned over the editorship of those treatises to me. In working on updating those volumes recently, I thought it would be a useful topic for today's article.
Valuing farm chattels and marketing rights of a farmer at death – it’s the topic of today’s post
There is no specific Treasury Regulation that addresses the valuation of tangible chattel property (personal property) beyond Treas. Reg. §20.2031-6 (addressing household goods/personal effects) and Treas. Reg. §20.2031-1 which addresses general valuation concepts.
Treas. Reg. §20.2031-1(b) states:
“Livestock, farm machinery, harvested and growing crops must generally be itemized and the value of each item separately returned. Property shall not be returned at the value at which it is assessed for local property tax purposes unless that value represents the fair market value as of the applicable valuation date. All relevant facts and elements of value as of the applicable valuation date shall be considered in every case.”
It’s often easier to value chattels and inventory them than it is to value farm/ranch real estate. Most farm machinery has an established market. As a result, appraisals of farm machinery and equipment usually are not controversial. If there is an established retail market for chattel property, it is to be value at retail. Treas. Reg. §20.2031-1(b). As the regulation states, “For example, the fair market value of an automobile (an article generally obtained by the public in the retail market) includible in the decedent's gross estate is the price for which an automobile of the same or approximately the same description, make, model, age, condition, etc., could be purchased by a member of the general public and not the price for which the particular automobile of the decedent would be purchased by a dealer in used automobiles. Examples of items of property which are generally sold to the public at retail may be found in §§ 20.2031-6 and 20.2031-8.” Id.
This same approach is to be used with respect to farm machinery and equipment and also farm vehicles. For example, in Estate of Love v. Comr., T.C. Memo. 1989-470, the decedent was in the business of breeding and racing thoroughbred horses and died 11 days after a brood mare mated. It was not possible as of the date of the decedent’s death (the valuation date) to determine whether the mare was pregnant at the time the decedent died, but the IRS went ahead and assumed that the mare was pregnant on the date of the decedent’s death for valuation purposes. Doing so greatly increased the value of the mare. The Tax Court determined that that post-death pregnancy of the mare was not to be taken into account when valuing the mare for estate tax purposes. There was no way that a hypothetical willing buyer would have known that the mare was pregnant, and the Tax Court determined that the assumption by the IRS of the mare’s pregnancy was not in accord with Treas. Reg. §20.2031-1(b). The Tax Court also excluded post-death sales of horses in the determination of the mare’s value and relied on comparable sales of horses near the date of the decedent’s death. The Tax Court’s opinion was upheld on appeal. 923 F.2d 335 (4th Cir. 1991).
Farm buildings, fences, water wells and similar items are customarily appraised as part of the farm real estate. But, if a fixture (and associated chattel equipment) is linked with crop production, valuation is more problematic. An example of such an item would be an irrigation well used to pump water for crop irrigation. At least in the areas of the Great Plains and the western Midwest, IRS offices have historically valued detachable chattel items as farm machinery. Such items of property include aboveground pivot irrigation systems, motors and pumps. The associated land on which the irrigated crops are grown is typically appraised along with any immovable fixtures (i.e., wells; well casings; pivot stanchions) in place.
Harvested grain in inventory of a farmer usually doesn’t present a valuation issue. The grain is valued in accordance with trading exchanges for the type of crop involved as of the date of death. For example, in Willging v. United States, 474 F.2d 12 (9th Cir. 1973), the plaintiff was a wheat farmer that reported income on the accrual basis. The value of the 1966 opening grain inventory increased by over $36,000 from January 1, 1966 until the date of the farmer’s death in November. The estate claimed that the increase in the inventory values escaped taxation because of the basis step-up rule of I.R.C. §1014. The appellate court disagreed, reversing the trial court. The court noted that the farmer determined income annually by adding to the sales price of products sold during the year the value of his closing inventory, and then subtracting from that amount the value of the opening inventory. Inventories were valued under the “farm price” method (market price less direct costs of disposition). The farmer deducted expenses in the year incurred. Because the farmer elected to be taxed under the accrual method, the court noted that the value of the grain was realized when it increased the inventory value. It wasn’t realized when it was later sold. Thus, his death didn’t have the effect of accruing items which would not otherwise have been accrued, but his death closed the tax year for his last tax year for the income he had received that year.
Many farmers are members of agricultural cooperatives and may hold cooperative marketing rights as of the time of death. This is particularly true with respect to dairy farmers and is also common among beekeepers. How are such rights valued? In Cordeiro’s Estate v. Comr., 51 T.C. 195 (1968), the petitioner acquired a herd of dairy cows from the decedent. The decedent was a member of a cooperative marketing association and had been required to market all of his milk from the herd through the cooperative. The decedent had been allocated “base” as a measure of his share in the proceeds of the cooperative’s milk sales. The decedent’s membership and base expired upon the decedent’s death and the petitioner succeeded to it and membership in the cooperative. The Tax Court determined that the base was separate from the dairy herd and that the petitioner’s cost basis in the dairy cows was to be determined without any value attributed to the base. A milk base is an intangible right to sell a certain amount of milk at a particular price. See, Priv. Ltr. Rul. 7818002 (Jan. 6, 1978). See also, Vander Hoek v. Comr., 51 T.C. 203 (1968), acq., 1969 A.O.C. LEXIS 210 (May 9, 1969).
Similarly, a rice allotment has been held to be a right this is devisable, descendible, transferable and salable. First Victoria National Bank v. United States, 620 F.2d 1096 (5th Cir. 1980). The court said that the allotment was similar to business goodwill. That reasoning could support an IRS argument that other USDA program benefits that a decedent had applied for have value for tax purposes associated with death.
Valuation issues for farmers and ranchers can be unique. When particular items of chattel property are involved, specific valuation guidance is often lacking, and the existing guidance is dated. While the courts have addressed some of the issues, the general advice of not being greedy holds true. If a valuation amount looks reasonable to an IRS examining agent, chances are IRS won’t push the issue.
This is just one of the issues that will be addressed at the 2020 Farm & Ranch Income Tax/Estate and Business Planning national conference in Deadwood, South Dakota on July 20-21. You may attend either in-person or online. For more information on the conference and how to registration information click here: https://washburnlaw.edu/employers/cle/deadwoodcle.html
Saturday, June 20, 2020
In the mid-1950s, my Father was having the first of several ponds dug on farm property in northeastern Indiana that he and my Mother had purchased a few years earlier. During the excavation Mastodon bones (fossils) were unearthed in the muck and grey/blue clay, including a nearly full set of teeth and jaw bones. Mastodon bones were also unearthed on nearby farms and when a local branch campus of Purdue and Indiana Universities opened in the fall of 1964 it was given the nickname “Mastodons.”
An issue that I am certain never crossed my Father’s mind, likely because my parents owned both the surface and subsurface estates of the farm, was whether the fossils were “minerals” that would belong to the owner of the mineral estate. But, the legal classification of fossils is a very important issue when the fossils are valuable.
Are fossils “minerals” that are owned by the owner of the mineral estate? It’s the topic of today’s post.
Surface Estate and Mineral Estate
A fee simple owner of real estate can maintain possession and control of the surface of the property and sell/convey the rights to the “minerals” (such as oil and gas). Upon such a conveyance, the owner of the mineral rights (known as the mineral estate owner) can economically benefit from the extraction of the minerals. Depending on the mineral deed that conveys the minerals, the deed language may include all minerals known and unknown or the definition of “minerals” may be limited to specific ones.
Definition of “Minerals”
A common granting clause in a mineral deed specifies that the grantor either conveys or reserves “the oil, gas and other minerals.” That language can raise an issue concerning what “other minerals” means. Does it include such things as gravel, clay granite, sandstone, limestone, coal, carbon dioxide, hot water and steam? The courts have struggled with this issue and have reached differing conclusions. Does the phrase mean anything that is in the soil that the surface estate owner doesn’t use for agricultural purposes? Does is matter how the substance is extracted? Does it matter if the material is located in the subsoil rather than the topsoil? Is it material if the substance can be extracted without significant damage to the surface estate?
In 1949, the Texas Supreme Court issued a significant opinion on the issue of whether the term “minerals” includes substances other than oil and gas. Heinatz v. Allen, 217 S.W.2d 994 (Tex. 1949). The court utilized the “common meaning” rule under which all substances ordinarily thought of as minerals at the time the deed was executed are deemed to be minerals conveyed by the deed regardless of whether the parties knew the substances existed. That would seem to include in the definition of minerals such substances as gold, silver, coal, iron ore, etc.. Substances such as sand, gravel, water, etc. that are ordinarily associated with ownership of the surface estate would not be included in the definition of minerals. But the test is not a perfect, all-inclusive one and other factors can be relevant – such as exceptional value; surface destruction; and commercial and/or industrial meaning. In addition, state law may have a specific definition that applies in a particular situation.
What Are Fossils?
The issue of whether dinosaur fossils are “minerals” for the purposes of a mineral reservation clause in a mineral deed was an issue in a recent Montana case. In Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020), the court dealt with the issue in a case with millions of dollars on the line. Under the facts of the case, the plaintiffs (a married couple), leased farm and ranch land beginning in 1983. Over a period of years, the owner of the land transferred portions of his interest in the property to his two sons and sold the balance to the plaintiffs. From 1991 to 2005, the plaintiffs and the sons operated the property as a partnership. In 2005, the sons severed the surface estate from the mineral estate and sold their remaining interests in the surface estate to the plaintiffs. A mineral deed was to be executed at closing that apportioned one-third of the mineral rights to each son and one-third to the plaintiffs. After the transactions were completed, the plaintiffs owned all of the surface estate of the 27,000-acre property and one-third of the mineral (subsurface) estate. At the time, none of the parties suspected there were valuable dinosaur fossils on the property, and none of them gave any thought to whether dinosaur fossils were part of the mineral estate as defined in the mineral deed. Likewise, none of the parties expressed any intent about who might own dinosaur fossils that might be found on the property.
Specifically, the mineral deed stated that the parties would own, as tenants in common, “all right, title and interest in and to all of the oil, gas, hydrocarbons, and minerals in, on and under, and that may be produced from the [Ranch].” The purchase agreement required the parties “to inform all of the other parties of any material event which may [affect] the mineral interests and [to] share all communications and contracts with all other Parties.”
In 2006, the plaintiffs gave permission to a trio of fossil hunters to search (and later dig) for fossils on the property. The hunters ultimately uncovered dinosaur fossils of great value including a nearly intact Tyrannosaurus rex skeleton and two separate dinosaurs that died locked in battle. The fossils turned out to be extremely rare and quite valuable, with the “Dueling Dinosaurs” valued at between $7 million and $9 million. In 2014, the plaintiffs sold the Tyrannosaurus rex skeleton to a Dutch museum for several million dollars. A Triceratops foot was sold for $20,000 and a Triceratops skull was offered for sale for over $200,000. The proceeds of sale were placed in an escrow account pending the outcome of a lawsuit that the sons filed. The sons (the defendants in the present action) sued claiming that the fossils were “minerals” and that they were entitled to a portion of any sale proceeds. The plaintiffs brought a declaratory judgment action in state court claiming that the fossils were theirs as owners of the surface estate. The defendants removed the action to federal court and asserted a counterclaim on the basis that the fossils should be included in the mineral estate. The trial court granted summary judgment for the plaintiffs on the basis that, under Montana law, fossils are not included in the ordinary and natural meaning of “mineral” and are thus not part of the mineral estate. Murray v. Billings Garfield Land Co., 187 F. Supp. 3d 1203 (D. Mont. 2016).
On appeal, the appellate court reversed. Murray v. BEJ Minerals, LLC, 908 F.3d 437 (9th Cir. 2018). The appellate court determined that the term “fossil” fit within the dictionary definition of “mineral.” Specifically, the appellate court noted that Black’s Law Dictionary defined “mineral” in terms of the “use” of a substance, but that defining “mineral” in that fashion did not exclude fossils. The appellate court also noted that an earlier version of Black’s Law Dictionary defined “mineral” as including “all fossil bodies or matters dug out of mines or quarries, whence anything may be dug, such as beds of stone which may be quarried.” Thus, the appellate court disagreed with the trial court that the deed did not encompass dinosaur fossils. Turning to state court interpretations of the term “mineral”, the appellate court noted that the Montana Supreme Court had held certain substances other than oil and gas can be minerals if they are rare and exceptional. Thus, the appellate court determined that to be a mineral under Montana law, the substance would have to meet the scientific definition of a “mineral” and be rare and exceptional. The appellate court held that those standards had been met. The plaintiffs sought a rehearing by the full Ninth Circuit and their request was granted. Murray v. BEJ Minerals, LLC, 920 F.3d 583 (9th Cir. 2019). The appellate court then determined that the issue was one of first impression under Montana law and certified the question of whether dinosaur fossils constitute “minerals” for the purpose of a mineral reservation under Montana law to the Montana Supreme Court. Murray v. BEJ Minerals, 924 F.3d 1070 (9th Cir. 2019).
The Montana Supreme Court answered the certified question in the negative – dinosaur fossils are not “minerals” for the purpose of the mineral reservation at issue because they were not included in the expression, “oil, gas and hydrocarbons,” and could not be implied in the deed’s general grant of all other minerals. “Fossils” and “minerals” were mutually exclusive terms as the parties used those terms in the mineral deed. Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020).
In making its determination, the Montana Supreme Court reasoned that whether a substance or material is a “mineral” is based on whether it is rare and valuable for its mineral properties, whether the conveying instrument expressed an intent to use the scientific definition of the term, and the relation of the substance or material to the land’s surface and the method and effect of its removal. The Court also noted that deeds are like contracts and should be interpreted in accordance with their plain and ordinary meaning to give effect to the parties’ mutual intent at the time of execution.
The Court noted that the term “minerals” is defined in various areas of Montana statutory law (including tax provisions) and none include “fossils,” and that the only statutory provision mentioning fossils and minerals in the same statute referred to them separately. The Court also noted that the U.S. Department of Interior (for purposes of federal law) had made an administrative decision in 1915 that dinosaur fossils are not “minerals.” As such, the terms were mutually exclusive as used in the mineral deed between the parties, and the plaintiffs maintained ownership of any interests that the two sons had not specifically reserved in the mineral deed. The deed simply did not contemplate including “fossils” under the mineral reservation clause. Instead, the Court concluded that “minerals” under Montana law are a resource that is mined as a raw material for further processing, refinement and eventual economic exploitation. Fossils are not mined, they are excavated, and they are not rare and valuable due to their mineral properties. Therefore, unless specifically mentioned in the mineral deed, language identifying “minerals” would not “ordinarily and naturally” include fossils.
Based on the Montana Supreme Court’s answer to the certified question, the U.S. Court of Appeals for the Ninth Circuit affirmed the federal district court’s order granting summary judgment to the plaintiffs and declaring them the sole owners of the dinosaur fossils. Murray v. BEJ Minerals, LLC, No. 16-35506, 2020 U.S. App. LEXIS 19064 (9th Cir. Jun. 17, 2020).
While it’s not possible to anticipate what might be found on or under a tract of land, drafters of mineral deeds must carefully consider the potential impact of drafting language. This issue can be of primary importance, as the Montana case illustrates. Also, while it didn’t apply to the Montana case, the Montana Governor signed H.B. 229 into law on April 16, 2019. That legislation specifies that dinosaur fossils are not minerals and that fossils belong to the holder of the surface estate.
If only that Mastodon unearthed in the 1950s had been a Tyrannosaurus rex….
Wednesday, June 17, 2020
As part of an estate plan, an heir may be given an option to buy certain assets of the decedent at a specified price. In agricultural estates, such an option is typically associated with farmland of the decedent, and often gives the optionee (the person named in the will with the right to exercise the option) a very good deal for the property upon exercise of the option.
Often the question arises as to the basis of the property in the hands of the optionee when the option is exercised and the resulting tax consequences when the property is later sold.
Tax issues associated with the exercise of an option – it’s the topic of today’s post.
Options – The Basics
There is no question that an option can be included in a will. A testator has the right to dispose of their property as desired. The only significant limitation on testamentary freedom involves the inability to completely disinherit a spouse. Even if the will leaves nothing for the surviving spouse, under state law the surviving spouse has a right to an elective share entitling the surviving spouse to “elect” to take a portion of the estate regardless of what the deceased spouse’s will says (except, of course, if a valid prenuptial agreement was executed). Under most state laws, a surviving spouse’s elective share comprises anywhere from between one-third to one-half of the decedent’s estate. In addition, in some states, the spousal elective share can include retirement assets or life insurance.
What are the tax consequences when an optionee exercises an option? Does the exercise result in tax consequences to the decedent’s estate? What are the tax consequences if the optionee later sells the property that was acquired by the exercise of the option?
Decedent’s estate. The exercise of an option results in no tax consequence to the decedent’s estate. The exercise of the option, followed by the sale of the property by the estate to the holder of the option does not result in gain or loss to the estate. In Priv. Ltr. Rul. 8210074, Dec. 10, 1981, the decedent's son was given an option under the terms of the parent’s will to purchase some of the parent’s farmland at $350/acre. The son exercised the option and paid the estate $26,668 for the land. At the time the option was exercised, the farmland was worth $114,293 (as valued on the parent’s estate tax return). The IRS determined that the combined basis of the option and the real estate subject to the option was $114,293 with $26,668 of that allocable to the land. Thus, when the real estate was sold to the son for $26,668, it equaled the basis in the land in the hands of the estate resulting in neither gain nor loss to the estate.
When the optionee exercises the option in a will or trust, the primary question is what the income tax basis of the property received under the option is in the optionee’s hands. I.R.C. §1014 is the applicable basis provision for property acquired from a decedent. The provision states in pertinent part, “(a)In general Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be— (1) the fair market value of the property at the date of the decedent’s death,… (b)Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent….
This ‘”stepped-up” basis rule applies to property required to be included in the decedent’s gross estate, including property that is subject to an option in a will (or trust) that grants the beneficiary an option to purchase the property at a beneficial price from the estate. The option is treated as property acquired from the decedent and receives an income tax basis equal to its fair market value as of the date of the decedent’s death. Its basis is the estate tax value of the property subject to the option less the price the beneficiary must pay to exercise the option. A beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the optionee’s basis in the property.
In Cadby v. Comr., 24 T.C. 899 (1955), acq., 1956-2 C.B. 5, the decedent died in 1942. His will included a provision directing the executor and trustee to sell some of the decedent’s stock to a family member and another person for $25,000 upon proof that the family member had purchased from the decedent’s surviving spouse preferred stock in the same company for $6,000 if payment were made within two years of the decedent’s death. If payment wasn’t made within the specified timeframe, disposition of the stock was left to the discretion of the executor and trustee. Shortly after the decedent’s death, the family member sold his rights under the will to a third party for $13,000.
In determining the tax consequence of the transaction to the family member, the Tax Court noted that the fair market value of the decedent’s stock interest subject to the option was $55,243 as of the date of death as denoted on the decedent’s federal estate tax return. In addition, the family member paid $6,000 for the stock he purchased from the decedent’s surviving spouse. Thus, the family member’s income tax basis in the stock was $61,243.40. From that amount, the Tax Court subtracted the option price of $25,000 and the payment to the surviving spouse of $6,000. The result, $30,243.40, was the option price. Because the family member held a one-half interest in the option, that one-half interest was worth $15,121.70. Thus, the sale for $13,000 did not trigger any taxable income to the family member.
Twelve years after the Tax Court’s ruling in Cadby, the IRS issued a Revenue Ruling formally stating its position that a beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the beneficiary’s basis in the property. Rev. Rul. 67-96, 1967-1 C.B. 195. In 2003, the IRS issued a private letter ruling again confirming the Tax Court’s approach in Cadby. Priv. Ltr. Rul. 200340019 (Jun. 25, 2003). Under the facts of the ruling, under the terms of Mother's will, the taxpayer was given the right to purchase the Mother’s home upon the Mother’s death at an amount less than fair market value. The basis in the option and in the home upon exercise of the option was determined in accordance with Rev. Rul. 67-96. Thus, the basis in the option upon its exercise was measured by the difference between the value of the home for federal estate tax purposes and the option price. In addition, as a result of exercising the option, the taxpayer’s basis in the home was the sum of the basis of the option and the actual option price paid.
Options can play an important role in transitioning a farming or ranching business to the next generation. Not only must thought be given to the financial ability of the optionee to exercise the option, the income tax issues triggered upon exercise of the option and, when applicable, the subsequent sale of the property acquired by exercising the option must also be considered.
Monday, June 15, 2020
In recent years, all states except California and Maryland (and New York, to some extent) have enacted Equine Activity Liability Acts designed to encourage the continued existence of equine-related activities, facilities and programs, and provide the equine industry limited protection against lawsuits. The laws vary from state-to-state, but generally require special language in written contracts and liability releases or waivers; require the posting of warning signs; an attempt to educate the public about inherent risks in horse-related activities; and provide immunities designed to limit liability. The basic idea of these laws is to provide a legal framework to incentivize horse-related activities by creating liability protection for horse owners and event operators.
An important question is whether the laws extend to farm animals and persons working on farms and ranches.
Liability rules involving horses, farm animals and associated events – it’s the topic of today’s post.
State Law Variations
Under the typical statute, an “equine activity sponsor,” “equine professional,” or other person can only be sued in tort for damages related to the knowing provision of faulty tack failure to determine the plaintiff’s ability to safely manage a horse, or failure to post warning signs concerning dangerous latent conditions. For example, in Germer v. Churchill Downs Management, No. 3D14-2695, 2016 Fla. App. LEXIS 13398 (Fla. Ct. Ap. Sept. 7, 2016), state law “immunized” (among other things) an equine activity sponsor from liability to a “participant” from the inherent risks of equine activities. The plaintiff, a former jockey visited a racecourse that the defendant managed. It was a spur-of-the-moment decision, but he was required to get a guest pass to enter the stables. He was injured by a horse in the stables and the court upheld the immunity provisions of the statute on the basis that the requirement to get a guest pass before entering the stables was sufficient protocol to amount to “organization” which made the plaintiff’s visit to the stables “an organized activity” under the statute.
While many state equine activity laws require the postage of warning signs and liability waivers, not every state does. For example, the statutes in CT, HI, ID, MT, NH, ND, UT, WA and WY require neither signage nor particular contract language.
Recovery for damages resulting from inherent risks associated with horses is barred, and some state statutes require the plaintiff to establish that the defendant’s conduct constituted “gross negligence,” “willful and wanton misconduct,” or “intentional wrongdoing.” For example, in Snider v. Fort Madison Rodeo Corp., No. 1-669/00-2065, 2002 Iowa App. LEXIS 327 (Iowa Ct. App. Feb. 20, 2002), the plaintiff sued a parade sponsor and a pony owner for injuries sustained in crossing the street during a parade. The court determined that the omission of a lead rope was not reckless conduct and that the plaintiff assumed the risk of crossing the street during the parade. Similarly, in Markowitz v. Bainbridge Equestrian Center, Inc., No. 2006-P-0016, 2007 Ohio App. LEXIS 1411 (Ohio Ct. App. Mar. 30, 2007), the court held that there was no evidence present that the plaintiff’s injuries sustained in the fall from a horse was a result of the defendant’s willful or wanton conduct or reckless indifference. In addition, the signed liability release form complied with statutory requirements. However, in Teles v. Big Rock Stables, L.P., 419 F. Supp. 2d 1003 (E.D. Tenn. 2006), the provision of a saddle with stirrups that could not be shortened enough to reach plaintiff’s feet which then caused the plaintiff to fall from a horse raised jury question as to whether faulty tack provided, whether the fall was the result of the inherent risk of horseback riding, and whether the defendant’s conduct was willful or grossly negligent and, thus, not covered by the signed liability release form.
What constitutes an “inherent risk” from horse riding is a fact issue in many states due to the lack of any precise definition of “inherent risk” in the particular state statute. For example, under the Texas Equine Activity Liability Act, the phrase “inherent risk of equine activity” refers to risks associated with the activity rather than simply those risks associated with innate animal behavior. See, e.g., Loftin v. Lee, No. 09-0313, 2011 Tex. LEXIS 326 (Tex. Sup. Ct. Apr. 29, 2011). The Ohio equine activities immunity statute has been held to bar recovery for an injury incurred while assisting an employer unload a horse from a trailer during a day off, because the person deliberately exposed themselves to an inherent risk associated with horses and viewed the activity as a spectator. Smith v. Landfair, No. 2011-1708, 2012 Ohio LEXIS 3095 (Ohio Sup. Ct. Dec. 6, 2012). Also, in Einhorn v. Johnson, et al., No. 50A03-1303-CT-93, 2013 Ind. App. LEXIS 495 (Ind. Ct. App. Oct. 10, 2013), the Indiana Equine Activity Act barred a negligence action after a volunteer at a county fair was injured by a horse. The plaintiff’s injuries were determined to result from the inherent risk of equine activities. Likewise, in Holcomb v. Long, No. A14A0815, 2014 Ga. App. LEXIS 726 (Ga. Ct. App. Nov. 10, 2014), the Georgia Equine Activities Act barred recovery for injuries sustained as a result of slipping saddle during horseback ride; slipping saddle inherent risk of horseback riding. See also, Fishman v. GRBR, Inc., No. DA 17-0214, 2017 Mont. LEXIS 602 (Mont. Sup. Ct. Oct. 5, 2017).
Application to Farm Animals
Iowa and Texas amended their existing laws in 2011 to include farm animals. The Iowa provision, known as the “Domesticated Animal Activities Act” (Iowa Code §§673.1-673.3) was amended due to a state Supreme Court decision. The Texas “Farm Animal Act” is an expanded revision to that state’s Equine Activity Act.
Iowa. The Iowa law was enacted in 1997 and amended in 2011 as a result of a 2009 Iowa Supreme Court decision, Baker v. Shields, 767 N.W.2d 404 (Iowa 2009). Under the facts of the case, a farmhand suffered a severe leg fracture in a fall from a horse during an attempt to move his employer’s cattle. What was assumed to be the employer’s horse was a two-year old that the farmhand had successful ridden a few days earlier. The farmhand sued his employer (a father and son duo) to recover for his damages, claiming that because his employer did not carry workers’ compensation insurance as the plaintiff claimed Iowa law required, he was entitled to a presumption that his injury was the direct result of the employer’s negligence and that the negligence was the proximate cause of his injury.
The employer moved for summary judgment based on the immunity granted in the Domesticated Animal Activities Act (Act). Based on the language of the statute and the history behind enactment in most of the states with equine liability laws, the employer’s claim of immunity under the Act looked to be a long-shot. However, the trial court granted the employer’s motion for summary judgment, finding that a horse is a “domesticated animal,” riding a horse is a “domesticated animal activity,” and the horse’s actions were an inherent risk of that activity. More importantly, the trial court noted that the statute provided that a “person” is not liable under the Act and reasoned that “person” should be broadly construed to include employer/employee settings involving the use of livestock – such as the employer’s horse in this case. The trial court also noted that the Act defined “participant” as “a person who engages in a domesticated animal activity, regardless of whether the person receives compensation” and reasoned that this indicated application to employment situations.
The Supreme Court affirmed based on its belief that the Iowa legislature intended the statute to apply broadly to all “persons” and that the statutory definitions of “domesticated animal activity sponsor” and “domesticated animal event” did not preclude ag employment situations involving domesticated livestock (although the “sponsors” and “activities” listed in the statute have nothing to do with common ag employment situations).
At trial, and again at the Supreme Court, the farm hand argued that the Act did not specifically exempt farming operations as a “domesticated animal activity sponsor” and, as such, only applied to activities involving participation of members of the general public (as “spectators” in or “participants” of activities involving domesticated animals) and not “traditional farming operations done by employees.” However, the Iowa Supreme Court agreeing with the trial court, determined that the Act applied, and that the employer was immunized from suit. The Court’s opinion was a stretch (to say the least) of the intent and meaning of the Act’s language. At the time, the Court’s decision was the first court opinion to hold that a state equine activity (or domestic animal activity) liability act applied to common agricultural employment situations with the effect of immunizing the employer from suit from damages arising from inherent risks associated with the subject animal. In 2011, the Iowa legislature amended the statute to include domestic animals.
Texas. In 1995, Texas enacted the Equine Activity Act (Equine Act). Ch. 87 of Tex. Civ. Prac. & Rem. Code. The Equine Act provided that “any person, including an equine activity sponsor or an equine professional, is not liable for property damage or damages arising from the personal injury or death of a participant…[that] results from the dangers or conditions that are an inherent risk of equine activity.” An equine activity sponsor is “a person or group who sponsors, organizes, or provides the facilities for an equine activity…without regard to whether the person operates for profit.” The statute provides many examples demonstrating the specific application of the Equine Act and its concern for equine activities unrelated to ranching activities such as breeding, feeding and working equine animals as a vocation. None of the examples hinted at any application to ranchers’ and ranch hands’ involvement with horses.
In 2011, the Texas legislature amended the Equine Act. The amendment renamed the law as the “Farm Animal Activity Act” and broadened coverage to include other farm animals in addition to equines. Veterinarians and livestock shows were also included under its coverage, and the words “handling, loading, or unloading” were added to the definition of “farm animal activity.” The Farm Animal Activity Act limits the liability of “any person, including a farm animal activity sponsor [or] farm animal professional,” but also includes examples of a person whose liability is limited that is demonstrated to be event organizers and facility providers with “professionals” defined as trainers and equipment renters. All of the livestock examples relate to shows, rides, exhibitions, competitions and similar events. The Farm Animal Act limits liability to or for a “participant.” A “participant is defined as “a person who engage in [a farm animal] activity without regard to whether the person is an amateur or professional or whether the person pays for the activity or participates in the activity for free.
In Waak v. Rodriguez, No. 19-0167, 2020 Tex. LEXIS 528 (Tex. Sup. Ct. Jun. 12, 2020), ranch owners (a married couple) bred Charolais cattle on their 760-acre ranch in southeast Texas. They hired an individual (Raul Zuniga) on a part-time basis to work the cattle, do landscaping and cut hay. Raul later started working full-time for them and lived on the ranch in a mobile home that he was purchasing from them. After training him how to work and cut cattle, Raul was given daily tasks and often worked cattle alone. In late 2013, the couple asked Raul to moved cattle to another location on the ranch, a task he had done often in the past. The couple then went left to run errands in town about 20 miles away. Upon their return to the ranch, the owners found Raul lying dead behind the barn. A medical examiner determined that Raul’s cause of death at (almost) age 34 was “blunt force and crush injuries” that were “severe enough to have come from extensive force like that of a large animal trampling the body.” His surviving parents and children sued the ranch owners for wrongful death. They did not participate in the Texas workers’ compensation system. The lawsuit claimed that a bull killed Raul and that the owners were negligent in failing to provide a safe workplace; failing to properly train Raul; and failing to warn of the dangers of working cattle and failing to properly supervise him. The owners claimed that the Farm Animal Activity Act barred the lawsuit, and the trial court agreed. The appellate court reversed, however.
On further review, the Texas Supreme Court affirmed the appellate court’s decision – the Farm Animal Activity Act did not apply, and the suit was not barred. The Court noted that the text and examples contained the legislation did not make any reference to ranchers or ranch hands or otherwise indicate that they were covered. The Court also indicated its belief that no reported decision anywhere in the country applied an equine statute to farming or ranching or limit an employee’s recovery for on-the-job injuries. The ranch owners’ attorneys failed to bring the Iowa case to the Court’s attention (the owners’ attorneys were civil litigators from a big-city firm and not rural ag lawyers). The Court also noted that while the legislature had broadened the statute in 2011 and renamed it, it still limited liability protection to event organizers and facilities providers as well as professional trainers and equipment renters. All of the livestock examples in the amended statute still were in the context of “shows.” Ranch hands, the Court noted, do not work as “amateurs” or “professionals” and do not pay to do their work and don’t typically work for free. Ranch hands are not “participants.”
State Equine Activity Liability laws are designed to provide liability protection for injuries arising from horse-related activities. The Iowa and Texas provisions have been modified to include farm animals. It would have been interesting had the ranch owners in the Texas case brought the Iowa case to the Texas Supreme Court’s attention. While doing so may not have resulted in a different outcome, the Court would have been forced to deal with it.
Thursday, June 11, 2020
County commissioners (also known in some states as supervisors or something similar) often find themselves dealing with unique situations. In rural counties, the commissioners are often familiar with the common ag issues that arise that are within the commission’s jurisdiction. In the more urban counties, some of the things that a county commissioner can have deal with can be rather surprising. So, what are a few of the more common items that a county commissioner must deal with in an agricultural context?
The ag-related matters that a county commissioner may have to deal with – it’s the topic of today’s post.
Fences and State Fence Law
Robert Frost once said that, “Fences make good neighbors.” G.K. Chesterton has been quoted as saying, “Whenever you remove any fence, always pause long enough to ask why it was put there in the first place.” For rural landowners, perhaps one of the most common and contentious issues involves disputes concerning partition fences. Partition fences are those that separate adjoining lands. Each state has numerous laws concerning partition fences. Those laws involve such issues as the construction of fences and what a fence is to be built of, what is deemed to be a “legal” fence, liability for damages caused by livestock that escape their enclosure, the maintenance of partition fences, the role of the county commissioners serving as fence viewers in settling fence disputes and rules for handling stray animals.
In some instances, adjoining landowners may come to an agreement as to how to allocate the responsibility between themselves for the building and/or maintenance of a partition fence. If an agreement is reached, it may be wise to put the agreement in writing and record it in the county Register of Deeds office in the county where the fence is located. However, if the adjoining landowners cannot reach an agreement concerning fence building and/or maintenance, the “fence viewers” should be called. In many states, the county commissioners (or their designees) in the county where the fence in question is located are the fence viewers. The statutory procedures vary from state to state, but the basic approach is that if adjoining landowners can’t settle their dispute personally, then the “fence viewers” can be called to determine how a fence should be built and/or maintained. That means that country commissioners must know and understand state fence law.
County commissioners often must deal with zoning issues. In the agricultural context, the issues can include matters involving how an applicable zoning ordinance applies to a particular tract of land based on how the land is used as well as the size of the tract. Many ordinances are drafted in general language designed to have broad application. That means that they sometimes are not clear in how they apply to a particular agricultural operation. Is simply cutting hay on a five-acre tract, “agricultural” or is it still residential or some other classification. Commissioners must be well-trained on zoning issues and what statutory language means and how the courts interpret it.
Generally, a county’s zoning authority arises under a specific state statute, which grants cities and counties the ability to enact “planning and zoning laws and regulations” “for the protection of the public health, safety and welfare.” But, as applied to agriculture, care should be taken to think through clearly just exactly what constitutes “agriculture.” For example, is a 600-head hog confinement building “agriculture” or is it a commercial/industrial building?
To establish a new zoning regulation, it’s often the case that a county must first require a planning commission to recommend the nature and number of zones or districts which it deems necessary and the boundaries of the same, as well as appropriate regulations. Additionally, it’s typically the case that regulations must be uniform for each class or kind of building and land uses throughout each district, but the regulations in one district may differ from those in other districts.
Commonly, once the planning commission has made its recommendation based on public input, the governing body either may: (1) Approve the recommendations by the adoption of the same by ordinance in a city or resolution in a county; (2) override the planning commission's recommendations by a super-majority vote of the membership of the governing body; or (3) return the matter to the planning commission for further consideration, together with a statement specifying the basis for the governing body's failure to approve or disapprove.” A similar process is followed if a county wishes to amend an existing zoning regulation.
Following this process, a county is limited in what type of zoning regulations may be adopted. Under the usual process that is common in many states, the county may adopt zoning regulations which may include, but are not limited to provisions which: (1) provide for planned unit developments; (2) permit the transfer of development rights; (3) preserve structures and districts listed on the local, state or national historic register; (4) control the aesthetics of redevelopment or new development; (5) provide for the issuance of special use or conditional use permits; and (6) establish overlay zones. Thus, so long as the zoning regulation is for the protection of the public health, safety and welfare, and falls within one of these six types, then it is within the scope of the county’s zoning authority.
The scope of a county’s zoning authority with regards to wind generation is a big issue in many rural counties. The Kansas Supreme Court, construing Kansas law, has addressed the issue. Zimmerman v. Board. of County. Commissioners, 289 Kan. 926, 939, 218 P.3d 400, 410 (2009). In Zimmerman, the Wabaunsee County commissioners passed a zoning regulation prohibiting commercial wind farms in the entire county. The Kansas Supreme Court found that under K.S.A. §§12-753(a) and 12-755, the county’s zoning regulation was not unreasonable since the county commissioners found that commercial wind farms would adversely affect aesthetics of the county, commercial wind farms were not in conformance with a comprehensive plan which sought to maintain open spaces and scenic landscape, a large portion of the community’s wishes were against the wind farms.
However, while the county zoning ordinance banned all large-scale commercial windfarms, it allowed for small windfarms, and also established zoning regulations concerning the construction of small windfarms, including density and spacing requirements, as well as setback distance requirements. The court ultimately upheld the zoning regulation, which established the counties ability to ban all commercial wind development, as well as establish setback distances for small scale wind farms.
Zimmerman also established that a county’s ability to pass zoning regulations affecting wind power generation was not preempted by state law, namely the Kansas Electric Public Utilities Act (KEPUA). There the court held that KEPUA only preempted local zoning in two situations, (1) placement or siting of nuclear power plants, and (2) placement or siting of electrical transmission lines. Hence, any county regulation regarding wind turbine setbacks would not be preempted by state law, unless it is specifically asserted by the KCC or “clearly stated” by legislation such as KEPUA.
To restate, the Kansas Supreme Court has held local governments have the power to pass zoning regulations, so long as that power is “exercised in conformity with the statute which authorizes the zoning.’ See Genesis Health Club, Inc. v. City of Wichita, 285 Kan. 1021, 1033, 181 P.3d 549 (2008). The same requirements apply to counties when they adopt or modify zoning regulations, particularly in a wind generation setting. At least in Kansas, so long as a county follows the state law procedures set out above, and so long as the zoning regulation is for the protection of the public health, safety and welfare, then it will be valid. Particularly in a wind generation setting, a Kansas county has the authority to establish setbacks for wind turbines, under Zimmerman, so long as the state statutory process is followed, and so long as that authority hasn’t been specifically preempted by a state law such as the Kansas Electric Public Utilities Act. The same is likely true in many other states.
Being a county commissioner can be a rewarding experience. But, it can be a difficult job and requires knowledge of many issues to properly represent the county. This is particularly true for those counties that have a mix of urban and agricultural interests.
Tuesday, June 9, 2020
Often a parent (or parents) will advance money to a child. The reasons for doing so are varied, such as making a large loan but then forgiving the payments each year consistent with the federal gift tax present interest annual exclusion (currently $15,000), but a significant question is whether such an advance of funds is a loan or a gift. The proper classification makes a difference from a tax standpoint.
Is an advance of funds to a child a loan or a gift – that’s the topic of today’s post.
The IRS presumption is that an advance is a gift when a transfer between family members is involved. The taxpayer can overcome the presumption by showing that repayment was expected and that the taxpayer actually intended to enforce the debt. In making that determination, the IRS utilizes a set of factors to evaluate whether an advance of funds amounts to a loan or a gift. Those factors include whether the borrower signed a promissory note; whether interest was charged; whether collateral secured the indebtedness; whether payment was actually made; whether demand for repayment occurred when a payment was missed; whether there was a fixed due date for the loan; whether the borrower had the ability to repay the debt; how the parties characterized the transaction, and; whether the transaction was reported for federal tax purposes as a loan. In essence, the question boils down to whether there is a bona fide debtor-creditor relationship.
In Miller v. Comr., T.C. Memo. 1996-3, the petitioners (a married couple) operated a ranch and employed their two sons to manage it. One of the boys also managed his parents’ commercial property business in Georgia and that one of the sons helped manage. The Mother transferred $100,000 to a son by giving him two $50,000 checks in the summer and fall of 1982. She wrote the word “loan” on the check register and the check stub for each check and the checks were recorded in an account labeled “Notes Receivable – S. Miller” in the Mother’s general ledger. She was trying to help him pay off a $56,000 mortgage on a house he and his wife bought in 1980 for $300,000 that became due in 1982. In November of 1982, he used $56,000 of the $100,000 that he received from his Mother to retire the mortgage. The son signed a non-interest-bearing noted in the principal amount of $100,000 that was payable to his Mother. The note was not secured by any collateral. The note specified that the son was to pay his Mother on demand or three years after it was executed if no demand was made. However, the Mother didn’t consider the three-year-later date to be a fixed date on which the son had to pay her, and she had no intention of demanding payment on that date, or any other date. She also never discussed with her son any consequences of his failing to make payment. In late 1982, the son made a $15,000 payment on the note, but didn’t make any more over the next three years. The Mother never sought to enforce repayment, instead writing a “forgiveness” letter to him each year. The IRS took the position (based on the multiple factors) that the loans were gifts. The Tax Court agreed, which meant that the Mother had gift tax liability.
In Estate of Bolles v. Comr., T.C. Memo. 2020-71, the decedent had five children and expressed a desire to treat them equally upon her death. She kept a personal record of advances to each child and any repayment that a child made. She treated the original advances as loans and forgave the “debt” account of each child annually in the amount of the federal gift tax present interest annual exclusion. The decedent and her spouse established a trust to hold some of their jointly owned property, including a substantial art collection and office building in San Francisco. At the time of her death she and her five children were among the beneficiaries of the trust. Her oldest child encountered financial difficulties and entered into an agreement with the trust to use trust property as security for $600,000 in bank loans. The son also owed the trust back-rent from his architecture practice. The son failed to meet the loan obligations and the trust was liable for the bank loan. The decedent transferred over $1 million to the son from 1985 through 2007. The son did not make any repayments after 1988. The decedent also had a revocable trust created in 1989. That trust specifically excluded the son from any distribution from her estate. It was later amended to include a formula to account for the “loans” made to the son during her lifetime.
Upon her death, another son filed a federal estate tax return and the IRS determined a deficiency of $1,152,356, arguing that the decedent’s advances to the oldest child were taxable gifts and not loans. The Tax Court determined that the amounts were gifts based on a non-exclusive, nine-factor analysis used in determining the status of advances: (1) whether there was a promissory note or other evidence of indebtedness; (2) whether interest was charged; (3) whether there was security or collateral; (4) whether there was a fixed maturity date; (5) whether a demand for repayment was made; (6) whether actual repayment was made; (7) whether the transferee had the ability to repay; (8) whether records maintained by the transferor and/or the transferee reflect the transaction as a loan; and (9) whether the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.
The court determined that the decedent did not have a reasonable expectation of repayment due to the son’s financial situation and employment history. However, a small portion of the advances made to the son while his financial situation was more favorable were loans because the decedent could expect repayment based on the son’s improved financial condition. The Tax Court noted that with respect to situations involving loans to family members, an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan.
Be careful when making loans or gifts to children. Take care to document the transaction(s) carefully and make sure to structure it with the factors listed above in mind to achieve the desired result. Also, be mindful of another weapon the IRS might utilize in certain transactions, including those involving family members – the “step-transaction” doctrine. This is another potential problem that can arise when the gift/loan distinction is not in issue. For example, in Estate of Cidulka v. Comr., T.C. Memo. 1996-149, the IRS successfully utilized the doctrine to trigger gift tax liability. The decedent had made annual gifts of stock during his life to his son, daughter-in-law and grandchildren. He treated the transfers as gifts for gift tax purposes and kept each one at or under the applicable gift tax present interest annual exclusion (currently $15,000) so that he wouldn’t have to pay gift tax on the transfers. Over a 14-year period, the daughter-in-law dutifully transferred her gift each year to her husband (the decedent’s son) on the exact same day her father-in-law transferred the stock to her. The IRS didn’t have trouble picking that one apart. It took the position that the annual gifts to her were really for her son, exceeded the annual exclusion amount and were subject to gift tax.
Transferring funds to children can be full of traps. Be advised.
Saturday, June 6, 2020
Spray-drift issues with respect to dicamba and the use of dicamba-related herbicides on dicamba tolerant (DT) soybeans and cotton increased substantially during the 2017 growing season across portions of the primary soybean (and cotton) growing parts of the country. The use of dicamba increased in an attempt to control weeds in fields planted with crops that are engineered to withstand it. Some states, notably Missouri and Arkansas, took action to ban dicamba products because of drift-related damage issues.
Now, the U.S. Circuit Court of Appeals for the Ninth Circuit has vacated the conditional new-use registrations of XtendiMax (by Bayer (formerly Monsanto), BASF’s Engenia and Corteva’s FeXapan for use on dicamba-tolerant (DT) soybean and cotton finding that the Environmental Protection Agency’s (EPA’s) late 2018 decision to extend the 2016 registrations violated the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA). The decision creates major problems for producers that purchased and planted DT seed because the associated weed control technology cannot be used.
What are the implications of the recent federal court’s opinion? Does it apply nationwide? What are the drift issues associated with dicamba? What options do affected farmers have going forward?
Uniqueness of Dicamba
In many instances, spray drift is a straightforward matter. The typical scenario involves either applying chemicals in conditions that are unfavorable (such as high wind), or a misapplication (such as not following recommended application instructions). But, dicamba is a unique product with its own unique application protocol.
- Dicamba is a very volatile chemical and is rarely sprayed in the summer months. This is because when the temperature reaches approximately 90 degrees Fahrenheit, dicamba will vaporize such that it can be carried by wind for several miles. This can occur even days after application.
- The typical causes of spray drift are application when winds are too strong, a temperature inversion (temperature not decreasing with atmospheric height) exists or there has been a misapplication of the chemical.
- For the new dicamba soybeans, chemical manufacturers reformulated the active ingredient to minimize the chance that it would move off-target due to it volatility.
- Studies have concluded that the new formulations are safe when applied properly, but if a user mixes-in unapproved chemicals, additives or fertilizer, the safe formulations revert to the base dicamba formulation with the attendant higher likelihood of off-target drift.
- Soybeans have an inherit low tolerance to dicamba. As low as 1/20,000 of an application rate can cause a reaction. A 1/1000 of rate can cause yield loss.
- The majority of crops damaged from vapor drift may not actually result in yield loss. That’s particularly the case if drift damage occurs before flowering. However, if the drift damage occurs post-flowering the likelihood of yield loss increases. Also, studies have shown that a slight rain event can stop the volatilizing of dicamba.
- The label is the law. This is particularly true with the new chemicals used on Xtend crops. The labels are very specific with respect to additives, nozzles, boom height, and wind speed and direction.
DT Seeds and Associated Herbicides
In 2015, the Obama Administration’s USDA deregulated DT soybean and cotton seeds via the Plant Patent Act (PPA). At that point, Monsanto began to sell the DT seeds in advance of the 2016 growing season. This was done before EPA had approved the companion dicamba herbicides for over-the-top (OTT) use. In 2016, approximately 1.7 million acres of DT soybeans and 50,000 acres of DT cotton were planted. The prior versions of dicamba herbicides could not legally be used on the emergent DT crops, but some farmers applied those older, more volatile versions to the DT crops. In the fall of 2016, the EPA announced that it would grant two-year conditional registrations for three lower-volatility, OTT dicamba herbicides (Monsanto’s XtendiMax; Dupont’s FeXapan; and BASF’s Engenia) in 34 states. The EPA has the authority to grant conditional registrations of pesticides and herbicides under FIFRA, and the EPA cited the benefits of the grant as providing an effective tool to treat noxious weeds and glyphosate-resistant weeds. The EPA noted that the lower-volatility formulations posed little-to-no risk of adverse environmental effects if used according to the label.
Throughout the 2017 growing season, complaints of alleged dicamba-caused damage to commercial crops and other plants increased. Bayer/Monsanto proposed label changes to XtendiMax for use during the 2018 growing season to address off-site drift. The EPA approved additional label restrictions for OTT dicamba products for the 2018 growing season. In late 2018, the EPA granted conditional extensions to the 2016 registrations for two more years. The EPA determined that doing so would provide growers with an additional tool to help manage weeds that are difficult to control for which few alternatives are available, and would provide a long-term benefit by delaying resistance to other herbicides when used appropriately. The EPA also noted that, based on field trials and land-grant university research, non-DT crops could be damaged by off-site drift that could result in yield reductions if the drift occurred during the reproductive growth states of the non-DT crops and, as a result, imposed more restrictions on OTT applications of the dicamba herbicides to DT soybeans and cotton.
Challenge to the Registrations
In National Family Farm Coalition v. United States Environmental Protection Agency, No. 19-70115, 2020 U.S. App. LEXIS 17495 (9th Cir. Jun. 3, 2020), a coalition of activist groups sought review of the EPA’s 2016 registration decision for XtendiMax, and then amended the petition to include the 2017 label amendments. Oral argument in the case was held in August of 2018. However, the EPA granted the additional two-year conditional registrations before the court decided the case. As a result, the court dismissed the petition. The plaintiffs again sued in early 2019, challenging the EPA’s late 2018 decision to extend the registrations for the OTT dicamba herbicides for two more years. The court did not hear oral arguments in the case until15 months later.
Under FIFRA, the EPA must determine that any amendment to a pesticide/herbicide registration “would not significantly increase the risk of any unreasonable adverse effect on the environment.” Such effects include “any unreasonable risk to man or the environment, taking into account the economic, social and environmental costs and benefits of the use of any pesticide…”. 7 U.S.C. §136(bb). The court determined that the EPA “substantially understated the risks that it acknowledged” and “entirely failed to acknowledge other risks.” The court believed that the EPA understated the DT seed acreage plantings in 2018, failed to account for substantial non-compliance with label restrictions, and didn’t account for social cost of DT soybeans and DT cotton achieving a monopoly or near monopoly due to farmers planting DT seeds simply to avoid drift problems. But, the court failed to mention that some farmers refused to plant DT seeds for the express purpose of possibly being drifted upon and suing for damages. The court also made no mention of the fact that numerous drift complaints in 2017 did not result in any yield loss and in some cases resulted in a yield bump.
The court also determined that the EPA didn’t account for the social cost of “divisiveness” that dicamba-related issues was creating in rural communities.
As a result, the court vacated the registrations even though it noted the harshness that its decision would have on growers that had already purchased DT soybean and cotton seeds and the associated dicamba products.
Comments on the Court’s Decision
The court’s decision to vacate the registrations has implications for farmers in the 34 states where the conditional registrations allowed OTT dicamba. At least that’s the general belief expressed in farm (and other) media. It is true, that any case brought via the Administrative Procedure Act (APA) gives rise to the possibility that the court could vacate the administrative decision or rule with respect to all persons and in all areas of the country, rather than simply with respect to either the parties to the lawsuit or the areas within the court’s jurisdiction. However, the U.S. Supreme Court recently held that the text of the APA does not permit that broad of a remedy. Trump v. Hawaii, 138 S. Ct. 2392 (2018). 5 U.S.C. §706 states in relevant part as follows:
“To the extent necessary to decision and when presented, the reviewing court shall decide all relevant questions of law, interpret constitutional and statutory provisions, and determine the meaning or applicability of the terms of an agency action. The reviewing court shall— “(2) hold unlawful and set aside agency action, findings, and conclusions found to be— (A) arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law;…”
As applied in the dicamba case, the provision doesn’t specify whether the registrations should be set aside on their face or as applied to the plaintiff. There is also no clear statement in the APA that the traditional rules of fundamental fairness (equity) are displaced. Given this, and the guidance from the Supreme Court’s recent APA decision, the appropriate remedy for the Ninth Circuit to utilize is equitable in nature – determining the rights of the parties to the case rather than a vacatur that impacts farmers in all 34 states involved.
It is also worth noting that the Ninth Circuit delayed hearing oral arguments for 15 months with full knowledge that waiting until planting season was beginning to hear the case and render its decision would cause maximum damage to impacted farmers, again points to an equitable remedy instead of a wholesale vacatur.
In his First Inaugural Address, President Abraham Lincoln stated, “At the same time, the candid citizen must confess that if the policy of the Government upon vital questions affecting the whole people is to be irrevocably fixed by decisions of the Supreme Court, the instant they are made in ordinary litigation between parties in personal actions the people will have ceased to be their own rulers, having to that extent practically resigned their Government into the hands of that eminent tribunal.” President Lincoln was speaking of the Supreme Court and pointing out that Supreme Court opinions are not the supreme law, the Constitution is. Likewise, for a lower court to render a decision vacating DT seed registrations impacting farmers in areas of the country outside of the court’s jurisdiction is contrary to Supreme Court precedent and principles of equity.
So what’s next? It depends on what the EPA chooses to do. EPA could seek a full en banc review by all of the Ninth Circuit judges rather than the three-judge panel that heard the case. The EPA could also request the court stay its opinion until the soybean and cotton growing seasons are over. The EPA could also simply choose to ignore the court’s opinion outside the Ninth Circuit. In that event, only farmers in Arizona would be impacted by the court’s decision. This approach, for example, is a tactic that the IRS often employs in tax cases that it loses. It issues a “non-acquiescence” to the court’s opinion, explains why the court was wrong, and continues audit activity in areas outside the court’s jurisdiction. If the EPA were to do that, the major soybean and cotton growing regions would not be impacted in 2020.
Presently, disaffected farmers and ag retailers are considering what changes to plans need to be made. Some are also inquiring about refunds for technology fees associated with the seed purchases. But, for many farmers, perhaps the largest hurdle going forward will be the lack of alternative products to compensate for the increase of acres. The supply chain was not counting on the millions of acres currently attributed to DT traits being impacted in such a manner.
The Ninth Circuit’s opinion potentially creates havoc for many soybean and cotton farmers. The next few days should be instructive in learning how far reaching the court’s decision will be for the present growing season. It may just be time for the EPA to tell the Ninth Circuit to go “pound sand” in terms of the court trying to impose its decision outside of the states within the Ninth Circuit.
Thursday, June 4, 2020
On July 20-21, Washburn Law School will be conducting a national conference on farm income tax and farm estate and business planning in Deadwood South Dakota. Also occurring nearly simultaneously will be the law school’s first “CLE Excursion.” In today’s post I provide a preview of the conference and the excursion.
Farm Income Tax/Estate and Business Planning Conference
If you represent ag clients in handling tax issues and or work with them on estate and business plans, this conference is a focused event on issues tailored to the farm clientele that will be useful to your business. Numerous tax rules as well as the rules surrounding estate and business planning for the ag client are unique. The unique rules and the planning challenges and opportunities they present will be discussed.
The conference will be held at the Lodge at Deadwood, a premier conference facility in just outside Deadwood, South Dakota in the beautiful Black Hills with proximity to Mount Rushmore, Devils Tower, Spearfish Canyon and other beautiful locations.
Day 1 (July 20) – Farm Income Tax
On Monday, July 20, the discussion will focus on various farm income tax topics. Speakers for the day include myself, Paul Neiffer, and U.S. Tax Court Judge Elizabeth Crewson Paris The topics for the day include:
- Caselaw and IRS update (including tax provisions in the CARES Act)
- CARES Act Update (PPP and EIDL)
- GAAP Accounting Update
- Restructuring Credit Lines
- Deducting Bad Debts
- Forgiving Installment Sale Obligations
- Passive Losses
- R.C. §199A Advanced Planning
- Practicing Before the U.S. Tax Court
- NOLs and EBLs
- FSA Advanced Planning
- CFAP Update (including payment limitation planning)
- Like-Kind Exchanges and I.R.C. §1245 property
Day 2 (July 21) – Farm Estate and Business Planning
On Tuesday, July 21, the focus will shift to farm estate and business planning. Speakers for the day along with myself will be Prof. Jeff Jackson, Brandon Ruopp, Marc Vianello and Prof. Shawn Leisinger
- Caselaw and IRS update
- Incorporating a Gun Trust Into an Estate Plan
- Retirement Planning
- Common Estate Planning Mistakes of Farmers and Ranchers
- Post-Death Management of the Family Farm and Ranch Business
- Estate and Gift Tax Discounts for Lack of Marketability
- Valuation of Farm Chattels and Marketing Rights
- Ethical Issues Related to Risk
You can learn more about the conference and find registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
Corresponding with the farm income tax and estate/business planning conference will be Washburn Law School’s “CLE Excursion. While this event is primarily for Washburn Law Alumni, others are welcome to register. An informal gathering will be on Friday evening, July 17. On Saturday, July 18, with two hours of CLE that day. A day of sightseeing is planned for Sunday, July 19 with a CLE conference also at the Lodge at Deadwood. CLE topics for July 20 will be:
- Gun Trusts
- Law and Technology
On July 20 an excursion will also take place to Mount Rushmore and Crazy Horse mountain. You can learn more about this event and register here: http://washburnlaw.edu/employers/cle/deadwoodcle.html
If you are unable to attend due to the virus or concerns over the virus, the two-day conference will be live-streamed. We use a superior streaming technology that allows you to participate in the conference from the comfort and safety of your own office.
A room block has been established for the tax/planning conference. When you call the Lodge at Deadwood, just mention that you will be attending Washburn Law School’s summer conference. A special rate has been negotiated for the room block.
This conference will take place shortly after the end of the filing season (assuming it isn’t postponed again) at a time when many will also be ready for a nice place to vacation at and also take in a continuing education conference. It is also possible to register for both events and pick and choose the topics you would like to attend. In addition, as noted the farm income tax/farm estate and business planning conference can also be attended online as it will be broadcast live online.
I hope to see you in Deadwood this summer. If you can’t be there, I hope you can attend online.
Tuesday, June 2, 2020
Economic conditions in agriculture have been difficult for several years. Added to the down economic cycle that much of agriculture has experienced are the severe hits the economy has taken by actions of state governors reacting to the virus. Prices for various agricultural commodities are off significantly and Chapter 12 farm bankruptcy filings are up. One of the measures that the Congress has created to try to provide relief to businesses is the Paycheck Protection Program (PPP). I have written about the details of that program in other posts, but another aspect of the program that impacts farmers has now come into focus – the issue of whether a farmer in Chapter 12 bankruptcy is eligible for a PPP loan.
Chapter 12 filers and PPP loan eligibility – it’s the topic of today’s post.
Under 1986 amendments to the Bankruptcy Act of 1978, Congress created Chapter 12 bankruptcy for “family farmers.” Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, Pub. L. No. 99-554, 100 Stat. 3105 (1986), adding 11 U.S.C. § 1201 et seq. The Act was scheduled to expire on October 1, 1993 but was extended numerous times before being made a permanent part of the Bankruptcy Code by the Bankruptcy Act of 2005, effective July 1, 2005. Chapter 12 was designed as a response to the difficulties that farmers (and fishermen) suffered in the 1980s. Chapter 12 is conceptually and statutorily similar to other reorganization-type bankruptcies, but provides more flexibility in making periodic payments to take into account the seasonal nature of many farming or fishing operations. Under Chapter 12, the debtor proposes a repayment plan that lasts three to five years. Chapter 12 is also less expensive and, in many respects, less complex than other forms of reorganization bankruptcy.
PPP and Applicants in Bankruptcy
On March 27, 2020, the President signed into law the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, Pub. L. No. 116-136, 134 Stat. 281 (2020). The CARES Act amended the Small Business Administration’s (SBAs) existing “7a Loan Program” to create the PPP. The PPP provides loans for eligible small businesses to cover allowed uses including payroll costs, interest on mortgage obligations and rent. The SBA’s First Interim Rule did not address eligibility of bankrupt debtors for the PPP, but it did require an applicant to fill out a form that required the applicant to certify that the applicant was not “presently involved in bankruptcy.” However, in the SBA’s Fourth Interim Final Rule, posted to its website on April 24, 2020, the SBA said in a Q and A that a business would not be approved for a PPP loan if the business was in bankruptcy. The rationale given was that making a PPP loan to an applicant in bankruptcy would be too risky – either via unauthorized use of funds or non-repayment of unforgiven loans.
Implications for Applicants in Bankruptcy
A bankruptcy court in Wisconsin recently dealt with the issue of PPP loan eligibility for a farmer in Chapter 12 bankruptcy. In Schuessler v. United States SBA, No. 20-02065-bhl, 2020 Bankr. LEXIS 1347 (E.D. Wisc. May 22, 2020), the debtors, a married couple operating a farm dairy operation, filed Chapter 12 bankruptcy in late 2018. On the same day, their wholly-owned, limited liability company (LLC) entity that runs the daily farming and dairy operation filed a separate Chapter 12 petition. The debtors direct the farming operation and own the real estate and improvements. The cases were jointly administered, and the debtors’ second amended plan was confirmed on May 8, 2019. The debtors’ income comes primarily from milk sales and from the sale of culled cows. Due to the present economic crisis exacerbated by state governors, the debtors’ milk sale revenue declined by more than 30 percent. Since January of 2019, the wholesale price of milk declined from nearly $19.00 to $12.50 per cwt. In addition, due to slaughterhouse closures, the debtors received much lower than historical prices for their culled cow sales. The debtors listed a significant mortgage and utility expenses on the bankruptcy schedules and noted that they employ 14 people with an average monthly payroll of $59,835.
The debtors applied for a Paycheck Protection Program (PPP) loan from the Small Business Administration (SBA) and were rejected because of their pending bankruptcy case. They otherwise met the requirements of the PPP. Without the loan, there was no doubt that the debtors would be forced to lay off essential employees and would be potentially driven out of business. The debtors then filed for Declaratory Judgment, Writ of Mandamus and Injunctive Relief against the SBA. The bankruptcy court rejected the debtors’ claims and dismissed the complaint.
The bankruptcy court noted that the SBA’s Fourth Interim Final Rule, Section III (4) specified that a debtor in bankruptcy is not eligible for a PPP loan. The issue was whether the SBA’s position violated the anti-discrimination provisions contained in 11 U.S.C. §525(a). Those provisions bar the government from revoking, suspending, or refusing to renew “a license, permit, charter, franchise, or other similar grant” based on a person either being in or having been a debtor in bankruptcy. The bankruptcy court noted that the U.S. Court of Appeals for the Seventh Circuit (to which any appeal would be made) had not yet ruled on the issue of the scope of 11 U.S.C. §525(a), but that four other Circuit Courts of Appeal had. Three of those courts took a narrow view of 11 U.S.C. §525(a) and only the U.S. Court of Appeals for the Second Circuit determined that debtors in bankruptcy couldn’t be denied any “property interests” that were essential to the debtor’s “fresh start” in bankruptcy. Stolz v. Brattleboro Housing Authority, 315 F.3d 80 (2d Cir. 2002).
The bankruptcy court also agreed with the SBA’s reliance on other courts that had recently held that the denial of PPP eligibility to bankrupt debtors did not violate 11 U.S.C. §525(a) because the PPP funds are distributed via “loans” and are, as a result, outside the scope of the antidiscrimination provisions of 11 U.S.C. §525(a). See Cosi, Inc. v. SBA, Adv. No. 20-50591 (Bankr. D. Del. Apr. 30, 2020); Trudy’s Texas Star, Inc. v. Carranza, Adv. No. 20-1026 (Bankr. W.D. Tex. May 7, 2020). In addition, the bankruptcy court noted that in In re Elter, 95 B.R. 618 (Bankr. E.D. Wis. 1989) the refusal to extend a government-guaranteed student loan based on the debtor’s bankruptcy history did not violate 11 U.S.C. §525(a). It was the plain terms of the CARES Act creating the PPP as a subsidized loan guarantee program, the bankruptcy court reasoned, that kept it beyond the anti-discrimination provisions of 11 U.S.C. §525(a) that applied to a “license, charter, franchise, or other similar grant.” While the underlying statute (15 U.S.C. §636(a)(36)(F)(i)) is silent on whether bankrupt debtors are ineligible for PPP loans, the bankruptcy court noted that there was nothing in the statute that suggested the Congress intended to limit the SBA’s rulemaking or that the Congress provided an exhaustive list of eligibility requirements that the SBA couldn’t supplement via rulemaking. Thus, the Fourth Interim Final rule was not beyond the SBA’s delegated authority. In addition, the court held that the Fourth Interim Final Rule did not violate the APA for being arbitrary and capricious. The bankruptcy court noted that had the Congress intended to bar the SBA from denying loan eligibility to applicants in bankruptcy, it could have done so.
The Wisconsin bankruptcy court’s conclusion barring Chapter 12 debtors from PPP eligibility is harsh. It clearly runs counter to the policy objective of Chapter 12 bankruptcy – to keep farming operations in business and servicing their debt after having their debt restructured. Chapter 12 was enacted based heavily on the recognition that farming is subject to numerous factors that can be beyond the control of the particular farmer. That’s certainly the case with the economic collapse brought on by the (largely unconstitutional) actions of various state governors. The bankruptcy court’s decision also runs counter to two other bankruptcy court decisions on the PPP eligibility issue – a bankruptcy court in Texas and one in Vermont. See Hidalgo County Emergency Service Foundation v. Carranza, Adv. No. 20-2006, 2020 Bankr. LEXIS 1174 (Bankr. S.D. Tex. Apr. 25, 2020); and In re Springfield Hospital, Inc., No. 19-10283, 2020 Bankr. LEXIS 1205 (Bankr. D. Vt. May 4, 2020). Indeed, the Texas bankruptcy court also noted the lack of collateral requirements to obtain a PPP loan and that the funds need not be repaid if they were used in a qualified manner, illustrating the minimal-to-non-existent risk to a lender of a borrower’s default.
Congress has been apprised of the SBA’s position and the inconsistent rulings by courts. Unless the Congress takes action (or the SBA changes its mind), more farming operations will fail than otherwise would.
Friday, May 29, 2020
Numerous cases have been filed in recent years alleging damage to soybean crops as a result of dicamba drift. However, one significant case has involved alleged dicamba drift damage to a peach crop. In 2019, the federal trial court judge hearing the case allowed much of the case to go to the jury. In early 2020, the jury returned a $265 million judgment against Monsanto/Bayer and BASF. $15 million of that amount was to compensate the peach farmer. $250 million was punitive damages. Is that allocation of damages proper and reasonable? A defective Ferrari may have something to say about the allocation.
Dicamba drift, a defective Ferrari and allocation of damages – it’s the topic of today’s post.
The Bader Case
Monsanto introduced dicamba-tolerant seeds for cotton in 2015 and for soybeans in 2016. The seeds were popular with many farmers to control weeds that had become tolerant to other herbicides, including Roundup. However, at the time the seeds were released, the EPA had not yet approved the newer formulations of dicamba (BASF’s Engenia and Monsanto’s XtendiMax with Vaporgrip and Roundup Xtend with VaporGrip) to be sprayed on crops. Those newer formulations were less volatile and less likely to vaporize and drift to nearby crops for which they were not intended. Starting in 2016, numerous crop damage complaints arose in certain parts of the country, particularly in southeast Missouri. Bader Farms, Inc., the largest peach farm in Missouri, claimed that its entire peach crop was destroyed by dicamba drift from nearby cotton fields that were planted with Monsanto’s Roundup Ready Xtend cotton seeds. Those seeds had been genetically modified to withstand dicamba and glyphosate.
Specifically, the peach farm claimed that its orchard was destroyed after the defendants (Monsanto/Bayer and BASF) conspired to develop and market dicamba-tolerant seeds and dicamba-based herbicides. Bader Farms, Inc. claimed that the damage to the peaches occurred when dicamba drifted from application to neighboring fields. It claimed that the defendants released its dicamba-tolerant seed with no corresponding dicamba herbicide that could be safely applied. As a result, farmers illegally sprayed an old formulation of dicamba herbicide that was unapproved for in-crop, over-the-top, use and was "volatile" or prone to drift.
While many cases had previously been filed on the dicamba drift issue, Bader Farms, Inc. did not join the other litigation because those cases focused on damages to soybean crops. Monsanto moved to dismiss the claims for failure to warn; negligent training; violation of the Missouri Crop Protection Act; civil conspiracy; and joint liability for punitive damages. BASF moved to dismiss those same counts except the claims for failure to warn. The trial court granted the motion to dismiss in part. Monsanto argued that the failure to warn claims were preempted by the Federal Insecticide, Fungicide, and Rodenticide Act ("FIFRA"), but the plaintiff claimed that no warning would have prevented the damage to the peaches.
The trial court determined that the peach farm had adequately plead the claim and denied the motion to dismiss this claim. Both Monsanto and BASF moved to dismiss the negligent training claim, but the trial court refused to do so. However, the trial court did dismiss the claims based on the Missouri Crop Protection Act, noting that civil actions under this act are limited to “field crops” which did not include peaches. The trial court did not dismiss the civil conspiracy claim based on concerted action by agreement, but did dismiss the aiding and abetting portion of the claim because that cause of action is not recognized under Missouri tort law. The parties agreed to a separate jury determination of punitive damages for each defendant.
The Jury Verdict
In mid-February of 2020, after a three-week trial, the jury returned a $265 million verdict against Monsanto/Bayer and BASF, with $250 million of that being punitive damages. Trial evidence revealed that the defendants anticipated drift before the new, less volatile, formulation was released. The jury concluded that the companies negligently released the dicamba-tolerant seeds without the necessary herbicide to prevent off-target drift, and that they were negligent when they released the less volatile herbicide. The jury also determined that the companies conspired to “create an ecological disaster to increase profits.”
The companies are appealing. They deny that Bader Farms, Inc. suffered any damage from dicamba drift. The experts for the companies testified that armillaria root rot fungus was the cause of the damage to the peach crop. They claimed that armillaria had gotten into the soil and had been slowly infecting and killing the peach trees. While the expert for Bader Farms testified that the damage was caused by dicamba drift, he also admitted that he was not a peach expert and agreed that armillaria was present in the orchard and was damaging the trees. The companies also pointed out the peach farm did not sustain any monetary damage and that peach profits actually increased during the timeframe at issue.
After the jury returned its verdict, both parties have filed numerous briefs with the court. Last week, Bader Farms, Inc. motioned to bar Monsanto’s request for “post-trial judicial notice” of screen shots from the farm’s website that Monsanto believes would establish that dicamba drift was not the cause of the loss of the peach crop.
As noted, the jury returned a total verdict of $265 million. $250 million of that is punitive damages designed to punish the companies involved. In other words, the punitive damages were roughly 16 times that of the compensatory damages awarded to Bader Farms, Inc. Is that reasonable? Where do the courts draw the line between compensatory and punitive damages? A recent case sheds some light on the issue. In Adeli v. Silverstar Auto, Inc., No. 19-1481/19-1602, 2020 U.S. App. LEXIS 16206 (8th Cir. May 21, 2020), the plaintiff claimed that the defendant intentionally misrepresented the condition of a used Ferrari that it sold to him. The jury agreed and awarded the plaintiff $20,201 in compensatory and incidental damages (approximately $7,000 of the amount was for compensatory damages) and $5.8 million in punitive damages on his claims for fraud, breach of express warranty, and deceptive trade practices under Arkansas Law. The defendant then moved to alter or amend the judgment, claiming that the jury’s $5.8 million punitive damage award was unconstitutionally excessive under the Due Process Clause of the Fourteenth Amendment. The trial court agreed and reduced the punitive damage award to $500,000. The defendant appealed claiming, among other things, that the punitive damage award should have been further reduced. The farm claimed that the $5.8 million amount was correct and shouldn’t have been reduced.
The appellate court noted that while juries have considerable flexibility in determining the amount of punitive damages, the Due Process Clause bars the imposition of “grossly excessive or arbitrary punishments on a tortfeasor.” In other words, the award is excessive if it “shocks the conscience” of the court or “demonstrates passion or prejudice on the part of the trier of fact.” While that standard doesn’t establish a bright line, there are factors that guide courts in determining a proper award of punitive damages. Those factors are: (1) the degree of reprehensibility of the defendant’s conduct; (2) the disparity between actual or potential harm suffered and the punitive damage award; and (3) the difference between the punitive damage award and the civil penalties authorized in comparable cases.
The appellate court believed that the defendant’s conduct was reprehensible. The defendant knew that the car’s headers were cracked and needed replaced, having been advised as such by a Ferrari technician. The defendant advertised the car for sale, however, as having completed a pre-purchase inspection by a Ferrari dealership. The plaintiff asked for a copy of the pre-purchase inspection, but was sent instead an invoice from the Ferrari dealer that reflected the defendant’s choice not to repair the tire pressure monitoring system. It didn’t disclose the defendant’s choice not to fix the cracked headers. The defendant represented the car as “turnkey” and “ready to go.” The plaintiff bought the car for $90,000, signing an “as is” purchase contract. On his way home from picking up the car, the plaintiff detected a fuel smell. The next day the plaintiff had the car towed to a garage that specialized in Ferraris which discovered a fuel leak and the cracked headers, making it unsafe to drive. The garage identified over $30,000 worth of repairs. The defendant refused to take the car back.
As for the disparity between the harm and punitive damages, the appellate court factored the incidental damages into the total harm that the plaintiff suffered and upheld the trial court’s finding of a 1:24.75 ratio ($20,021/$500,000). A single-digit ratio was not required, given the fraud that the defendant engaged in. On the comparable civil penalty factor, the appellate court cited other comparable caselaw finding a ratio between actual and punitive damages close to the 1:24.75 ratio set by the trial court. Ultimately, the appellate court affirmed the trial court’s award of $500,000 of punitive damages.
Application to Bader Farms
From the time the jury in Bader Farms returned its verdict, the parties have been battling over the proper amount of punitive damages. The companies claim that the punitive damage award is unconstitutionally too high. But, the ratio in Bader Farms is approximately 1:16.7. That’s a lower ratio than the court approved in Adeli. Bader Farms, Inc., in a recent filing in its case, claims that the Ferrari case supports an even higher punitive damage award. Whether the court agrees will be based on the multi-factor Due Process analysis noted above.
The dicamba trait may be presently at its highest use rate. Technology has not improved the potential drift issue, but education and wider usage of the dicamba trait likely has. However, the present tough financial condition of many farmers could make it more likely that unapproved types of dicamba will be used this crop growing season. In future years, the use of the dicamba trait may drop with newer technologies taking a larger part of market share. In particular, the Enlist trait appears to be safer more sprayer-friendly compared to dicamba and comes with rules that are easier to follow and less potential for drift.
As for the case involving the peach farm, it will be interesting to see how the ultimate damage award shakes out.
Wednesday, May 27, 2020
During the last couple of months while various state governors have issued edicts randomly declaring some businesses essential and other non-essential, the ag industry has continued unabated. The same is true for the courts – the ag-related cases and tax developments keep on coming in addition to all of the virus-related developments.
As I periodically do, I provide updates of ag law and tax issues of importance to agricultural producers and others in the ag industry, as well as rural landowners in general.
That the topic of today’s post – a few recent developments in ag law and taxation.
FSA Not Entitled To Set-Off Subsidy Payments
In Re Roberts, No. 18-11927-t12, 2020 Bankr. LEXIS 1338 (Bankr. D. N.M. May 19, 2020)
Bankruptcy issues are big in agriculture at the present time. Several recent blog articles have touched on some of those issues, including bankruptcy tax issues. This case dealt with the ability of a creditor to offset a debt owed to it by the debtor with payments it owed to the debtor. The debtors (husband and wife) borrowed $300,000 from the Farm Service Agency (FSA) in late 2010. The debtors enrolled in the Price Loss Coverage program and the Market Facilitation Program administered by the FSA. The debtors filed Chapter 11 bankruptcy in mid-2018 and converted it to a Chapter 12 bankruptcy in late 2019. The debtors defaulted on the FSA loan after converting their case to Chapter 12.
The debtors were entitled to receive approximately $40,000 of total MFP and PLC payments post-petition. The FSA sought a set-off of the pre-petition debt with the post-petition subsidy payments. The court refused to the set-off under 11 U.S.C. §553 noting that the offsetting obligations did not both arise prepetition and were not mutual as required by 11 U.S.C. §553(a). There was no question, the court opined, that the FSA’s obligation to pay subsidy payments arose post-petition and that the debtors’ obligation to FSA arose pre-petition. Thus, set-off was not permissible.
HSA Inflation-Adjusted Amounts for 2021
Rev. Proc. 2020-32, 2020-24 I.R.B.
Persons that are covered under a high deductible health plan (HDHP) that are not covered under any other plan that is not an HDHP, are eligible to make contributions to a health savings account (HSA) subject to certain limits. For calendar year 2021, an HDHP is a health plan with an annual deductible of at least $1,400 for individual coverage or $2,800 for family coverage, and maximum out-of-pocket expenses of $7,000 for individual coverage or $14,000 for family coverage. For 2021, the maximum annual contribution to an HSA is $3,600 for self-only coverage and $7,200 for family coverage.
Charitable Deduction Allowed for Donated Conservation Easement
Champions Retreat Golf Founders, LLC v. Comr., No. 18-14817, 2020 U.S. App. LEXIS 15237 (11th Cir. May 13, 2020), rev’g., T.C. Memo. 2018-146
The vast majority of the permanent conservation easement cases are losers for the taxpayer. This one was such a taxpayer loser at the Tax Court level, but not at the appellate level. Under the facts of the case, the petitioner claimed a $10.4 million charitable deduction related to the donation of a permanent conservation easement on a golf course. The IRS denied the deduction on the basis that the easement was not exclusively for conservation purposes because it didn’t protect a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem as required by I.R.C. §170(h)(4)(A)(ii). The IRS also asserted that the donation did not preserve open space for the scenic enjoyment of the general public or in accordance with a governmental conservation policy for the public’s benefit under I.R.C. §170(h)(4)(A)(iii). The Tax Court agreed with the IRS and denied the deduction. The Tax Court determined that the “natural habitat” requirement was not met – there was only one rare, endangered or threatened species with a habitat of only 7.5 percent of the easement area. In addition, the Tax Court noted that part of the golf course was designed to drain into this habitat area which would introduce chemicals into it. Thus, the easement’s preservation of open space was not for public enjoyment nor in accordance with a governmental policy of conservation.
On further review, the appellate court reversed. The appellate court found that the deduction was proper if the donation was made for the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem or was made for the preservation of open space for the scenic enjoyment of the general public. The appellate court noted that without the golf course, the easement would satisfy the requirements and an easement deduction is not denied simply because a golf course is included. The appellate court remanded the case for a determination of the proper amount of the deduction.
Residence Built on Farm Was “Farm Residence” For Zoning Purposes
Hochstein v. Cedar County. Board. of Adjustment, 305 Neb. 321, 940 N.W.2d 251 (2020)
Many cases involve the issue of what is “agricultural” for purposes of state or county zoning and related property tax issues. In this case, Nebraska law provided for the creation of an “ag intensive district.” In such designated areas, any “non-farm” residence cannot be constructed closer than one mile from a livestock facility. The plaintiff operated a 4,500-head livestock feedlot (livestock feeding operation (LFO)) and an adjoining landowner operates a farm on their adjacent property. The adjoining landowner applied to the defendant for a zoning permit to construct a new house on their property that was slightly over one-half mile from the plaintiff’s LFO. The defendant (the county board of adjustment) approved the permit and the plaintiff challenged the issuance of the permit on the basis that the adjoining landowner was constructing a “non-farm” residence. The defendant affirmed the permit’s issuance on the basis that the residence was to be constructed on a farm. The plaintiff appealed and the trial court affirmed. On further review, the appellate court affirmed. On still further review by the state Supreme Court, the appellate court’s opinion was affirmed. The Supreme Court noted that the applicable regulations did not define the terms “non-farm residence” or “farm residence.” As such, the defendant had discretion to reasonably interpret the term “farm residence” as including a residence constructed on a farm.
Ag Cooperative Fails To Secure Warehouse Lien; Loses on Conversion Claim.
I dealt with the issue in this case in my blog article of March 27. You may read it here: https://lawprofessors.typepad.com/agriculturallaw/2020/03/conflicting-interests-in-stored-grain.html In the article, I detail many of the matters that arose in this case.
The facts of the case revealed that a grain farmer routinely delivered and sold grain to the defendant, an operator of a grain warehouse and handling facility. The contract between the parties contemplated the sale, drying and storage of the grain. The farmer also borrowed money from the plaintiff to finance the farming operation and granted the plaintiff a security interest in the farmer’s grain and sale proceeds. The plaintiff filed a financing statement with the Secretary of State’s office on Feb. 29, 2012 which described the secured collateral as “all farm products” and the “proceeds of any of the property [or] goods.” The financing statement was amended in late 2016 and continued. The underlying security agreement required the farmer to inform the plaintiff as to the location of the collateral and barred the farmer from removing it from its location without the plaintiff’s consent unless done so in the ordinary course of business. It also barred the farmer from subjecting the collateral to any lien without the plaintiff’s prior written consent. However, the security agreement also required the farmer to maintain the collateral in good condition at all time and did not require the plaintiff’s prior written consent to do so.
The plaintiff complied with the 1985 farm products rule and the farmer gave the plaintiff a schedule of buyers of the grain which identified the defendant. From 2014 through 2017, the farmer sold grain to the defendant, and the defendant remitted the net proceeds of sale via joint check to the farmer and the plaintiff after deducting the defendant’s costs for drying and storage – a longstanding industry practice. The plaintiff, an ag lender in an ag state, claimed that it had no knowledge of such deductions until 2017 whereupon the plaintiff sued for conversion. The defendant did not properly perfect a warehouse lien and the lien claim was rejected by the trial court, but asserted priority on a theory of unjust enrichment. The trial court rejected the unjust enrichment claim.
The state Supreme Court agreed, refusing to apply unjust enrichment principles in the context of Article 9 of the Uniform Commercial Code (UCC). The court did so without any mention of UCC §1-103 (b) which states that, "Unless displaced by the particular provisions of the Uniform Commercial Code, the principles of law and equity” including the law merchant [undefined] and the law relative to capacity to contract; duress; coercion; mistake; principal and agency relationships; estoppel, fraud and misrepresentation; bankruptcy, and other validating or invalidating cause [undefined] supplement its provisions.” This section has been characterized as the "most important single provision in the Code." 1 J. White & R. Summers, Uniform Commercial Code § 5. “As such, the UCC was enacted to displace prior legal principles, not prior equitable principles.” However, the Supreme Court completely ignored this “most important single provision in the Code.” The Court also ignored longstanding industry practice and believed an established ag lender in an ag state that it didn’t know the warehouse was deducting its drying and storage costs before issuing the joint check.
The developments keep rolling in. More will be covered in future articles.
Monday, May 25, 2020
A taxpayer that donates a “qualified real property interest” to a “qualified organization” can receive a charitable contribution deduction upon satisfying numerous technical requirements. A primary requirement is that the easement donation be exclusively for conservation purposes. That requirement, however, can only be satisfied if the conservation purposes are protected in perpetuity. I.R.C. §§170(h)(2)(C); (h)(5)(A). Essentially, that means that legally enforceable restrictions must be in place that will bar the use of the portion of the property that the taxpayer retains from being used in a manner that is inconsistent with the conservation purposes of the donated easement.
But, can anything here on earth really last forever? What if the easement is extinguished by court action? There’s a rule for that contingency and it requires careful drafting of the easement deed. Numerous court opinions have dealt with the issue, including a couple in recent weeks.
Dealing with potential extinguishment of a perpetual conservation easement donation – it’s the topic of today’s post.
The Issue of Extinguishment – Treasury Regulation
While the law generally disfavors perpetual control of interests in land, for a taxpayer to claim a tax deduction for a donated conservation easement, the easement must be granted in perpetuity. But if the conditions surrounding the property subject to a perpetual conservation easement make impossible or impractical the continued use of the property for conservation purposes, a Treasury Regulation details the requirements to be satisfied to protect the perpetual nature of the easement if a judicial proceeding extinguishes the easement restrictions. Treas. Reg. §1.170A-14(g)(6)(i)-(ii).
The regulation requires that, at the time of the donation, the donor must agree that the donation gives rise to a property right that is immediately vested in the donee. Treas. Reg. §1.170A-14(g)(6)(ii). The value of the gift must be the fair market value of the easement restriction that is at least equal to the proportionate value that the easement restriction, at the time of the donation, bears to the entire property value at that time. See Treas. Reg. §1.170A-14(h)(3)(iii) relating to the allocation of basis. The proportionate value of the donee’s property rights must remain constant such that if the conservation restriction is extinguished and the property is sold, exchanged or involuntarily converted, the done is entitled to a portion of the proceeds that is at least equal to that proportionate value of the restriction. The only exception is if state law overrides the terms of the conservation restriction and specifies that the donor is entitled to the full proceeds from the conversion restriction. Treas. Reg. §1.170A-14(g)(6)(ii).
Extinguishment – Cases
The formula language necessary to comply with the regulation must be precisely drafted. The IRS has aggressively audited perpetual easement restrictive agreements for compliance. Consider the following:
- In Carroll, et al. v. Comr., 146 T.C. 196 (2016), the petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the donees were entitled to a proportionate share of extinguishment proceeds not to be less than the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008.
Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds was tied to the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
- In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner acquired a building in 2001 for $58.5 million. In 2004, the petitioner transferred a façade easement on the building via deed to a qualified charity (a preservation council) to preserve the exterior building perimeter. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building – the petitioner and any subsequent owner couldn’t demolish or alter the protected elements without the charity’s permission. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from its mortgagee banks. However, the easement deed provided that in the event the façade easement was extinguished through a judicial proceeding, the mortgagee banks will have claims before that of the donee charity to any proceeds received from the condemnation proceedings until the mortgage is satisfied.
By the time of the easement donation, the value of the building had increased to $257 million, of which $33.4 million was attributable to the easement. The petitioner claimed a $33.4 million charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity's claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property if the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.
The petitioner claimed that the First Circuit's decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination must remove any preferential treatment of the lender in all situations, creating an exception for unusual situations that could possibly occur at some point in the future. The First Circuit determined that the Tax Court's reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that a broad reading was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due which could result in the loss of the property without the charity receiving a pro rata portion of the property value.
In the present case, the Tax Court rejected the view of the First Circuit, noting that its decision would be appealable to the Seventh Circuit and, thus, the Tax Court was not bound by the First Circuit's decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5). The Tax court also pointed out that other Circuits had agreed with the Tax Court's interpretation of the subordination rule since Kaufman was decided. The Tax Court also noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of a need to have taxing agencies to agree to give up rights to a priority interest that might arise in the future for delinquent taxes when the taxes were not delinquent.
The IRS assessed a gross valuation misstatement penalty in 2008 and additional accuracy-related and negligence penalties in 2014. The petitioner contested the penalties, but the Tax Court, in a later proceeding, determined that there is no requirement that IRS determine the penalties at the same time or by the same IRS agent. The only requirement, the Tax Court held, was that each penalty, at the time of initial determination, was approved in writing by a supervisor before being communicated to the petitioner. That requirement was satisfied. That later proceeding on the penalty issue is at 152 T.C. No. 4 (2019).
- In Salt Point Timber, LLC, et al. v. Comr., T.C. Memo. 2017-245, the petitioner was a timber company that granted a perpetual conservation easement on a 1,032-acre property for which the petitioner claimed a $2.13 million deduction on its 2009 return. The easement preserved the view of natural, environmentally significant habitat on the Cooper River by barring development. The petitioner received $400,000 for the donated easement, and the done satisfied the definition of a “qualified organization” under I.R.C. §170(h)(1)(B). The appraised value of the easement was $2,530,000. The IRS disallowed the deduction on the basis that the easement grant allowed the original easement to be replaced by an easement held by a disqualified entity. In addition, the IRS claimed that the grant allowed the property to be released from the original easement without the extinguishment regulation being satisfied. The petitioner claimed that there was a negligible possibility that the easement could be held by a non-qualified party. The court agreed with the IRS, noting that the grant did not define the term “comparable conservation easement” or what type of organization could hold it, just that an “eligible donee” could hold it. The court noted that an assignment of the easement is different from a replacement of the easement. As such, the grant did not restrict that the holder of the easement had to be a “qualified organization.” The court also determined that the chance that the easement could be replaced was other than negligible as Treas. Reg. §1.170A-14(g)(3) required.
- In PBBM-Rose Hill, Ltd., v. Comr., 900 F.3d 193 (5th Cir. 2018), the petitioner owned a tract of land subject to a use restriction requiring it to only be used for recreational facilities open space for 30 years. At the time of the petitioner’s ownership, the property was a golf course with a clubhouse. The petitioner wanted to sell the property, but before doing so wanted to remove the use restriction. A local buyer expressed interest, but also wanted to block any removal of the use restriction. The sale went through after the buyer agree to allow the removal of the use restriction. However, before the sale closed, the petitioner conveyed a conservation easement of the property to a land trust. The terms of the easement stated that the property was to remain open for public use for outdoor recreation and that fees for such use could be charged. Upon extinguishment of the easement, the land trust would be entitled to a portion of the sale proceeds equal to the greater of the fair market value of the easement at the time of the donation or a share of the proceeds after expenses of sale and an amount attributable to improvements constructed on the property. The IRS denied the charitable deduction.
The Tax Court agreed with the IRS position based on its findings that the easement did not protect the conservation purpose under I.R.C. §170(h)(4)(A) and didn’t satisfy the perpetuity requirement of I.R.C. §170(h)(5)(A) because the easement deed’s extinguishment provision did not comply with Treas. Reg. §1.170A-14(g)(6). As such, the easement donation was not “exclusively for conservation purposes as required by I.R.C. §170(h)(1)(C). The Tax Court held that the easement value was $100,000 rather than the $15.2 million that the petitioner claimed. The Tax Court also upheld the gross valuation misstatement penalty that the IRS had imposed. On appeal, the appellate court affirmed that the petitioner was not entitled to any charitable deduction and upheld the penalty. The appellate court held that when determining whether the public access requirement for a recreation easement is fulfilled, the focus is to be on the terms of the deed and not the actual use of the land post-donation. The appellate court determined that the terms of the easement satisfied the public-access requirement of Treas. Reg. §1.170A-14(d)(5)(iv)(C). However, the appellate court concluded that the contribution was not exclusively for conservation purposes because the requirements of Treas. Reg. §1.170A-14(g)(6)(ii) were not satisfied. The deed, the appellate court noted, allowed the value of improvements to be subtracted from the proceeds before the donee took its share, and that Priv. Ltr. Rul. 200836014 no longer represented the current position of the IRS and could not be used to alter the plain meaning of the regulation which mandates that the donee receive at least the proportionate value of the “proceeds.” The appellate court also agreed with the Tax Court that the gross valuation misstatement penalty applied to the difference between the amount the petitioner deducted on its return ($15 million) and the $100,000 deduction allowed by the Tax Court.
- In Coal Property Holdings, LLC v. Comr., 153 T.C. No. 7 (2019), the petitioner donated to a qualified charity an open space conservation easement over property which was previously subjected to surface coal mining and which was also subject to oil and gas leases and certain improvements. The IRS denied a charitable deduction because the easement wasn’t protected in perpetuity, and the Tax Court agreed. The conservation purpose of allowing the land subject to the easement to continue to recover from and provide scientific insight into the long-term effects of mining didn’t entitle the charity to a proportionate part of the proceeds if the subject property were sold upon a judicial extinguishment of the easement. As such, the easement wasn’t perpetual in nature as required by I.R.C. §170(h)(5)(A) and I.R.C. §1.170A-14(g)(6). While the petitioner claimed that the deed language contained a “regulation override” mandating that the deed be interpreted to satisfy the perpetuity requirements of the Code and Regulations, the Tax Court rejected that argument because it was a condition subsequent constituting a savings clause that the court would not enforce.
On this issue, the IRS also argues that when an easement deed’s proceeds allocation formula deducts (from the proceeds allocable to the done) an amount attributable to “improvements” made by the owner after the donation, no charitable deduction is allowed. The IRS position is that the deduction violates the extinguishment regulation (Treas. Reg. 1.170A-14(g)(6)(ii)), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008).
- In Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22, the petitioner donated a permanent conservation easement to a qualified entity and claimed a $16 million charitable deduction. The deed granting the easement contained a clause specifying the result if the easement were extinguished as the result of a court order. The IRS pointed out that in the event of a forced judicial sale, Treas. Reg. §1.170A-14(g)(6)(ii) requires the charity to receive an equal proportionate value of the sale proceeds that extinguishes the interest to the value of the easement as compared to the value of the property at the date of the donation. The language of the deed at issue held the charity’s payment constant, equal to the value as of the date of the contribution. It did not tie the charity’s payment to a percentage of the value of the property at the time of the forced sale equal to the percentage of value the easement was to the property at the time of the donation. The IRS denied the entire $16 million donation and the Tax Court agreed.
The Tax Court noted that the deed language did not create a proportion or fraction representing the donee’s share of the property right and a corresponding fraction of the proceeds to which the donee was entitled in perpetuity. Rather, the Tax Court noted, the language gave the charity a “proportionate value…at the time of the gift” which guaranteed only that a fixed dollar amount would go to the charity. The Tax Court also held as irrelevant a declaration of intent executed by an officer of the charity that the deed language reflected the charity’s intent to be in full compliance with the Code. What mattered was the donor’s intent, not the charity’s intent. Even so, the deed language failed to conform to the Code. The Tax Court also determined that the deed language was not ambiguous. Thus, the easement was not protected in perpetuity and the full deduction was disallowed.
Challenge to the Validity of the Regulation
In Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020), the petitioner challenged the validity of the extinguishment regulation. 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) violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).
The Tax Court, agreeing with the IRS, upheld the validity of the regulation. The full Tax Court held that the extinguishment regulation (Treas. Reg. §1.170A-14(g)(6)) 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), 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. Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54. 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.
The extinguishment regulation is, perhaps, the most common audit issue for IRS when examining permanent conservation easement donations. The clause specifying how proceeds are to be split when a donated conservation easement is extinguished is routinely included in easement deeds. The cases point out that the clause must be drafted precisely to fit the confines of the regulation. A regulation that now has survived an attack on its validity. Many perpetual easement donations will potentially be affected.
Thursday, May 21, 2020
The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017. However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.” But, what if the exchange involves non-like-kind cash “boot” or otherwise fails the requirements of the Code? Is there a way to still achieve tax deferral?
“Fixing” a tax-deferred exchange that has failed – it’s the topic of today’s post.
The tax deferral of an IRC §1031 exchange is only achieved if the requirements of IRC §1031 are satisfied. If the requirements are not satisfied, the exchange is taxable as a sale or exchange under the general rules of IRC §1001.
There are four basic requirements to achieving tax-deferred treatment under IRC §1031:
- There is an exchange of property rather than a sale; IRC §1031(a)(1).
- The property exchanged and the property received must be like-kind real estate;
- The property exchanged and the property received must both be held for the productive use in a trade or business or for investment; and
- The exchange of properties must be simultaneous, or the replacement property must be identified within 45 days of the exchange and the identified property must be received within 180 days of the identification or the due date of the return (including extensions), if shorter. IRC §§1031(a)(3)(A)-(B)((ii).
If an exchange satisfies the requirements of IRC §1031, but property is received that is not like-kind (such as money or other non-like kind property, the recipient of the property recognizes gain to the extent of the sum of the money and the fair market value of the non-like-kind property received. I.R.C. §1031(b). That means that tax deferral is not achieved with respect to the non-like-kind property (or “boot”) received in the exchange. But a taxpayer may elect to recognize the gain on the boot under the installment method of I.R.C. §453. Similarly, a taxpayer that fails to satisfy the requirements of IRC §1031 may be able to defer gain on the transaction under IRC §453 by properly structuring the sale.
Treasury Regulation Example
Treasury Regulation §1.1031(k)-(1)(j)(2)(vi), Example 4, indicates that a buyer’s installment note issued to a seller qualifies for installment treatment under IRC §453. In the Example, the buyer offers to buy the seller’s real property, but doesn’t want to have the transaction structured as a like-kind exchange. As a result, the seller enters into an exchange agreement with a qualified intermediary to facilitate the exchange. Under the agreement, the seller transfers the real property to the qualified intermediary who then transfers the property to the buyer. The buyer pays $80,000 cash and issues a 10-year installment note for $20,000. The Example specifies that the seller has a bona fide intent to enter into a deferred exchange, and the exchange agreement specifies that the seller cannot receive, pledge, borrow or otherwise obtain the benefits of the money or other property that the qualified intermediary held until the earlier of the date the replacement property is delivered to the seller or the end of the exchange period. The Example also points out that the buyer’s obligation bears adequate stated interest and is not payable on demand or readily tradable. The qualified intermediary acquires replacement property having a fair market value of $80,000 and delivers it, along with the $20,000 installment obligation, to the seller.
While the $20,000 of the seller’s gain does not qualify for deferral under IRC §1031(a), the seller’s receipt of the buyer’s obligation is treated as the receipt of an obligation of the person acquiring the property for purposes of installment reporting of gain under IRC §453. Thus, the Example concludes that the seller may report the $20,000 gain on the installment method on receiving payments from the buyer on the obligation
A safe harbor exists that provides protection against an IRS assertion that a taxpayer is in actual or constructive receipt of money or other property held in a qualified escrow account, qualified trust, or by a qualified intermediary. Treas. Regs. §§1.1031(k)-1(g)(3)-(4); T.D. 8535 (Jan. 1994). With respect to a qualified intermediary, the determination of whether a taxpayer has received payment for purposes of IRC §453 is made as if the qualified intermediary is not the taxpayer’s agent. Treas. Regs. §§1.1031(k)-1(j)(2)(ii); (g)(4). Thus, when a taxpayer transfers property under such an arrangement and receives like-kind property in return, the transaction is an exchange rather than a sale, and the qualified intermediary is not deemed to be the taxpayer’s agent. See Priv. Ltr. Rul. 200327039 (Mar. 27, 2003). Similarly, when a buyer places money in an escrow account or with the qualified intermediary, the seller is not in constructive receipt of the funds if the seller’s right to receive the funds is subject to substantial restriction. See, e.g., Stiles v. Commissioner, 69 T.C. 558 (1978). The Treasury Regulations state that any agency relationship between the seller and the qualified intermediary is disregarded for purposes of IRC §453 and Treas. Reg. §15a.453-1(b)(3)(i) in determining whether the seller has constructively received payment. Treas. Reg. §1.1031(k)-1(j)(2)(vi), Example 2.
Exchange Transaction Example
Assume that Molly Cule owns a tract of farmland that she uses in her farming business and would like to exchange it for other farmland in an I.R.C. §1031 transaction. Bill Bored and Molly enter into a purchase contract, calling for Bill to buy Molly’s farmland. The purchase contract clearly states that Bill must accommodate Molly’s desire to complete an IRC §1031 exchange and states that Molly desires to enter into an IRC §1031 exchange. Molly and a qualified intermediary then enter into an exchange agreement specifying that the qualified intermediary agrees to acquire Molly’s farmland and transfer it to Bill. The agreement also states that the qualified intermediary will acquire like-kind farmland and transfer it to Molly. Molly assigns her rights in and to the farmland she gave up to the qualified intermediary. She also assigns her rights to the qualified intermediary in all contracts she enters into with the owner who holds title to the replacement farmland.
The exchange agreement requires Molly to identify replacement farmland within 45 days of the initial exchange and to notify the qualified intermediary of the identified parcel within that 45-day period. The exchange agreement allows Molly 180 days from the date of the first exchange to receive the identified property.
The exchange agreement specifies that the qualified intermediary will sell Molly’s farmland and hold the sales proceeds until the qualified intermediary buys replacement farmland. When the replacement farmland is purchased, it will then be transferred to Molly.
Structured sale aspect. The exchange agreement says that if the transaction qualifies under I.R.C. §1031, but Molly receives “boot,” the qualified intermediary and Molly must engage in a structured sale for the boot. This is to bar Molly from having any right to receive cash from the exchange. Similarly, the exchange agreement contains additional language stating that if the transaction fails to qualify for I.R.C. §1031 treatment for any reason, the qualified intermediary and Molly must engage in a structured sale. The structured sale involves the qualified intermediary making specified periodic payments to Molly pursuant to an installment sale agreement (based on the consideration the qualified intermediary holds) coupled with a note for a set number of years. Thus, the exchange agreement is drafted to specify that if an installment sale results, Molly will report each payment received into income in the year she receives it.
The assignment agreement. If the installment sale language is triggered, the exchange agreement specifies that the qualified intermediary will assign its obligations to make the periodic payments under the installment note to an assignment company pursuant to a separate assignment agreement between the qualified intermediary and the assignment company. Molly is not a party to this agreement. The assignment agreement requires the qualified intermediary to transfer a lump sum to the assignment company. The lump sum amount equals the discounted present value of the stream of payments that the qualified intermediary must make under the installment note and exchange agreement. In return, the assignment company assumes the qualified intermediary’s obligation to pay Molly. Thus, the assignment company becomes an obligor under the installment note.
As discussed above, Example 4 of Treas. Reg. §1.1031(k)-1(j)(vi), involves an installment note that the buyer issues to the seller of the property. That note qualifies for installment treatment under I.R.C. §453. In the example involving Molly, it is the qualified intermediary that issues the note. While the regulation states that the qualified intermediary is not the agent of the Molly for purposes of IRC §453, that is only the case until the earlier of the identification (or replacement) period, or the time that Molly has the unrestricted right to receive, pledge, borrow or otherwise benefit from the money or other property that the qualified intermediary holds. Treas. Reg. §1.1031(k)-1(j)(2)(ii). But, the risk of Molly being in constructive receipt of the buyer’s funds is eliminated if the exchange agreement is drafted carefully to fit within the safe harbor.
As an alternative to the approach of the example involving Molly, what if a different taxpayer, Millie, engaged in a similar transaction and used installment reporting but received all of the cash up front via a loan. Will an arrangement structured in this manner achieve tax deferral?
Facts of the example. Millie sells an asset to Howard’s Exchange Service (HSE) and HSE resells the asset to Andy. Millie receives a loan from Usurious Bank, an independent lender shortly after selling the asset to HSE for an amount equating the selling price to HSE. The repayment of the loan is funded by installment payments over a period of time that HSE makes to Usurious Bank. Three escrow accounts are established with an escrow company affiliated with Usurious Bank. The escrow company, on a monthly basis, takes funds from HSE and moves it into Escrow Account No. 1 as an interest payment on the loan; then to Escrow Account No. 2 (which is designated as Millie’s account); and then to Escrow Account No. 3 to pay interest on the loan. The transactions are conducted as automatic debit/credit transactions that occur on a monthly basis over the length of the installment period.
Analysis. IRC §453 requires that the initial debt obligation be that of the buyer of the property for the seller to receive installment treatment on the proceeds of sale. If the obligor is someone other than the buyer, the debt is treated as payment on the sale. Treas. Reg. §15a.453-1(b)(3)(i). Thus, for installment sale treatment to result, HSE must be both the buyer of the asset and the obligor on the installment note rather than only being the obligor. This means that the transaction must be structured such that the obligation is due to Millie from Andy, followed by a substitution of the obligor via an independent transaction in which Andy assigns the obligation. In Rev. Rul. 82-122, 1982-1 C.B. 80, amplifying Rev. Rul. 75-457, 1974-1 C.B. 115, the substitution of a new obligor on the note and an increase in the interest rate, together with an increase in the amount paid monthly to reflect the higher interest rate, was not considered to be a satisfaction or disposition of an installment obligation within the meaning of I.R.C. §453B(a).
As for the escrow accounts, generally an installment note of the buyer cannot be used as security or pledged to support any other debt that benefits the seller. If that happens, the net proceeds of the debt are treated as a payment received on the installment sale. See IRC §453A(d)(1); Treas. Reg. §15A.453-1(b)(3)(i); Rev. Rul. 79-91, 1979-1, C.B. 179; Rev. Rul. 77-294, 1977-2, C.B. 173; Rev. Rul. 73-451, 1973-2, C.B. 158. However, there is an exception to this “pledge rule” that triggers gain recognition if the seller uses an installment obligation to secure a loan. Property that is used or produced in the trade or business of farming is not subject to the rule. I.R.C. §453A(b)(3)(b). Thus, a taxpayer who sells farmland (or other farm property) in an installment sale may use that installment receivable as security, or in a pledged manner, to borrow funds from a third party. The third party should collateralize the payments and file a UCC-1 to formally pledge and secure the installment payments
Tax-deferred exchanges post-2017 are limited to real estate exchanges. Normally, only the like-kind portion of the exchange qualifies for deferral. However, if an exchange involving farm property is structured properly, tax deferral can be achieved for the entire transaction. Careful drafting of the contracts involved is critical.
Friday, May 15, 2020
The interest among some farmers and ranchers in converting some of their land into a “solar farm” is growing. The opportunity for additional cash in tough economic times is driving the interest. Is it a good investment? Of course, the boondoggles of Solyndra, LLC in California and Crescent Dunes in Nevada are a reminder that such ventures can turn up dry. In addition, the federal government encourages ventures into solar energy production with the use of taxpayer dollars.
Solar energy production and the tax credit for producing electricity from the sun – it’s the topic of today’s post.
Residential Energy Credit
Currently, a taxpayer may claim a residential energy efficient property credit of 26 percent credit for the costs of the solar panels and related equipment and material installed to generate electricity for use by a residential or commercial building. I.R.C. §25D. A taxpayer is “allowed as a credit against the tax imposed…for the taxable year, an amount equal to the sum [of] the qualified solar electric property expenditures” – expenditures “for property which uses solar energy to generate electricity for use in a dwelling unit located in the United States and used as a residence by the taxpayer.” I.R.C. §25D(2). The credit is computed by taking into account the cost of solar panels as well as piping or wiring to connect the property to the dwelling unit plus labor costs. For a newly constructed home, the taxpayer may request that the homebuilder make a reasonable allocation, or the taxpayer may use any other reasonable method to determine the cost of the property that is eligible for the credit. IRS Notice 2013-70, 2013-47 IRB 528, Q&A No. 21.
A taxpayer that claims the credit for solar energy property installed in the taxpayer’s principal residence or vacation home must reduce the taxpayer’s income tax basis in the property by the amount of the credit. A “home” includes a house, houseboat, mobile home, cooperative apartment, condominium, and a manufactured home. See Instructions to Form 5695, Residential Energy Credits.
Commercial (Business) Energy Credit
I.R.C. §48 provides a credit for “energy property placed in service during [the] taxable year.” I.R.C. §48(a)(1). The amount of the credit is a percentage of energy based on each energy property placed in service during the taxable year. The energy percentage is 26 percent for solar energy property that is under construction on or before December 31, 2020 and placed in service before January 1, 2024. The credit belongs to the owner of the solar energy property. The credit is claimed on Form 5695 with the amount of the credit carried to Form 1040.
IRS Notice 2013-70 provides taxpayers with two methods to establish the beginning of construction – either by starting physical work of a significant nature (the “Physical Work” test) or by satisfying a safe harbor (the “Five Percent Safe Harbor” test). Under the safe harbor, construction is deemed to begin when the taxpayer pays or incurs five percent or more of the total cost of the energy property and thereafter makes continuous efforts to advance towards completion of the energy property. While either method may be used, construction is deemed to have begun on the date the taxpayer first satisfies one of the two methods.
Energy property is defined as any “equipment which uses solar energy to generate electricity to…a structure” and “equipment which uses solar energy to illuminate the inside of a structure.” I.R.C. §48(a)(3). The regulations provide additional guidance. Treas. Reg. §1.48-9(d)(1) provides that “solar energy property’ includes equipment and materials (and parts related to the functioning of such equipment) that use solar energy directly to (i) generate electricity (ii) heat or cool a building or structure, or (iii) provide hot water for use within a building or structure.” Treas. Reg. §1.48-9(d)(3) defines electric generation equipment as follows:
“Solar energy property includes equipment that uses solar energy to generate electricity, and includes storage devices, power conditioning equipment, transfer equipment, and parts related to the functioning of those items. In general, this process involves the transformation of sunlight into electricity through the use of such devices as solar cells or other collectors. However, solar energy property used to generate electricity includes only equipment up to (but not including) the stage that transmits or uses electricity.”
In addition, Treas. Reg. §1.48-9(d)(4) specifies that “[p]ipes and ducts that are used exclusively to carry energy derived from solar energy are solar energy property.” Because the credit is part of the general business credit under I.R.C. §38. Property that is eligible for the general business credit is tangible property for which depreciation is allowable.
The solar energy credit is part of the investment credit under I.R.C. §46(2) which means that it is subject to the rules that apply to unused general business credits under I.R.C. §38(a). Unused credit amounts are carried back one year and then to each of the 20 years following the unused credit year. The credit is nonrefundable and may only be used against the taxpayer’s actual tax liability. The entire amount of the unused credit must be carried back one year before it may be carried over to the next 20 years. I.R.C. §39(a)(2)(A).
The solar equipment can be owned by one party and used on another person’s property. In that situation, the owner/lessor may claim the energy credit provided that the solar property is placed in service and meets the other requirements of I.R.C. §48. Rev. Rul. 79-264, 1979-2 C.B. 92.
As noted, the owner of the solar energy property is entitled to the energy credit. If IRS challenges the ownership issue in lessor/lessee situations, the most important factor in determining ownership is the source of capital for the solar energy property. The party that is exposed to the risk of loss from supplying the necessary capital for the asset and retaining an actual and legal proprietary interest in the asset is the owner of the property that is entitled to the credit.
A lessor of new solar energy property may elect to pass the credit to the lessee if the transaction involves a profit intent and the and the lease is a bona fide lease. The property is deemed to be place in service when it is first held out for leasing to others in a profit-motivated leasing venture. See, e.g., Cooper v. Commissioner, 88 T.C. 84 (1987). A sale/leaseback is also possible which allows the lessee to claim the credit or would permit the lessor to pass-through its credit to a lessee.
A recent U.S. Tax Court case, Golan v. Comr., T.C. Memo. 2018-76, involved the solar energy credit as well as associated income tax basis, depreciation, at-risk and passive loss issues. The case is a good illustration of the issues that can arise when a farmer or rancher (or other taxpayer) gets involved with a “solar farm” project.
Fact of the case. In 2010, the petitioners (a married couple), sought an income-producing investment and thought they would do so by purchasing solar equipment from a seller of such equipment. The seller identifies property owners and offers them discounted electricity in exchange for permission to install solar panels and related equipment on their properties (known as “host properties”) The seller remains the owner of the solar equipment and temporarily retains the burdens and benefits of ownership (including all resulting tax credits and rebates). Then, the seller sells the solar equipment (and the associated rights and obligations) to a buyer such as the petitioners. An owner of a host property filed an application with the local utility company for an interconnection agreement (for net energy metering), and the seller entered into a power purchase agreement (PPA) with the owner of the host property. The seller, as noted, temporarily retained ownership of the solar equipment and was responsible for any servicing or repairs. The PPA barred the owner of the host property from assigning the PPA to another party without the seller’s consent, but the seller could assign it interest in the PPA to another party with 30 days’ notice to the host. Once the solar panels were installed, the utility company informed the host property owner of eligible rebates, which the host property owner assigned to the seller.
The sale of the solar equipment to the petitioners was accomplished in 2010 under a solar project purchase agreement coupled with a promissory note and guarantee that the petitioner’s signed. It was completed with a bill of sale and conveyance. The solar equipment was installed on the host properties in 2010, but under the purchase agreement, the “original use” of the solar equipment “shall commence on or after the Closing Date.” The purchase price was set at $300,000, consisting of a $90,000 down payment due on closing in early 2011; a $57,750 credit for the rebates the seller received from the utility company before the sale; and the petitioners’ promissory note in the principal amount of $152,250 with interest at 2 percent. The solar equipment secured the note and all monthly revenue generated from the solar equipment was to be applied to the note. If accrued interest exceeded monthly receipts for any particular month, the difference was to be carried forward and the petitioners would owe it in future months. If monthly receipts exceeded accrued interest and amortized principal, the excess would accelerate the loan’s repayment. Upon default, the seller would seek recourse against the solar equipment before exercising any remedies against the petitioners, and the petitioners were liable to pay any deficiencies owed to the seller if sale of the collateral upon foreclosure didn’t pay outstanding amounts owed to the seller. The petitioners also signed a guarantee for the note.
Ultimately, the petitioners failed to pay the down payment in 2011 but did make partial payment in 2012 and 2013. In addition, the petitioners directed the owners of the host properties to make direct payment of electricity bills to the seller who then credited the payments toward the note. The seller continued to honor the purchase agreement.
On their 2011 return, the petitioners Schedule C reported no income, but claimed various deductions including depreciation of $255,000. The petitioners stated that the Schedule C business was as a “consultant” for the seller’s business. The petitioners were also on the cash method of accounting. The $255,000 figure was arrived at as the difference between their claimed $300,000 basis in the solar equipment and $45,000. The $45,000 was one-half of the $90,000 energy credit claimed reduced by one-half in accordance with IRC §§50(c)(1) and (3)(A). On their associated Form 4562, the petitioners stated that the $255,000 deduction was a “[s]pecial depreciation allowance for qualified property.” Also attached to the 2011 return was Form 3468 on which they claimed a $90,000 energy credit (30 percent of $300,000).
The IRS disallowed the depreciation deduction on the basis that the solar equipment did not qualify for “bonus” depreciation because it was neither acquired after September 8, 2010 nor placed in service before January 1, 2012. The IRS also disallowed the energy credit claiming that the petitioners did not have a basis in the energy property because no funds changed hands. In addition, the IRS asserted that the petitioners were not at-risk with respect to the promissory note and, as a result, could not claim any basis in the note. The IRS based its position that the seller had a prohibited continuing interest in the solar equipment activity. See I.R.C. 465(b)(3). The IRS also took the position that the passive loss rules applied to the petitioners’ Schedule C loss and claimed solar energy credit. An accuracy-related penalty was also applied.
The Tax Court’s holdings:
- Income tax basis. Because the down payment of $90,000 payment was not paid in 2011, that amount could not be applied to the petitioners’ basis in the solar property for 2011, citing Treas. Reg. §1.1012-1(a). As for the $57,750 credit for the rebates assigned to the utility company by the owners of the host properties, the petitioners neither received them nor reported them as income. This amount could also not be applied to the petitioners’ basis in the solar equipment. It was not part of the petitioners’ cost of the solar equipment. The $152,250 promissory note was a recourse obligation that was issued in exchange for the solar equipment. As such, the face amount of the note could be included in the petitioners’ basis in the solar equipment.
The result was that the petitioners’ income tax basis in the solar equipment was $152,250.
- Bonus depreciation. The Tax Court determined that the solar equipment (which has a recovery period of 20 years) did qualify for bonus depreciation because the petitioners acquired it (as the original user) in January of 2011 and placed it in service that year. While the solar property was installed on the host properties in 2010, the IRS failed to prove that the property was connected to the grid in before 2011. As such, the solar property was not ready and available for its intended use until it was connected to the electric grid, and that was in 2011 rather than 2010.
- At-risk rules. The Tax Court disagreed with the IRS claim that the seller had a prohibited continuing interest in the solar equipment activity under I.R.C. §465(b)(3). The IRS failed to identify any provision of the purchase agreement entitling the seller to the solar equipment upon liquidation. Similarly, the seller was not shown to have an interest in the net profits of the petitioners’ solar energy venture. The right to have monthly revenue applied to the note was a permitted gross receipts interest. It was immaterial that the seller was also a promoter of the transaction.
- Passive loss rules. The petitioners claimed that the husband participated in the solar energy venture for at least 100 hours in 2011 and that his participation was not less than that of any other individual, thus satisfying the material participation test of Temp. Treas. Reg. §1.469-5T(a)(3). The Tax Court viewed the husband’s testimony as credible and that the IRS failed to establish otherwise.
- The Tax Court did not uphold the accuracy-related penalty, finding that the petitioners made a good faith effort to determine their tax liability and reasonably relied on the advice of their tax preparer.
The tax credit for solar energy electricity production is designed to incentivize solar energy production. But, there are other considerations besides tax in determining whether a “solar farm” investment is a good one for any particular farmer or rancher. Each situation is dependent on the facts. For those interested in a “solar farm” investment, seek good legal and tax counsel.
Tuesday, May 12, 2020
In a blog article last week https://lawprofessors.typepad.com/agriculturallaw/2020/05/doj-to-investigate-meatpackers-whats-it-all-about.html I noted that the Trump Administration and various state Attorneys General have called upon the U.S. Department of Justice (DOJ) to investigate the pricing activities of the major meatpackers. Aside from the economics of the situation and DOJ investigations, is there another approach that agricultural producers can take to enhance markets for their products? This question is of particular importance at the present time. Indeed, there may be a way for ag producers to work together to enhance prices for their products in a way that the law favors.
Collective action of agricultural producers to enhance markets for their products – it’s the topic of today’s post.
Historical Background – The Capper-Volstead Act
The National Board of Farm Organizations passed a resolution in 1917 urging the Congress to amend the antitrust laws to clearly permit farm organizations to make collective sales of farm, ranch and dairy products. This was the beginning of a concerted drive for further legislation to resolve the problems and issues facing agricultural co-ops, and ultimately resulted in the enactment of the Capper-Volstead Act (Act) in 1922. 7 U.S.C. 291. The purposes of the Act were to remedy two problems encountered under Section 6 of the Clayton Act. While Section 6 of the Clayton Act provided a basic exemption for agricultural organizations from application of the Sherman and Clayton Acts (i.e., antitrust law), it limited the exemption to organizations that did not have capital stock and, furthermore, Section 6 did not specifically sanction certain co-op marketing activities.
The Act provides that “persons engaged in the production of agricultural products as farmers, planters, ranchmen, dairymen, nut or fruit growers, may act together in associations, corporate or otherwise, with or without capital stock, in collectively processing, preparing for market, handling, and marketing in interstate and foreign commerce, such products of persons so engaged.” Id. As such, the Act extended the Section 6 Clayton exemption to capital stock agricultural co-ops comprised of agricultural producers. These co-ops can have marketing agencies in common and their members can make the necessary contracts and agreements to effect such purposes. However, agricultural co-ops must be operated for the mutual benefit of the members and no member of the association can be permitted more than one vote because of the amount of stock or membership capital owned, or the co-op cannot pay dividends on stock or membership capital in excess of 8 percent per year. Most co-ops comply with both requirements as a matter of practice or because their state statute requires both. In addition, the co-op is prohibited from dealing in the products of nonmembers to an amount greater in value than are handled by it for members. Without these special provisions, agricultural marketing co-ops probably could not exist. The member farmers likely would be engaged in prohibited price fixing.
The grant of immunity from antitrust charges is further limited by Section 2 which empowers the Secretary of Agriculture to issue cease-and-desist orders when an organization exempt from antitrust restrictions is found to be monopolizing or restraining trade, to the extent that the price of any agricultural product is unduly enhanced. 7 U.S.C. § 292 While this does not give the Secretary of Agriculture primary or exclusive jurisdiction over such organizations, they can still be sued under the antitrust laws for exceeding the exemption granted.
An agricultural co-op must satisfy two requirements in order to be shielded by the Act from antitrust liability. First, the organization must be involved in the “processing, preparing for market, handling, or marketing “of the agricultural products of its members. 7 U.S.C. § 291 Thus, the exemption has been held not to apply to the activities of firms or persons operating packing houses. Case-Swayne Co. v. Sunkist Growers, Inc., 389 U.S. 384 (1967), reh'g denied, 390 U.S. 930 (1968). Second, the organization claiming to be immunized from liability must be composed of “members” that are “producers of agricultural products” or cooperatives composed of such producers. 7 U.S.C. § 291 As such, the exemption does not cover the activities of an association consisting in part of persons engaged in “production” and in part of persons not so engaged. For example, in In re Mushroom Direct Purchaser Antitrust Litigation, 621 F. 2d 274 (E.D. Pa. 2009), the court held that the fact that one member was a non-farmer processor barred the application of the Act’s exemption. A non-farmer member had power to participate in control and policymaking of co-op through voting. However, non-producer associate members with no control over the co-op are not statutory “members” and do not strip the co-op of its exempt status. See, e.g., Agritronics Corporation v. National Dairy Herd Assoc., Inc., 914 F. Supp. 814 (N.D. N.Y. 1996).
The United States Supreme Court has construed the Section 1 exemption restrictively by denying exempt status to a broiler chicken nonprofit marketing and purchasing co-op, in which nine of the 75 members did not own breeder fowl. Although the nine were vertically integrated into other processing stages of the broiler industry, their failure to raise their own breeder fowl took them outside the term “farmers” as used in the Act. The Court made it clear that the exemption only applies if all participants in the organization qualify under the Act. National Broiler Marketing Association v. United States, 436 U.S. 816 (1978). While the Court did not address the question of whether an integrated agribusiness would always be a disqualified participant in an association (and thereby cause the association to lose its exempt status) that is otherwise protected by the Act, a concurring opinion in the case indicated that determination is to be made on a case-by-case basis by analyzing the nature of the association’s activities, the degree of integration of its members, and the functions that are historically performed by farmers in the industry. In a 2011 case, the United States District Court for the District of Idaho followed the approach set forth by the concurring opinion in National Broiler and declined to adopt a bright-line rule that any degree of vertical integration either disqualifies a farming operation from participating in a Capper-Volstead eligible association, or is irrelevant in such a determination. In re Fresh and Process Potatoes Antitrust Litigation, 834 F. Supp. 2d 1141 (D. Idaho 2011).
Even if the Act’s Section 1 exemption applies and a particular co-op qualifies for the exemption, the exemption does not legalize activities which are coercive, such as boycotts aimed at forcing nonmembers to join the co-op. While co-op price fixing has been held to be permissible under the Act’s Section 1 exemption, a boycott to force nonmembers to adhere to prices established by the co-op has been held to not be within the scope of the exemption. Maryland & Virginia Milk Producers Ass'n., Inc. v. United States, 362 U.S. 458 (1960).
Permissible activities allowed by the Act include agricultural producers acting together in associations to collectively process, prepare for market, handle and market products. Producers in one association can agree on marketing practices with producers of another association by informal means, by use of a common marketing agent, or through a federation. Cooperatives formed under the Act are not totally exempt from the scope of the antitrust laws. Such a cooperative may lose its limited antitrust exemption if it conspires or combines with persons who are not producers of agricultural products. For example, a dairy cooperative combined with labor officials, municipal officers and other non-producers to seek control of the supply of fluid milk in the Chicago area by paying to producers artificially high noncompetitive prices. Any immunity that the dairy co-op might have had under Section 6 of the Clayton Act or under Section 1 of the Act was lost. United States v. Borden Co., 308 U.S. 188 (1939).
Similarly, Section 2 of the Act does not protect co-ops that unduly enhance prices of agricultural products. That is particularly the case if price enhancement is the result of production limitations. As noted above, the Act allows agricultural producers to act together to process, prepare for market, handle and market an agricultural product after it has been planted and harvested. Thus, by its terms, the Act does not apply to production limitations, acreage limitations or collusive crop planning. See In re Fresh and Process Potatoes Antitrust Litigation, No. 4:10-MD-2186-BLW, 2011 U.S. Dist. LEXIS 138777 (D. Idaho Dec. 2, 2011); “A Report of the U.S. Department of Justice to the Task Group on Antitrust Immunities, p. 68 (1977), Dkt. 111-114, Ex. M.; Farmer Cooperatives in the United States,” Cooperative Information Report 1, Section 3, USDA, Rural Business – Cooperative Service, p. 17 (1980, reprinted 1990), Dkt. 111-116, Ex. O.
While the Secretary of Agriculture can enforce Section 2 by investigating complaints of undue price enhancement, there has not yet been a case where the evidence has been deemed sufficient to warrant a hearing. The U.S. Department of Justice, the Federal Trade Commission, and private parties may bring actions against a co-op when the alleged conduct is not protected by the Act or in the first instance when the co-op failed to meet the Act’s organizational requirements.
Other Laws Granting Limited Immunity to Agricultural Co-ops
The Cooperative Marketing Act. The Cooperative Marketing Act of 1926 permits agricultural producers and their associations to legally acquire and exchange past, present and prospective data concerning pricing, production and marketing. This information may also be exchanged through “federations” of co-ops and by or through a common agent “created or selected” by the producers, co-op, or federation.
The Robinson-Patman Act. The Robinson-Patman Act became law in 1936 and focuses on price discrimination between or among purchasers. In general, Robinson-Patman prohibits sellers from charging different prices for commodities of “like grade and quality” if the effect of the discrimination “may be substantially to lessen competition or tend to create a monopoly”. However, price discrimination is lawful if the price differential is justified by savings in the cost of manufacture, sale or delivery resulting from the differing methods or qualities in which such commodities are sold or delivered to such purchasers or the price difference is the result of changed market conditions. It also provides that co-op patronage refunds will not be characterized as illegal rebates with respect to sellers of products.
The Agricultural Marketing Agreement Act. Under the Agricultural Marketing Agreement Act (AMAA) of 1937, the Secretary of Agriculture is authorized “to enter into marketing agreements with processors, producers, associations of producers, and others engaged in the handling of any agricultural commodity or product thereof in interstate or foreign commerce or which “directly burdens, obstructs, or affects” such commerce. 7 U.S.C. § 608. A marketing agreement is a formal, but voluntary agreement between the Secretary and handlers of a particular agricultural commodity. The purpose of a marketing agreement and order is “to establish and maintain such orderly marketing conditions for agricultural commodities in interstate commerce as will establish” reasonable prices which farmers receive for their agricultural commodities. Marketing agreements affect the quality, size and quantity of an agricultural commodity shipped to markets and are essentially self-help mechanisms to advance the economic interests of the industry. Marketing agreements exist for a wide variety of agricultural crops including raisins grown in California, avocados grown in Florida, and papayas grown in Hawaii. The AMAA provides that “[t]he making of any such agreement shall not held to be a violation of any of the antitrust laws of the United States, and any such agreement shall be deemed to be lawful.” The AMAA was upheld as constitutional in United States v. Rock Royal Cooperative, Inc., 307 U.S. 533 (1939).
The Agricultural Fair Practices Act. The Congress enacted the Agricultural Fair Practices Act (AFPA) in 1968 to correct what was perceived to be an imbalance in bargaining position between producers and processors of agricultural products. Because the marketing and bargaining positions of individual farmers may be adversely affected if they are unable to join freely together in co-op organizations, the AFPA makes it unlawful for either a processor or a producers' association to engage in practices that interfere with a producer's freedom to choose whether to bring products to market individually or to sell them through a producers' coop. The AFPA does not prohibit other discriminatory practices by handlers of agricultural products, nor does it require them to deal with or bargain in good faith with a co-op. The AFPA pre-empts certain provisions of state agricultural marketing and bargaining laws.
The present economic conditions in much of agriculture are difficult. The DOJ investigation is just another investigation in a long line of investigations involving the meat packing industry. As an alternative, ag producers do have other options to market their products with some degree of legal protection from antitrust laws. Overcoming obstacles to forming such marketing organizational alliances may presently be very important.
Friday, May 8, 2020
Earlier this week President Trump asked the U.S. Department of Justice (DOJ) to investigate the pricing practices of the major meatpackers. In addition, 11 state Attorneys General have asked the DOJ to do the same. They pointed out in the DOJ request that the four largest beef processors control 80 percent of U.S. beef processing. According to USDA data, boxed beef prices have recently more than doubled while live cattle prices dropped approximately 20 percent over the same timeframe. The concern is that the meatpackers are engaged in price manipulation and other practices deemed unfair under federal law.
Questions about the practices of the meatpacking industry are not new – they have been raised for well over a century. Indeed, a very significant federal law was enacted a century ago primarily because of the practices of the major meatpackers. So, why is there still talk about investigations? Is existing law ineffective?
Meatpacking industry practices, investigations and the law – it’s the topic of today’s post.
The United States Senate authorized an investigation of the buying and selling of livestock in 1888 to determine if anti-competitive practices were present. The investigation revealed that major meatpackers were engaging in unfair, discriminatory and anti-competitive practices by means of price fixing, agreements not to compete, refusals to deal and similar arrangements. The Senate report contributed to the political support for the Sherman Act of 1890.
In 1902, an injunction was sought against the major meatpackers alleging antitrust violations. The injunction was issued in 1903 and was sustained by the Supreme Court in 1905. See, e.g., Swift & Company v. United States, 196 U.S. 375 (1905). The injunction, however, was not successful in correcting the situations deemed anti-competitive. The same defendants or their successors were indicted and tried for alleged violations of the antitrust laws, but were acquitted after trial in 1912. The dominance and anti-competitive activities of the packers continued, and in 1917, President Wilson directed the Federal Trade Commission (FTC) to investigate the packing industry. The FTC report documented widespread anti-competitive practices involving operations of stockyards, actions of commission persons, operation of weighing facilities, disposal of dead animals and control of packing plants.
During congressional debate of the Packers and Stockyards Act (PSA), the major packers signed a consent decree in an attempt to ward off the new legislation. The consent decree was entered into on February 27, 1920, and it enjoined the “Big Five” meatpackers (Swift & Co., Armour & Co., Cudahy Packing Co., Wilson & Co., and Morris & Co.) from certain activities. The Big Five were prohibited from maintaining or entering into any contract, combination or conspiracy, in restraint of trade or commerce, or monopolizing or attempting to monopolize trade or commerce. The consent decree also prohibited the Big Five from engaging in any illegal trade practice as well as owning an interest in any public stockyard company, any stockyard terminal railroad or any stockyard market newspaper or journal. The injunction also prohibited the Big Five from having an interest in the business of manufacturing, selling or transporting, distributing or otherwise dealing in any of numerous food products, mainly fish, vegetables, fruits, and groceries and many other commodities not related to the meatpacking industry. Similarly, the injunction prohibited the Big Five from using or permitting others to use their distribution systems or facilities for the purchase, sale, handling, transporting or dealing in any of the enumerated articles or commodities. The injunction also prevented the owning or operating of any retail meat markets except in-plant sales to accommodate employees. Because the Big Five controlled all the warehousing in their exercise of monopoly power, the injunction prevented them from having an interest in any public cold storage warehouse or engaging in the business of selling or dealing in fresh milk or cream.
Even though the Attorney General of the United States personally appeared before the House Committee on Agriculture and recommended against the proposed legislation on the ground that the consent decree would eliminate the evils in the packing industry and make legislation unnecessary, President Harding signed the PSA into law on April 15, 1921. Consequently, some of the “Big Five” filed suit seeking to have the consent decree either vacated or declared void. However, in 1928, the United States Supreme Court upheld the consent decree. Swift & Co. v. United States, 276 U.S. 311 (1928). Similarly, the Supreme Court turned down a request to modify the decree in 1932. Swift & Co. v. United States, 286 U.S. 106 (1932). A similar request was also rejected in 1961. Swift & Co. v. United States, 367 U.S. 909 (1961). The decree, however, was terminated on November 23, 1981. United States v. Swift & Co., 1982-1 Trade Cas. (CCH) ¶64,464 (N.D. Ill. 1981).
The PSA was “the most far-reaching measure and extend[ed] further than any previous law into the regulation of private business with few exceptions.” 61 Cong. Rec. 1872 (1921). In addition, the powers given to the Secretary of Agriculture were more “wide-ranging” than the powers granted to the FTC, the Act was upheld as constitutional in several court cases from 1922 to 1934. Unquestionably, the PSA extends well beyond the scope of other antitrust law.
One of the major provisions of the PSA concerns price manipulation.
Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. This is a distinct concern in the livestock industry.
In recent years, numerous courts have addressed the issue of whether the statutory language requires a producer to prove that a packer’s conduct had an adverse impact on competition. For example, in late 2001, a nationwide class action lawsuit was certified against Iowa Beef Processors (subsequently acquired by Tyson Fresh Meats, Inc.) on the issue of whether Tyson’s use of “captive supply” cattle (cattle acquired other than on the open, cash market) violated Section 202 of the PSA. Pickett v. IBP, Inc., No. 96-A-1103-N, 2001 U.S. Dist. LEXIS 22453 (M.D. Ala. Dec. 26, 2001). The class included all cattle producers with an ownership interest in cattle that were sold to Tyson, exclusively on a cash-market basis, from February 1994 through and including the end of the month 60 days before notice was provided to the class. The claim was that Tyson’s privately held store of livestock (via captive supply) allowed Tyson to need not rely on auction-price purchases in the open market for most of their supply. Tyson was then able to use this leverage to depress the market prices for independent producers on the cash and forward markets, in violation of the PSA. In early 2004, the federal jury in the case returned a $1.28 billion verdict for the cattle producers. However, one month later the trial court judge, while not disturbing the economic findings that the market for fed cattle was national, that the defendant’s use of captive supply depressed cash cattle prices and that cattle acquired on the cash market were of higher quality than those the defendant acquired through captive supplies, granted the defendant’s motion for judgment as a matter of law, thereby setting the jury’s verdict aside. The trial court judge ruled that Tyson was entitled to use captive supplies to depress cash cattle prices to “meet competition” and assure a “reliable and consistent” supply of cattle. Pickett v. Tyson Fresh Meats, Inc., 315 F. Supp. 2d 1172 (M.D. Ala. 2004). On appeal, the U.S. Court of Appeals for the Eleventh Circuit affirmed. Pickett v. Tyson Fresh Meats, Inc., 420 F.3d 1272 (11th Cir. 2005). The U.S. Supreme Court declined to hear the case. 547 U.S. 1040 (2006). Later the U.S. Court of Appeals for the Tenth Circuit reached the same conclusion. See Been, et al. v. O.K. Industries, 495 F.3d 1217 (10th Cir. 2007), cert. den., 131 S. Ct. 2876 (2011). The courts held that to establish a violation of §202 of the PSA, a plaintiff must show that defendant’s practice injured or was likely to injure competition. In other words, the courts held that to demonstrate that a monopsonist (e.g., a single buyer that significantly controls the market) engaged in unfair practices, the seller must show that the buyer’s practices threatened to injure competition by arbitrarily decreasing prices paid to sellers with likely effect of increasing resale prices.
Most of the other courts that have considered the issue have also determined that Section 202 of the PSA requires a producer to prove that a packer’s conduct adversely impacted competition. See, e.g., London v. Fieldale Farms Corp., 410 F.3d 1295 (11th Cir. 2005), cert. den., 546 U.S. 1034 (2005); Adkins v. Cagle Foods, JV, LLC, 411 F.3d 1520 (11th Cir. 2005); Terry v. Tyson Farms, Inc., 604 F.3d 272 (6th Cir. 2010), cert. den., 131 S. Ct. 1044 (2011). While the United States Court of Appeals for the Fifth Circuit, in a contract poultry production case, ruled that the plain language of Section 202 does not require a plaintiff to prove an adverse effect on competition, the court granted en banc review with the full court later reversing the 3-judge panel decision. Wheeler, et al. v. Pilgrim’s Pride Corp., No. 07-40651, 2009 U.S. App. LEXIS 27642 (5th Cir. Dec. 15, 2009).
In 2009, contract poultry growers in Texas, Arkansas, Oklahoma and Louisiana brought a PSA price manipulation case against the company that provided them with chicks, feed, medicine and other inputs. City of Clinton v. Pilgrim’s Pride Corporation, 654 F. Supp. 2d 536 (N.D. Tex. 2009). The company had filed for Chapter 11 bankruptcy and, as part of reorganizing its business activities closed certain facilities and terminated some grower contracts. The terminated growers claimed the defendant’s actions violated Section 192(e) of the PSA as actions that had the effect of manipulating the price of chicken by terminating those growers that were not near another poultry integrator so that they couldn’t sell their chickens to one of the defendant’s competitors, and terminating those growers who would not upgrade their chicken houses to include cool-cell technology even though not required by grower contracts. While the court held that the defendant could have a legitimate business reason for its decisions and might be able to show that the plaintiffs were not harmed by its actions, the court determined that the plaintiffs’ pleadings were sufficient to survive a motion to dismiss. In addition, the court held that the Texas growers had posed legitimate claims under the Texas Deceptive Trade Practices Act. In the subsequent bankruptcy proceeding, the bankruptcy court also held that the chicken supplier did not violate Section 192 of the PSA when it sought to reduce the supply of chicken on the commodity market by curtailing production in geographic areas where the supplier controlled the market. The court reasoned that the supplier closed plants and terminated particular grower contracts with the business purpose of trying to avoid going out of business, and that such conduct was more beneficial than detrimental to competition because if the supplier had gone out of business competition would have been lessened. In re Pilgrim’s Pride Corp., et al., 448 B.R. 896 (Bankr. N.D. Tex. Mar. 2, 2011). In a later proceeding in the same case, the court ruled on the claim that the supplier had violated Section 192 of the PSA when the supplier induced the growers to sign a new contract that allowed the supplier to terminate the contract for “economic necessity.” The court held that the growers failed to establish that the supplier had engaged in the kind of unfair or deceptive acts that Section 192 prohibited. The court held that the “economic necessity” clause was valid and enforceable because it provided flexibility and efficiency that the PSA encouraged and because the supplier had a valid business reason for utilizing the clause. In re Pilgrim’s Pride Corp., et al., No. 08-45664 (DML), 2011 Bankr. LEXIS 960 (N.D. Tex. Mar. 24, 2011).
In June of 2010, the USDA issued proposed regulations providing guidance on the handling of antitrust-related issues under the PSA. 75 Fed. Reg. No. 119, 75 FR 35338 (Jun. 22, 2010). Under the proposed regulations, "likelihood of competitive injury" was defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue. The regulations eventually made it into the form of an Interim Final Rule but were later withdrawn. 82 FR 48594 (Oct. 18, 2017).
The current request that the DOJ investigate the meatpacking industry is nothing new. As noted, investigations of the industry have been going on for over 130 years. A good case can be made that the courts have not carried out the legislative intent of the PSA provision concerning price manipulation.
Wednesday, May 6, 2020
On April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.htmlI published a detailed article on this blog concerning the CARES Act and, in particular, the Paycheck Protection Program (PPP). The PPP is an extension of the existing Small Business Administration (SBA) 7(a) loan program for a “qualified small business” with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirement that the borrower cannot find credit elsewhere. The purpose of the program is to support small businesses and help support their payroll during the coronavirus situation. In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans.
Over the past six weeks, the U.S. Treasury Department and the SBA have been issuing guidance concerning various aspects of the CARES Act, including the PPP. In spite of all of the guidance, questions remain for farmers and ranchers.
Lingering questions and issues surrounding the PPP – it’s the topic of today’s post.
Is Ag Eligible?
After some initial questions concerning whether farming and ranching businesses qualified for the PPP, the SBA issued an Interim Final Rule and an FAQ clarifying that ag businesses are eligible upon satisfying certain requirements. Unfortunately, while ag businesses are eligible apparently some lenders were apparently advising farmers that participation in the PPP would either reduce their USDA farm subsidies or eliminate their eligibility for them. That is not true. There is no basis for reaching that conclusion based on the statutory language. Some lenders were also apparently informing farmers that they wouldn’t be eligible for the ag part of the CARES Act Food Assistance Program. Again, there is no basis for that conclusion.
Other Areas of Concern
Loss on Schedule F? While the SBA has clarified that Schedule F income can be used for computing loan eligibility, the SBA has taken the position that a loss on line 34 of Schedule F disqualifies the farm/ranch taxpayer from loan eligibility based on earnings. Thus, such a farmer can only qualify for a PPP loan based on employee payroll costs (if any). That’s a harsh rule as applied to farmers and ranchers – particularly smaller operations that don’t have employees. Income that shows up on a form other than Schedule F doesn’t count toward for purposes of loan computation. While this could be changed in the future, the present position of the SBA is that eligible income is only that subject to self-employment tax.
Passive rental income. As noted above, the SBA position is that loan eligibility is tied to self-employment earnings. Apparently, that position means that rental income that is not reported on Schedule F fails to qualify (such as that reported on either Schedule E or on Form 4835).
Partnerships. For a partnership, PPP loan filing is at the partnership level. Thus, a partner is precluded receiving a loan at the partner level. A partnership can count all employee payroll costs for loan computational purposes and all self-employment income of partners reported on line 14a of Schedule K/K-1. That amount is then reduced by any I.R.C. §179 expense deduction claimed; unreimbursed partnership expenses claimed, and depletion claimed on oil and gas properties. The result is then multiplied by 92.35% to arrive at net self-employment earnings. If the final amount exceeds $100,000, it is to be reduced to $100,000. Whether that same computational approach applies to a Schedule F farmer (or Schedule C filer) is unclear. Relatedly, it’s unclear whether the ordinary income of manager-managed LLCs where self-employment tax is reduced counts toward the PPP loan computations purposes. Likewise, if a taxpayer has an interest in more than one partnership that are treated as self-employed entities, a question remains as to whether each entity can qualify for a loan or whether the $100,000 compensation limit must be allocated among the partnerships. The same lack of clarity applies to LLCs taxed as a partnership.
Commodity wages. In computing eligible wages, S or C corporations are only allowed to use taxable Medicare wages & tips from line 5c of Form 941 (Employer’s Quarterly Federal Tax Return). These wages are subject to FICA and Medicare taxes. If eligible wages must be subject to FICA and Medicare tax, agricultural commodity wages will not be eligible. Thus, the question is whether Form 943 (Employer’s Annual Federal Tax Return for Agricultural Employees) filers are to be treated as Form 941 filers.
Payroll costs. Certain sectors of the agricultural economy hire a significant amount of H2A workers. Recent guidance of the SBA and the Treasury indicate that wages paid to an H2A worker can count as eligible “payroll costs” if the worker satisfies the “principle place of residence” test under the Internal Revenue Code – at least 183 days present in the U.S. during the year. That would seem to mean that H2A workers in the U.S. year-round will also qualify. What’s not clear is whether wages paid to H2A workers count even if ultimately the worker is to return to the worker’s home country.
Loan forgiveness. As I noted in my article of April 1, https://lawprofessors.typepad.com/agriculturallaw/2020/04/disasteremergency-legislation-summary-of-provisions-related-to-loan-relief-small-business-and-bankruptcy.html loan proceeds that are forgiven and are not included in the recipient’s income do not give rise to deductible expenses by virtue of I.R.C. §265. On April 30, the IRS agreed. I.R.S. Notice 2020-32. Now certain members of the Congress are putting pressure on the I.R.S. to change its position. Another area needing clarification is how the amount of the loan that is forgiven is to be computed for a sole proprietor or self-employed taxpayer – is it based on eight weeks of self-employment income in 2019 plus qualified expenses, or is it simply limited to eight weeks of self-employment income? Is employer compensation counted as “wages”?
Bankruptcy. Can a debtor in reorganization bankruptcy apply for a PPP loan and receive funds upon satisfying the requirements for a loan? The answer, at least according to one bankruptcy court, is “yes.” In re Springfield Hospital, Inc., No. 19-10283, 2020 Bankr. LEXIS 1205 (Bankr. D. Vt. May 4, 2020). This is an important development for small businesses and farming operations.
The uncertainties surrounding the PPP are largely a result of the legislation being crafted in a rush without numerous hearings and vetting of the statutory language and thought being given to related impacts of the statutory provisions. Since enactment of the CARES Act in late March, guidance from the SBA and the Treasury/IRS has largely been of the non-substantial authority type. It’s not binding on the IRS or taxpayers. Unless the unclear aspects of the PPP are clarified substantially, it could mean that litigation could arise and be ongoing into the future.