Wednesday, April 1, 2020
Disaster/Emergency Legislation – Summary of Provisions Related to Loan Relief; Small Business and Bankruptcy
The disaster/emergency legislation enacted in late March is wide-ranging and far-sweeping in its attempt to provide economic relief to the damage caused by various federal and state “shut-downs” brought on by a widespread viral infection that originated in China in late 2019 and has spread to the United States. The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provides relief to small businesses and their employees, including farmers and ranchers, as well as to certain students. Some states have also acted to temporarily stop mortgage foreclosures.
I am grateful to Joe Peiffer of Ag and Business Legal Strategies located in Hiawatha, Iowa, for his input on some of the topics discussed below.
Recent disaster/emergency legislation related to loan relief, small business and bankruptcy – it’s the topic of today’s post.
Deferral of Student Loan Payments
The CARES Act provides temporary relief for federal student loan borrowers by requiring the Secretary of Education to defer student loan payments, principal, and interest for six months, through September 30, 2020, without penalty to the borrower for all federally owned loans. This provides relief for over 95 percent of student loan borrowers.
The CARES Act makes the following changes to the bankruptcy Code:
- A one-year increase in the debt limit to $7.5 million (from $2.73 million) for small businesses that file Chapter 11 bankruptcy. For one year after date of enactment, following the bill’s enactment, the measure temporarily excludes federal payments related to COVID-19 from income calculations under Chapter 11 bankruptcy proceedings. It would also allow debtors experiencing hardship because of COVID-19 to modify existing bankruptcy reorganization plans.
- Individuals and families currently undergoing Chapter 13 bankruptcy may seek payment plan modifications if they are experiencing a material financial hardship due to the virus, including extending payments for up to seven years after the due date of the initial plan payment. This provision expires one year after date of enactment.
- “Income” for Chapter 7 and Chapter 13 debtors does not include virus-related payments from the federal government. This provision expires one year after date of enactment.
- For Chapter 13 debtors, “disposable income” for purposes of plan confirmation does not include virus-related payments. This is also a one-year provision.
“Small Employer” Relief
The CARES Act provides qualified small businesses various options.
- Immediate SBA Emergency Economic Injury Disaster Grants. These $10,000 grants (advances) are to be used for authorized costs such as providing paid sick leave; maintaining payroll to retain employees; meeting increased material costs; making rent or mortgage payments; and repaying obligations which cannot be met on account of revenue losses. The grants are processed directly through the Small Business Association (SBA), but the SBA may utilize lenders (that are an SBA authorized lender) for the processing and making of the grants. A grant applicant may request an expedited disbursement. If such a request is made, the funds are to be disbursed within three days of the request. The CARES Act also removes standard program requirements including that the borrower not be able to secure credit elsewhere or that the borrower has been in business for at least a year, as long as the business was in operation as of January 31, 2020.
- Traditional SBA Economic Injury Disaster Loans (EIDL). The CARES Act expands this existing program such that the SBA can provide up to $2 million in loans to meet financial obligations and operating expenses that couldn’t be met due to the virus such as fixed debts, payroll, accounts payable and other bills attributable to actual economic injury. The loans are available to businesses and organizations with less than 500 employees. The interest rate is presently 3.75 percent and cannot exceed 4 percent for small businesses that can receive credit elsewhere. Businesses with credit available elsewhere are ineligible. The interest rate for non-profits is 2.75%. The length of the loan can be for up to 30 years with loan terms determined on a case-by-case basis, based on the borrower’s repayment ability. Applications will be accepted through December of this year.
- Forgivable SBA 7(a) Loan Program Paycheck Protection Loans. The Paycheck Protection Loan Program (PPP) is an extension of the existing SBA 7(a) loan program with many of the existing restrictions on 7(a) loans waived for a set timeframe including guarantee and collateral requirements and the requirements that the borrower cannot find credit elsewhere. In addition, a small business loan borrower is eligible for loan forgiveness on existing SBA 7(a) loans. The 7(a) loan program is the SBA's primary program for providing financial assistance to small businesses. For borrowers with an existing 7(a) loan, the SBA will pay principal, interest, and any associated loan fees for a six-month period starting on the loan’s next payment due date. Payment on deferred loans start with the first payment after the deferment period. However, this relief does not apply to loans made under the PPP.
For purposes of the PPP, a “qualified small business” is defined as a business that does not have more than 500 employees or the maximum number of employees specified in the current SBA size standards, whichever is greater; or if the business has more than one location and has more than 500 employees, does not have more than 500 employees at any one location and the business' primary NAICS code starts with "72" (Accommodation and Food Service – e.g., hotels, motels, restaurants, etc.); or is a franchisee holding a franchise listed on the SBA's registry of approved franchise agreements; or has received financing from a Small Business Investment Corporation. Sole proprietorships and self-employed individuals (i.e., independent contractors) may qualify under this program. Additionally, certain I.R.C. §501(c)(3) organizations; qualified veterans’ organizations; employee stock ownership plans; and certain Tribal businesses are also eligible.
The terms and conditions, like the guaranty percentage and loan amount, may vary by the type of loan. The lender must be SBA-approved. The loan proceeds can be used for payroll; continuing group health care benefits; a mortgage or rent obligation; payment of utilities; and any other debt obligation incurred before the “covered period.” Under the PPP, the bank can lend up to 250 percent of the lesser of the borrower’s average monthly payroll costs (before the virus outbreak) or $10,000,000 (with some exclusions including compensation over $100,000). For example, if the prior year’s payroll was $300,000, the maximum loan would be $62,500 (total payroll of $300,000 divided by 12 months = 25,000 x 2.5 = $62,500). The SBA guarantee is 100 percent
The interest rate cannot exceed 4 percent. Payments, including principal, interest and fees can be deferred anywhere from six to 12 months, and the SBA will reimburse lenders for loan original origination fees. A borrower can then apply for loan forgiveness to the extent the loan proceeds were used to cover payroll costs, mortgage interest, rent and utility payments during the eight-week period following loan disbursement.
The borrower must have been in business as of February 15, 2020 and employed employees and paid salaries and taxes or had independent contractors and filed Form 1099-MISC for them. Guarantee fees are waived, and the loans are non-recourse to the borrower, shareholders, members and partners of the borrower. There is no collateral that is required, and the borrower need not show an inability to secure financing elsewhere before qualifying for financing from the SBA.
The SBA will pay lenders for processing loans under the Payroll Protection Program in an amount of 5 percent of the loan up to $350,000; 3 percent of the loan from $350,000 to $2 million; and 1 percent of loans of $2 million or more. Lender fees are payable within five days of disbursement of the loan.
A borrower under the PPP can apply for loan forgiveness equals the amount the borrower spends in the eight-week period after the loan origination date on the following items (not to exceed the original principal amount of the loan): payroll costs (not to exceed $100,000 of annualized compensation per employee); payments of interest on any mortgage loan incurred prior to February 15, 2020; payment of rent on any lease in force prior to February 15, 2020; and, payment on any utility for which service began before February 15, 2020. The amount forgiven is not considered taxable income to the borrower. Documentation of all payment received under the PPP is necessary to receive forgiveness. Any amount that remains outstanding after the amount forgiven is to be repaid over a term not to exceed 10 years.
The amount forgiven will be reduced proportionally by any reduction in the number of employees retained as compared to the prior year. The proportional reduction in loan forgiveness also applies to reductions in the pay of any employee. The reduction if loan forgiveness applies when the reduction of employees or an employee’s prior year’s compensation exceeds 25 percent. It is increased for wages paid to employees that are paid tips. A borrower will not be penalized by a reduction in the amount forgiven for termination of an employee made between February 15, 2020 and April 26, 2020, as long as the employee is rehired by June 30, 2020.
A taxpayer that receives a PPP loan is ineligible for the Employee Retention Tax Credit. (discussed next).
- Employee Retention Credit. If a government order requires an employer to partially or fully suspend operations due to the virus (there is no statutory definition of “partially” or “fully”), or if business gross receipts have declined by more than 50 percent as compared to the same quarter in the immediately prior year, the employer can receive a payroll tax credit equal to 50 percent of employee compensation (“qualified wages”) up to $10,000 (per employee) paid or incurred from March 13, 2020 and January 1, 2021. For employers with greater than 100 full-time employees, qualified wages are wages paid to employees when they are not providing services (“services” is undefined) due to the virus-related circumstances described above. For eligible employers with 100 or fewer full-time employees, all employee wages qualify for the credit, whether the employer is open for business or subject to a shut-down order. Qualified wages must not “exceed the amount such employee would have been paid for working an equivalent duration during the 30 days immediately preceding such period.” As noted, the credit applies to the first $10,000 of compensation, including health benefits, paid to an eligible employee. The credit is provided for wages paid or incurred from March 13, 2020 through December 31, 2020.
The credit is allowed in each calendar quarter against Medicare tax or the I.R.C. §3221(a) tax imposed on employers at the rate of 50 percent of wages paid to employees during the timeframe of the virus limited to the applicable employment taxes as reduced by any credits allowed under I.R.C. §§3111(e) and (f) as well as the tax credit against amounts for qualified sick leave wages and qualified family leave wages an employer pays for a calendar quarter to eligible employees under the FFCRA. Thus, “applicable employment taxes” are reduced by the I.R.C. §§3111(e)-(f) credits and those available under the FFCRA. Then, the resulting amount is reduced by the Employee Retention Credit. If a negative amount results, the negative amount is treated as an overpayment that will be refunded pursuant to I.R.C. §6402(a) and I.R.C. §6413(b).
- Express Loan Program. The SBA’s Express Loan Program loan limit is increased to $1 million (from $350,000) until December 31, 2020. This program features an accelerated turnaround time for SBA review, with a response to applications within 36 hours.
- Tax Credit to Fund Paid Sick Leave. An employer with an employee that is paid sick-leave on account of the virus receives a FICA tax credit (employer share only) equal to the lesser of wages plus health care costs or $511 per day for up to 10 days. An employer providing sick leave to an employee with a sick family member, the credit is $200 per day, up to a maximum of $10,000.
Planning strategies. For businesses with immediate cashflow needs, a $10,000 EIDL grant can be applied for. Simultaneously, application can be made for PPL program loan. But, as noted, the basis for the separate loans and the costs being paid with each loan are different. An application can then be made seeking loan forgiveness. If this approach is inadequate, a traditional EIDL loan can be applied for. Also, if the business has sufficient cashflow, one of the FICA/Medicare tax credit options can be considered. Also, for employers with employees impacted by the virus or are caring for affected family members, the sick leave credit or the employee retention credit can be utilized if business operations were suspended or if gross receipts declined substantially.
The CARES Act contains many provisions that small employers can utilize to bridge the economic divide created by the government reaction to the virus. As the new programs are implemented rules will be developed that should address presently unanswered questions. The SBA has up to 30 days following the enactment of the CARES Act to issue regulations implementing and providing guidance on certain CARES Act provisions. In addition, the Treasury Department is required to issue regulations implementing and providing guidance under many CARES Act provisions. Issuance of regulations and guidance could delay loan approval and disbursement or modify/waive certain loan requirements.
The disaster/emergency legislation also made numerous tax changes. Those will be addressed in a future post.
Friday, March 27, 2020
Farmers often store harvested grain at a grain elevator. The elevator may either be a private elevator or a cooperative. In either event a storer of grain fits the definition of a “warehouse.” As a warehouse, certain statutory and common law remedies exist for the warehouse to recover costs expended for drying and storing grain. These remedies sometimes come into conflict with the farmer’s lender that typically has a secured interest in the farmer’s grain and “proceeds thereof.”
Conflicting interests in stored grain – it’s the topic of today’s post
The Purchase of Farm Products – Special Rule
A creditor seeking to protect a security interest in farm products must comply with the “Farm Products Rule.” The 1985 Farm Bill (Food Security Act) created a set of rules that federalized the farm products rules that had been adopted in different forms in many different states. Under the federal rule, 7 U.S.C. §1631(e) of Food Security Act (FSA) (a.k.a. “Farm Products Rule”), states could either adopt a centralized filing system for security interests in farm products or an actual notice system. Presently, 33 states require actual notice and 17 utilize a central filing system.
The Farm Products Rule allows a buyer in the ordinary course to purchase a farm product free and clear unless the buyer has received notice of a security interest in the farm product within one year before purchasing the farm product, or the buyer has received a notice of a filed effective financing statement [EFS] from the Secretary of State’s office and the buyer has failed to fulfill any notified payment obligations.
The direct notice system requires that a secured creditor send the purchaser of farm products a written notice that lists the following: (1) the secured creditor’s name and address; (2) the debtor’s name and address; (3) the debtor’s social security number or taxpayer identification number; (4) a description of the farm products covered by the security interest and a description of the property; and (5) any payment obligations conditioning the release of the security interest.
The description of the farm products must include the amount of the farm products subject to the security interest, the crop year, and the county or counties in which the farm products are located or produced.
The centralized system requires secured parties to file an EFS with the Secretary of State’s office. The EFS contains basically the same information as the actual notice document of the direct notice system.
If a lender does not properly comply with the Farm Products Rule, the buyer of the farm products obtains title to the goods free and clear of the lender’s security interest. However, the lender still has a perfected security interest against the “proceeds” of the farm products if the security agreement provides that the security interest extends to the proceeds.
Under §7-209 of the Uniform Commercial Code (UCC), a warehouse (a grain storage facility – either a private elevator or ag cooperative) has a lien against the bailor (the farmer) on the goods in the warehouse’s possession for unpaid storage, drying and transportation charges. At its most basic, the lien is a specific lien that attaches to the goods that the warehouse holds, but it can expand to a general lien covering “like charges in relation to other goods.” See Official Comment 1 to Model Version of UCC §7-209. As a result, the warehouse is in a favorable position of having a lien on the goods to help defray the unpaid storage and drying costs and related transportation costs. That is the case when the goods are in the warehouse’s possession, and where the lien is a possessory lien such as the Iowa provision. See Iowa Code §554.7209. The lien is lost when the warehouse voluntarily delivers the stored grain. 7 U.S.C. §209(e). It is also lost if the warehouse unjustifiably refuses to deliver the goods. Id.
Does a farmer’s lender that has a prior perfected interest in “crops and proceeds thereof” under the Farm Products Rule have priority over a warehouse with respect to storage and drying costs on the farmer’s grain at the warehouse? Under §9-333 of the UCC the warehouse lien, as a possessory lien, has “priority over a security interest in the goods unless the lien is created by a statute that expressly provides otherwise.” In other words, UCC Article 9 provides that if the possessory lien derives from common law, or derives from a statute that is silent as to the lien’s subordination to existing security interests, the possessory lien has priority over a previously perfected security interest. See Official Comment 2 to Model Version of UCC §9-333. This means that when a warehouse asserts a lien under UCC §7-209 to secure storage and drying fees on stored grain, the lien derives by statute.
UCC §7-209(c) also contains language that could subordinate the warehouse lien because the lien is only “effective against any person that so entrusted the bailor with possession of the goods that a pledge of them by the bailor to a good-faith purchaser for value would have been valid.” UCC §7-209(c). Thus, the warehouse lien is ineffective as against the secured party unless the circumstances surrounding the farmer’s delivery of the grain to the warehouse was such that “a pledge by the [customer] to a good faith purchaser for value would have been valid.” Official Comment 3 to UCC §7-209. Similarly, the warehouse lien is ineffective against a prior perfected security interest of the lender unless the lender entrusted the farmer with possession of the goods that a pledge of the goods by the farmer would have given a “hypothetical bona fide pledgee” priority over the secured lender. Id.
Illustrative Warehouse Lien Scenarios
Non ag situations. In K Furniture Co v. Sanders Transfer & Storage Co., 532 S.W.2d 910 (Tenn. 1975), an individual bought household furniture on credit from the plaintiff for use in his home. He granted the plaintiff a purchase money security interest (PMSI) (which was properly perfected) to secure payment of the purchase price. About four months later, his wife put the furniture in storage with the defendant under a standard warehouse receipt. The husband then defaulted on the PMSI and the plaintiff sought to recover the furniture without paying the storage charge. The defendant asserted its lien rights under UCC 7-209 and the trial court ruled held that the lien beat out the prior perfected PMSI and dismissed the case. On appeal, the appellate court reversed. The appellate court noted that there was nothing in the record to indicate that the secured lender had “delivered or entrusted the furniture to [the wife] with the actual or apparent authority to store the furniture…”. There was also no evidence that the plaintiff acquiesced in the wife procuring any document of title. Thus, the plaintiff’s PMSI had priority over the warehouse lien. It is important to note, however, that the court did not comment on whether it’s holding would have been different if it had been the husband, as the actual buyer of the furniture, had placed the furniture in storage.
In re Sharon Steel Corporation, 176 B.R. 384 (Bankr. W.D. Pa. 1995), the debtor filed Chapter 11 bankruptcy. A credit agreement said that the debtor could not “create, enter into any agreement to create, or suffer to exist, nor shall it permit any of its Subsidiaries to create, enter into any agreement to create, or suffer to exist, any Lien upon, or with respect to, any of its or such Subsidiary's properties, whether now owned or hereafter acquired, or assign, or permit any of its Subsidiaries to assign, any right to receive income, except:…(i) Liens arising by operation of law in favor of materialmen, mechanics, warehousemen…in the Ordinary course of business which secure its obligations to such Person…”. A security agreement granted the creditor a security interest in substantially all of the debtor’s property and stated, in part, “the Grantor will not create, permit or suffer to exist, and will defend the Collateral against and take such other action as is necessary to remove, any Lien on the Collateral except Permitted Liens, . . .”. Some of the debtor’s inventory and equipment were stored with another party that was listed in an attached Schedule to the security agreement and that party sought relief from the automatic stay to sell the inventory in it’s possession to satisfy its warehouse lien which arose after the creditor had perfected its interest in the same goods.
The bankruptcy court held that the creditor’s interest in the debtor’s inventory was subordinate to the warehouse lien because, “under the loan documentation, the debtor was permitted to incur warehouseman’s … liens in the ordinary course of business, and that such liens were ‘permitted liens’ under the security agreement.” The court noted that by permitting the debtor to store inventory with the warehouses and permitting the debtor to incur warehouse liens in the ordinary course of business, the lender effectively permitted the debtor to transfer its inventory to the warehouses as security for the debtor’s payment of the liens. Thus, the lender’s prior perfected security interest was subordinate to the warehouse liens.
Ag situations. For a lender that has a UCC Article 9 perfected security interest in a farmer’s “crop and proceeds thereof,” does that security interest in “proceeds” cover storage and drying costs incurred by an elevator upon storage of the grain in the elevator that are deducted from the amount of that grain that is sold to the elevator? If the elevator deducts charges for storing and drying and remits the balance to the farmer’s lender, has the elevator committed conversion? What if the security agreement has potentially contradictory language stating that the farmer borrower shall not, “... permit the collateral to be subject to any lien” but that the farmer must “do, or cause to be done, any and all acts that may at any time be appropriate or necessary to…preserve and protect the collateral.” That language is contradictory when the borrower lacks on farm storage and drying facilities necessary to “preserve and protect” the creditor’s collateral.
Without question, the customary business practice of grain warehouses is to offset its storage and drying costs from the grain sale proceeds paid to farmer’s secured lender. That offset amounts to the collection of a possessory warehouse lien under Article 7. Does that lien beat out the prior perfected farmer’s lender? In reality, the battle between the farmer’s lender and the warehouse is not one over “proceeds” of the sale of grain. Storage and drying costs are not “proceeds” of the sale of grain because they are not “received” on the “sale…or disposition…” of the grain. Rather, they are costs that are covered by a possessory warehouse lien. While a secured creditor can lose is security interest in collateral and not lose it in the proceeds of the collateral, as noted, storage and drying costs are not proceeds.
This all means that the battle between the farmer’s lender and the elevator is one of priorities. A warehouse must comply with UCC Article 9 provisions applicable to a warehouse lien to have a valid competing interest to the farmer’s prior perfected lender in “crops and proceeds thereof.” Although the UCC Article 9 provisions on security interests are basically uniform in all the states adopting the UCC, the states are non-uniform with regard to the treatment of agricultural liens. Hence, the answer concerning the priority between perfected security interests and “perfected” agricultural liens will vary from state to state.
Common Law Applications
Even though a valid UCC warehouse lien might be subordinate to a previously perfected security interest, a common law possessory lien would not be. Under UCC §9-333, a possessory lien has priority over a security interest in the goods unless the lien is created by a statute that expressly provides otherwise.” Because a common law lien is not statutorily-based, it does not trigger subordination under UCC §9-333. Similarly, a non-UCC possessory storage lien created by a statute that does not expressly provide for subordination to a security interest should also defeat subordination.
For example, in Chart One Auto Finance v. Inkas Coffee Distributors Realty, 2005 WL 1097097 (Conn. Super. Mar. 10, 2005), a lender held a prior perfected PMSI in an automobile. The automobile’s owner stored the vehicle in a parking lot. The owner defaulted on the loan, and the secured lender demanded possession of the automobile from the parking lot. The parking lot refused to release the vehicle until its storage fees were paid. The secured lender sued the parking lot in replevin. The parking lot counterclaimed, arguing that its common-law and statutory-lien rights (including a UCC §7-209 lien) were superior to the secured lender’s lien. The court agreed, noting that state (CT) law recognized a common-law possessory lien for storage. That meant that the “unless” part of UCC §9-333 didn’t apply, and there was no statute that gave the perfected security interest holder priority over the possessory lien.
What About Equity?
The UCC also provides for the application of equitable principles when Article 9 is concerned. UCC §1-103 (b) states, "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.” As quoted in Ninth District Production Credit Association v. Ed Duggan, Inc., 821 P.2d 788 (Colo. 1991).
Interestingly, not included in the list of general principles of law that can supplement UCC priorities is the equitable principle of unjust enrichment. However, the leading ag-related case allowing an unsecured creditor to assert an equitable principle to prevail against a prior perfected secured creditor involved a claim of unjust enrichment that was utilized to defeat a conversion claim. In that case, Producers Cotton Oil Co. v. Amstar Corp., 197 Cal. App. 3d 638, 242 Cal. Rptr. 914 (1988), a farmer sold his beets to the defendant. The plaintiff had loaned money to the farmer and had a prior perfected security interest in the farmer’s sugar beet crop and its proceeds. The plaintiff had notified the defendant of its security interest and required the farmer to get the plaintiff’s written consent before selling his sugar beets. The farmer notified the plaintiff that he had agreed to sell his beets to the defendant and the sale contracts specified that the defendant would deduct from the sales price amounts for seed, dirt haul, curly top virus assessment and California Beet Growers Association Dues. Harvesting costs were not mentioned. An employee of the plaintiff was in the fields during harvest, and made no objection. Net proceeds from the sale of the beet crop were paid to the plaintiff, and the plaintiff sued for conversion claiming that the deductions violated its security interest. The trial court disagreed, and the appellate court affirmed finding that the plaintiff had been unjustly enriched as a result of implied consent and prior course of dealing. See also Humboldt Trust and Savings Bank v. Entler, 349 N.W.2d 778 (Iowa 1984); Parkersburg State Bank v. Swift Independent Packing Company, 764 F.2d 512 (8th Cir. 1985).
Clearly, where a prior perfected lender has knowledge (actual or constructive) of services rendered to its collateral that could give rise to a warehouse lien, equitable principles would give priority to the lienholder. See, e.g., Peoples Trust and Savings Bank v. Security Savings Bank, 815 N.W.2d 744 (Iowa 2012). That would be the case even if the security agreement between the lender and the farmer does not allow the farmer to allow the collateral to become subject to a lien. That is particularly the case when the services rendered that are subject to the lien add value to the collateral (or prevents loss) that the secured party benefits from. See also 11 U.S.C. §557(h)(1). A key point is that it’s simply not plausible for an ag lender in an ag state (such as Iowa, for example) to claim lack of knowledge that grain delivered to an elevator incurs storage and drying fees that will be deducted from the proceeds of sale when the crop is later sold to the elevator. That has been a longstanding industry practice. Thus, a warehouse lien can be superior to a prior perfected security interest in situations involving industry practice coupled with actual, constructive or implied knowledge or consent in situations where technical compliance with the UCC is not present.
The conflict between the security interest of a lender in “proceeds” of crops of a farmer and a warehouse that stores the crops is generally decided in favor of the farmer’s prior perfected lender. However, a warehouse lien may prevail over a prior perfected security interest if the lender consented via the loan agreement or otherwise to the farmer’s placement of the harvested grain in storage with the warehouse. In that instance, the hypothetical “good faith purchaser” or “bona fide pledgee” requirements of UCC §7-209 could be met. In addition, a warehouse might prevail over the farmer’s prior perfected lender via the common law or a statute that gives the warehouse an additional possessory storage lien not subordinated under UCC §9-933. That could also be the result based on equitable principles. Can these principles be altered by contract? Basically, a contract (security agreement) cannot waive a statutory provision unless the statute allows for it; it can waive the common law (either precedent or principle) unless it would violate public policy; and it can waive an equitable principle if doing so is not unconscionable.
Wednesday, March 25, 2020
The Tax Cuts and Jobs Act (TCJA) has made estate and business planning much easier for most farm and ranch families. Much easier, that is, with respect to avoiding the federal estate tax. Indeed, under the TCJA, the exemption equivalent of the unified credit is set at $11.58 million per decedent for deaths in 2020, and with an unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax. The TCJA also retains the basis “step-up” rule. That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death.
But, with the slim chance that federal estate tax will apply, should estate and business planning be ignored? The answer is “no” if the desire is to keep the farming or ranching business in the family.
The basic estate planning strategies for 2020 and for the life of the TCJA (presently, through 2025) – that’s the topic of today’s post.
Existing plans should focus on avoiding common errors and look to modify outdated language in existing wills and trusts. For example, many estate plans utilize "formula clause" language. That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction. The intended result of the language is to cause the “credit shelter” trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption, and create a life estate in the trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon the surviving spouse’s subsequent death. As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.
It’s also important to have any existing formula clauses in current estate plans reviewed to ensure the language is still appropriate given the increase in the federal exemption amount. It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.
In addition, for some people, divorce planning/protection is necessary. Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection. Likewise, consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and create qualifying deductions for the entity. The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits. In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for farmers and ranchers with wealth that is potentially subject to federal estate (and gift) tax.
For the vast majority of family farming and ranching operations, it is not beneficial from a tax standpoint to make gifts during life. Gifted property provides the donee with a “carryover” income tax basis. I.R.C. §1015(a). A partial basis increase can result if the donor pays gift tax on the gift. I.R.C. §1015(d). If the property is not gifted, but is retained until death the heirs will receive a income tax basis equal to the date of death value. I.R.C. §1014. That means income tax basis planning is far more important than avoiding federal estate tax for most people. But, some states tax transfers at death with exemptions that are often much lower than the federal exemption. In those situations, planning to avoid or minimize the impact of state estate/inheritance tax should not be ignored. Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability
Other estate planning points to consider include:
- For life insurance, it’s probably not a good idea to cancel the policy before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance. For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
- Evaluate irrevocable trusts and consider the possibility of “decanting.” Decanting is the process of pouring the assets of one irrevocable trust into another irrevocable trust that contains more desirable terms. The rules surrounding trust decanting are complex concerning the process of decanting, but it can be a valuable option when unforeseen circumstances arise during trust administration.
- For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $15,000) and make sure to not have inflation adjusting references to the annual exclusion.
- For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
- While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate. This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP. Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
- At least through 2025, the choice of entity for the operational side of the farm/ranch business should be reevaluated in light of the 20 percent qualified business income deduction for non-C corporate businesses and the 21 percent income tax rate for C corporations.
Other Planning Issues
While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern. Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse.
Powers of attorney for both financial and health care remain a crucial part of any estate plan. For a farm family, the financial power should be in addition to the FSA Form 211, and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could.
For farms and ranches concerning about the business remaining viable into subsequent generations, the building of a management team is essential. This involves the development of management skills in the next generation, communication and recognizing various strengths and weaknesses of the persons involved. It’s also critical to ensure fair compensation for the inputs of labor and/or capital involved and adjust compensation arrangements over time as the changes in the inputs occur. Also, valuing ownership interests in a closely-held farming/ranching business is important. This can be largely achieved by a well thought-out and drafted buy-sell agreement as well as a first-option agreement.
While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary. Reviewing existing plans with an estate planning professional is important. Also, the TCJA is only temporary. The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation. If current law is not extended, it is estimated that the federal estate and gift tax exemption will somewhere between $6.5 and $7.5 million. While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $11.58 million amount.
One thing is for sure – a great deal of wealth is going to transfer in the coming decades. One estimate I have seen is that approximately $30 trillion in asset value will transfer over the next 30-40 years. That’s about a trillion per year over that timeframe. A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.
These topics will be addressed in detail at the Summer Ag Tax and Ag Estate/Business Conference in Deadwood, South Dakota on July 20-21. You can learn more about the conference and register here: http://washburnlaw.edu/employers/cle/farmandranchtax.html.
Monday, March 23, 2020
Section 404 of the Clean Water Act (makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” without obtaining a permit from the Secretary of the Army acting through the Corps of Engineers (COE). But, over the years, the Environmental Protection Agency (EPA) has used compliance orders to stymie the issuance of Section 404 permits. Another aspect of Section 404 permitting is the exemption for “normal farming activities.”
EPA compliance orders and “normal farming activities” – they are the topics of today’s post.
EPA Compliance Orders
As noted above, the EPA has issued "compliance orders" to landowners and other parties when it believes that the land in issue contains wetlands subject to its jurisdictional control. The issuance of a compliance order has the effect of freezing the affected party in place until a Section 404 permit is obtained. EPA has also taken the position that such orders do not give the affected party the right to a hearing or the ability to obtain judicial review because (in EPA's view) such orders are not "final agency action" that carries appeal rights with it. However, in Sackett v. United States Environmental Protection Agency, 566 U.S. 120 (2012), rev'g., 622 F.3d 1139 (9th Cir. 2010), a unanimous Supreme Court held that the CWA does not preclude pre-enforcement judicial review of EPA administrative compliance orders. Preclusion, the Court held, would violate constitutional due process requirements.
Under the facts of Sackett, the plaintiff had filled-in approximately one-half acre of their property with dirt and rock in preparation to build a house. The EPA issued a compliance order alleging that the parcel contained a wetland subject to the CWA permit requirements. The plaintiff sought a hearing with the EPA to challenge the finding, but EPA did not grant a hearing. The EPA continued to assert jurisdiction and the plaintiff sued in federal district court seeking injunctive and declaratory relief. The trial court granted the EPA's motion to dismiss for lack of subject matter jurisdiction because, according to the court, the CWA precludes judicial review of compliance orders before EPA starts enforcement action. The case was affirmed on appeal, but the U.S. Supreme Court reversed, noting that compliance order constitutes "final agency action" under the Administrative Procedure Act, and the landowners did not have an adequate remedy at law.
In 2015, the U.S. Court of Appeals for the Eighth Circuit held that a Corps of Engineers “preliminary determination” that the wetlands at issue on a tract that the owner sought to mine for peat had a “significant nexus” to a navigable river more than 100 miles away constituted a final agency action that could be appealed. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, 782 F.3d 994 (8th Cir. 2015), rev’g., 963 F. Supp. 2d 868 (D. Minn. 2013), cert. granted, United States Army Corps of Engineers v. Hawkes, Co., Inc., 136 S. Ct. 615 (2015). On further review, the U.S. Supreme Court unanimously affirmed. 136 S. Ct. 1807 (2016). The Court noted that the memorandum of agreement between the EPA and the Corps established that jurisdictional determinations are “final actions” that represent the government’s position, are binding on the Government in any subsequent federal action or litigation involving the position taken in the jurisdictional determination. When the landowners received an “approved determination” that meant that the government had determined that jurisdictional waters were present on the property due to a “nexus” with the Red River of the North, located 120 miles away. As such, the landowners had the right to appeal in court after exhausting administrative remedies and the government’s position take in the jurisdictional determination was judicially reviewable. Not only did the jurisdictional determination constitute final agency action under the Administrative Procedure Act, it also determined rights or obligations from which legal consequences would flow. That made the determination judicially reviewable.
Exemption for “Normal Farming Activities”
An exemption from the CWA § 404 permit requirement exists for “normal farming activities” such as plowing, seeding, cultivating, minor drainage, harvesting, upland soil and water conservation projects, construction or maintenance of farm ponds, irrigation ditches, maintenance of drainage ditches and construction or maintenance of farm roads not otherwise impairing navigable waters. 33 U.S.C. § 1344(f)(1). In general, COE regulations limit the exemption to pre-established farming activities that do not bring a new area into farming or require modifications to the hydrological regime. 33 C.F.R. § 323.4(a)(1)(ii). In addition, the EPA, not the COE, is the final authority to decide the scope of the exemption. 43 Op. Att'y. Gen. 15 (1979).
In general, the courts have narrowly construed the exemption to those situations where the agricultural activity is extremely minimal and no additional areas of “navigable waters” are brought into use. See, e.g., United States v. Huebner, 752 F.2d 1235 (7th Cir. 1985). As such, the exemption for agricultural activities applies only to prior established and continuing farming activities. For example, the conversion of wetlands to fish farming ponds has been held to constitute a new use that is ineligible for the “normal farming activities” exemption. Also, filling to stabilize riverbanks and re-channel streambeds has been held not to fall within the scope of the exemption as normal ranching or upland soil and water conservation practices.
Exempt activities are subject to a “recapture” provision that requires a permit if a discharge changes the use of the waters, impairs the waters' flow or circulation, brings an area of navigable waters into a use to which it was not previously subject, or reduces the reach of the waters. 33 U.S.C. § 1344(f)(2). Thus, only routine activities with relatively minor impacts on waters are exempt and the exemption will be lost if the activity is a new use and the activity reduces the reach or impairs the flow of water. For example, in United States v. Brace, 41 F.3d 117 (3d Cir. 1994), the court held that the “normal farming activity” exemption only applied to activities occurring on the particular site in question regardless of the relationship to the activities occurring on the remainder of the land. The site in issue adjoined cropland and was part of the same drainage system. In addition, the court held as irrelevant for CWA purposes a prior SCS classification of the drainage activities as a “commenced conversion.” The court also noted that even if the activities were held to be exempt, they would be subject to the recapture provision.
The same farming operation was still in court over a quarter of a century later over alleged wetland violations concerning their farming operations. All of the litigation stems from not being able to use the “normal farming activity” exemption. See United States v. Brace, No. 1:17-cv-00006 (BR), 2020 U.S. Dist. LEXIS 33423 (W.D. Pa. Feb. 27, 2020).
Farmers and ranchers have had to deal with the EPA and the COE for decades. The Section 404 permitting requirement of the CWA can be a difficult issue for some farming operations. However, it’s important to know that due process rights must be assured. It’s also important to understand the scope of the “normal farming activities” exemption from the permit rules. That can be a very useful exemption when needed.
Thursday, March 19, 2020
In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result. Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income. A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040.
Special rules apply to farm NOLs. Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA).
Farm NOLs – The Basics
Carryback rule. Until the TCJA changes, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years (or three years for a loss attributable to a federally declared disaster). I.R.C. §§172(b)(1)(F) and (h). An election to waive the five-year carryback resulted in a 2-year carryback. A “farming NOL” is defined as a the lesser of the NOL applicable for the tax year considering only income and deductions attributable to the farming business, or the NOL for the tax year.
Those were the rules in place through 2017. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. Determining whether a loss should be carried back two years instead of five depended on the farmer’s level of income in those carryback years and the applicable tax bracket.
Another beneficial rule can apply when an NOL is carried back to a prior year. Because two years back (as opposed to five years under pre-TCJA rules) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow the taxpayer to claim future depreciation deductions. This is the case, at least, on the taxpayer’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Under the pre-2018 rules, taxpayers could elect to forego an NOL carryback in favor of a carryforward (for 20 years). However, if a taxpayer elected not to carry a NOL back to offset income in prior years, the taxpayer was limited to carrying forward the NOL.
Impact of receiving farm subsidies. For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.
Excess business loss. An excess business loss (EBL) for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The NOL carried over from other years may not be used in calculating the NOL for the year in question. In addition, capital losses may not exceed capital gains. Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses. In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.
Post-2017 Tax Years
The TCJA made changes to how farmers can treat NOLs. For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year. For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC. In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form).
Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset). Technically, the NOL deduction is limited to the lesser of: (1) the aggregate of NOL carryforwards and carrybacks to the tax year, or (2) 80% of taxable income computed for the tax year without regard to the NOL deduction allowed for the tax year. I.R.C. §172(a).
Carryback issues. In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). Instead, under the TCJA, farmer NOLs can only be carried back two years. Non-farmers cannot carryback NOLs. As noted, NOLs that are carried back can only offset 80 percent of taxable income. However, NOLs that are carried forward will not expire after 20 years (as they did under prior law). Similar to the carryback rule, NOLs that are carried forward can only offset 80 percent of taxable income.
An individual taxpayer claiming a tax refund from an NOL carryback has the option of filing either Form 1045 or Form 1040X. The IRS instructions can be helpful in determining the best approach.
When filing an NOL carryback refund claim Form 1045 or 1040X can be filed. IRS transcripts and statements of account to verify the amounts reported for previous years can be helpful when preparing either Form. The Form 1045 and 1040X instructions also contain detailed lists of attachments to be included with each Form. Also, on Schedule A, an NOL must be included with the carryback claim.
If the taxpayer has multiple carrybacks to a tax year, taxable income is reduced (without regard to the NOL deduction) in the carryback year in the order in which incurred starting with the earliest year. After deducting an NOL, the resulting taxable income is used to determine the deductibility of any remaining NOL. NOLs from years beginning before 2018 can offset 100% of taxable income (without regard to the NOL deduction) in the carryback year whereas NOLs from post-2017 years can only offset 80% of taxable income (without regard to the NOL deduction) in the carryback year.
Note: When figuring a refund claim for an NOL carryback year, the applicable law is the tax law in effect for the carryback year not the tax law in effect for the NOL year.
Once the amount of the NOL deduction after carryback has been determined for the carryback year, the AGI that results after applying the NOL deduction is then used to recompute income or deduction items that are based on, or limited to, a percentage of AGI,
Note: In the case of a partnership or S corporation, the NOL rules are applied at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.
Carryover of unused NOL carryback. The amount of unused NOL carryback available for carryover requires determination of the taxpayer’s modified taxable income for the carryback year. Modified taxable income for this purpose is defined as the taxpayer’s taxable income with certain modifications. See Treas. Reg. §1.172-5; IRS Pub. 536, Net Operating Losses (NOLS) for Individuals, Estates, and Trusts. Any items that are affected by the taxpayer’s revised AGI after making some of the modifications must be re-figured using that revised AGI. The calculation can be accomplished via Form 1045, Schedule B.
NOL carryover. Taxpayers carrying back a farming loss, must first carry the entire farming loss to the earliest carryback year. Any unused farming loss is then carried back to the next earliest carryback year, and so on. If the carryback period is waived or the loss is not fully utilized in the carryback period, the unused NOL is carried forward indefinitely until it is fully utilized. An unused NOL is the sum of: (1) any farming loss less the amount of the farming loss that is deemed to be carried back; (2) any nonfarm NOL; and (3) any EBL for the NOL year.
Note: Procedurally, the unused NOL is carried forward to the first tax year after the NOL year. Any NOL not utilized in that year is carried forward to the next year and so on until the NOL is fully utilized.
Marital status changes. Additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward. In that case, only the spouse who had the loss can claim the NOL deduction. Moreover, for years when the couple file jointly, an NOL deduction is limited to the income of the spouse to whom it belongs. Therefore, a taxpayer filing a 2020 joint return with their spouse who later divorces can only carryback an NOL from a future year to offset his/her share of the taxable income reported on the 2020 joint return. Additionally, the refund for a person filing an NOL carryback claim against a joint return with a former spouse may be subject to limitations.
On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss. Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return. The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.
Change in filing status. Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years. A married couple who file jointly in the NOL year and the NOL carryback or carryover year, treat the NOL deduction as a joint NOL. If instead the couple file separately, then the spouse who sustained the loss takes the NOL deduction on their separate return.
When a married couple’s filing status differs between the NOL year and the NOL carryback or carryover year, special rules apply. If the couple filed separate returns in the NOL year but jointly in the carryback or carryforward year, then a separate NOL carryback/carryover is treated as a joint carryback/carryover to the carryback/carryover year. If the couple file jointly in the NOL year but separate returns in the carryback or carryforward year, then any joint NOL carryback/carryover is apportioned between the spouses based on the NOLs that would have resulted if the couple had filed separate returns in the NOL year.
Individual taxpayers report their NOL carryover as a negative figure on the “Other income” line of Schedule 1 (Form 1040) or Form 1040NR (line 21 for 2019). Estates and trusts include an NOL deduction on Form 1041, line 15b, for 2019.
For each NOL carryover, taxpayers should attach a statement to their tax return showing how the NOL deduction was figured as well as important facts about the NOL.
NOLs and Death
A NOL that has been carried forward is deductible on a decedent’s final income tax return. It cannot be carried over to a decedent’s estate. Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.
Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow. That's where the NOL rules come into play…and they get complex quickly.
Tuesday, March 17, 2020
The dramatic drop in the stock market over the last month has taken its toll on investments intended for use during retirement years. For example, the Dow Jones peaked at 29,551.42 on February 12, 2020, but had dropped to 20,188.52 at the close on March 16, 2020. This can cause a difficult tax issue for a decedent’s estate that faces federal estate tax liability by having the potential to trigger a higher than anticipated tax burden. But, there’s a valuation provision in the tax Code that can be beneficial – alternate valuation of I.R.C. §2032.
The alternate valuation provision for a federally taxable estate – it’s the topic of today’s post.
In general, property is valued for federal estate tax purposes as of the date of death. I.R.C. §2031(a). Unless an extension is filed, a federal estate tax return is due nine months after the date of the decedent’s death. However, the executor can make an election to value the estate within six months after death if the value of the property in the gross estate and the estate’s federal estate tax liability (including any generation-skipping transfers payable by reason of the decedent’s death – Treas. Reg. §20.2032-1(b)(1)) are both reduced by making the election. I.R.C. §2032(c); C.C.A. 201926013 (May 30, 2019). This is known as an alternate valuation election, and the election causes the estate’s property to be valued at six months after death or earlier if the property is disposed of before the end of the six-month period. I.R.C. §2032(a). In other words, property distributed, sold, exchanged or otherwise disposed of within six months of the decedent’s death is valued as of the date of the distribution, sale, exchange or other distribution. I.R.C. §2032(a)(1); Treas. Reg. §20.2032-1(a)(1). Any property not so disposed of is valued as of six months after death. I.R.C. §2032(a)(2). Post-death value changes due merely to a lapse of time are ignored and the date-of-death value is used. I.R.C. §2032(a)(3). If there is no numerically corresponding date six months after the decedent’s death, the alternate valuation date is the last day of the sixth month after death. Rev. Rul. 74-260, 1974-1 CB 275. For example, if the date of the decedent’s death was August 31, the correct alternate valuation date would be February 28 (or 29).
The election doesn’t create a direct issue with filing the federal estate tax return – it’s not due until nine months after the date of death. The only issue involved might be the shorter timeframe to get the estate assets valued if the election to use the alternate valuation date is made. Also, if the election is made, it is irrevocable (with a limited exception) and applies to all of the property included in the decedent’s gross estate. I.R.C. §2032(d)(1); Treas. Reg. §20.2032-1(b)(1). The election cannot be used as to only a portion of the property in the decedent’s estate. Id.
Income tax basis issues. If an alternate valuation election is made, the income tax basis of property that is acquired from the decedent is its value as of the applicable valuation date under the alternate valuation rules. I.R.C. §1014(a)(2); Treas. Reg. §1.1014-3(e). The adjusted basis of the property is the value as of the alternate valuation date, less any depreciation allowed or allowable from the time of the decedent’s death. Rev. Rul. 63-223, 1963-2 CB 100. If the estate extracts minerals and sells them during the alternate valuation period, gain or loss on sale is tied to their “in place” value on the date of sale (i.e., the alternate valuation date) without any reduction for depletion. Rev. Rul. 66-348, 1966-2 CB 433, as clarified by Rev. Rul. 71-317 CB 328. The “in place” value pegs the adjusted income tax basis.
Valuing deductions. With an alternate valuation election in place, the decedent’s estate is not entitled to an estate tax loss deduction for the amount by which an item of property included in the estate was reduced by virtue of the election. Form 706 instructions, p. 34 (Aug. 2019 version). If a set percentage of the decedent’s adjusted gross estate is bequeathed to charity, the estate’s charitable deduction is determined by using the value of the decedent’s adjusted gross estate as of the alternate valuation date. Rev. Rul. 70-527, 1970-2 CB 193. The same rule (in terms of using the alternate valuation date) applies to determining the amount of any marital deduction. I.R.C. §2032(b); Treas. Reg. §§20.2032-1(g); 20.2056(b)-4(a).
An alternate valuation election can be coupled with a special use valuation election. Rev. Rul. 83-31, 1983-1 CB 225.
Application of the Alternate Valuation Election
As indicated above, the decedent’s gross estate must be a taxable estate. Treas. Reg. § 20.2032-1(b)(1) (1958); Tax Reform Act of 1984, Sec. 1923(a), 98th Cong., 2d Sess. (1984). The purpose of making an alternate valuation election is to lessen the federal estate tax burden if values decline in the six-month period immediately following death. Consider the following example:
Example: Marcia, a widow, died on September 16, 2019, with a taxable estate of $15 million. At the time of her death she had an available estate tax exclusion of $11.40 million. Assume that the federal estate tax liability of Marcia’s estate, if her estate were valued as of the date of death, would be $1,440,000. Marcia’s estate consisted largely of publicly traded stock and, given the stock market plunge, was valued at $12 million on March 16, 2020 – six months after the date of her death. If the executor of Marcia’s estate elected alternate valuation, the resulting federal estate tax would be approximately $240,000. The election save’s Marcia’s estate $1,200,000 in federal estate tax.
As noted above, non-taxable estates cannot make an alternate valuation election. If an estate would not be subject to federal estate tax, an alternate valuation election could allow the estate’s heirs to obtain a higher income tax basis on property included in the gross estate if values had risen after death. That’s because of the income tax basis rule specifying that an asset included in a decedent’s estate receives an income tax basis equal to the asset’s fair market value in the recipient’s hands as of the date of death. Eligibility for an alternate valuation election requires that both the taxable value of the estate decline by making the election and the estate tax liability decline. If the value of the taxable estate drops during the six-month post-death period due to expenses being paid, no separate deduction is allowed for the expenses in computing the taxable estate. I.R.C. §2032(b).
The election is made by checking “Yes” on line 1 of Part 3 of Form 706 (the federal estate tax return) that is filed within one year after its due date (including extensions). I.R.C. §2032(d)(2); Estate of Eddy v. Comr., 115 T.C. 135 (2000). Thus, the election may only be made on the last estate tax return filed on or before the due date of the return (including extensions of time to file actually granted) or, if a timely return is not filed, the first estate tax return filed after the due date, provided the return is filed no later than one year after the due date (including extensions of time to file actually granted). Treas. Reg. §20.2032-1(b)(1). Application for an extension of time to make the election, or a protective election, can be made after the expiration of the one-year period from the return’s due date if the return is filed no later than one year after the due date (including extensions). Preamble to TD 9172, Jan. 3, 2005. A protective election allows the alternate valuation date to be used if it is subsequently determined that the transfer taxes upon death will be lower based on the alternate valuation rather than based on the date of death value of the gross estate. See, e.g., C.C.A. 201926013 (May 30, 2019).
When an alternate valuation election is made, the Form 706 must include: (1) an itemized description of all property in the estate on the date of death and the value of each item on that date; (2) an itemized disclosure of all distributions, sales, exchanges and other dispositions of property, and the date of each, during the six month period after the date of death; and (3) the value of each item of property on the valuation date under the election. Interest and rents accrued as of death and dividends declared on or before death that aren’t collected as of the date of death are to be separately stated. Treas. Reg. §20.6018-3(c)(6). Dispositions of estate property during the six-month post-death period must be substantiated. See, e.g., Treas. Reg. §20.6018-4(e).
The Matter of “Included” and “Excluded” Property
For most businesses, alternate valuation is straightforward. There is one value as of the date of death and a different value six months after death. However, in an agricultural estate many things occur during the six-month period immediately following the decedent’s death. For example, a decedent may have planted a crop shortly before death, which was harvested and sold within six months after death. Or perhaps the decedent had cows that were bred before the date of death and calved after death and were sold after the six-month period following death. When an alternate valuation election is made, not included in the estate’s valuation are any items that are income that the estate’s assets produce after the decedent’s death.
Help in determining whether these types of property are subject to alternate valuation invokes the concepts of “included” and “excluded” property. Included property is all property that is in existence at death that is part of the decedent’s gross estate. Included property is valued six months after death or as of the date of sale, whichever comes first. Treas. Reg. §20.2032-1(d). Thus, crops that are growing as of the date of death and are harvested and sold after death are valued as of the earlier of six months after death or the date of sale. Likewise, leased real estate or personal property and rents accrued to the date of the decedent’s death are included property. The underlying property and the accrued rents are to be valued separately. Rental amounts that accrue post-death and before the alternate valuation date are excluded property. If rent is paid in advance, it is to be treated similarly to advance payment of interest on obligations. Treas. Reg. §20.2032-1(d)(2).
Excluded property is property that is excluded from the gross value of the decedent’s estate under the alternate valuation election. Thus, income that is earned or accrued (whether received or not) after the date of the decedent’s death and during the alternate valuation period with respect to any property interest existing at the date of death is excluded property. This is the result unless such property is a form of included property itself or it represents the receipt of included property. Treas. Reg. §20.2032-1(d). For example, crops that are planted after death are ignored for purposes of alternate valuation. For property that exists as of the date of death and is disposed of gradually during the six-month period after death (such as silage that is fed during the six-month period following death), every day’s feeding is a disposition. Thus, a calculation must be made not only as to the value, but as to how much disappeared. The same is true of shelled corn, hay, or similar items. The inventory must show the disappearance over that time period, and some value must be attached to it.
The recent and dramatic decline in the stock market provides an opportunity for substantial estate tax savings for estate with the “right” set of facts. It’s all a matter of timing. For the time being, alternate valuation is “in vogue.”
Friday, March 13, 2020
Periodically on this blog I write about recent caselaw and IRS developments that farmers, ranchers and others should be aware about. The courts are constantly churning out cases that are important to agriculture and tax developments are always non-stop. It’s amazing how broad the reach is of the issues the courts and IRS address that touches agriculture in one way or another. Many of these issues may not be given much thought on a daily basis, but perhaps they should.
In today’s post, I look at a few more recent developments of relevance to agriculture – it’s the focus of today’s post.
IRS Loses Valuation Case
Grieve v. Comr., T.C. Memo. 2020-28
When interests in closely-held businesses are transferred, either by death or gift, and either federal estate or gift tax is involved, the valuation issue becomes highly relevant. For farms and ranches, blocks of non-controlling stock may be involved and the IRS may seek to apply a premium to the value of the stock to increase estate or gift taxes owed. Recently, the U.S. Tax Court shot down an IRS attempt to attach a premium to a gift of non-controlling stock among family members.
In the case, after the petitioner’s wife died, he formed two LLCs (Rabbit and Angus) for financial management and estate planning purposes. He then transferred some of the Class B shares of Rabbit to a grantor-retained annuity trust (GRAT) and the Class B shares of Angus to an irrevocable trust. The petitioner filed a 2013 gift tax return (Form 709) and attached appraisal reports that reported a taxable gift of nearly $10 million. The IRS rejected that valuation, claiming that the proper valuation was $17.8 million, and issued a notice of deficiency.
The Tax Court examined both appraisal reports, noting that the petitioner’s appraisal reports included independent analysis of the LLC shares using a combination of market and income approaches to determine the total value. Conversely, the Tax Court noted that the IRS included an assumption that selling the Class B share would encourage the petitioner’s daughter (who solely owned the Class A shares) to sell her 0.2 percent interest in the entities, which would increase the petitioner’s interests. However, the daughter testified that she would not be inclined to sell her interest, and if she were to sell, would seek a much higher premium that the IRS estimated. The Tax Court also determined that the IRS appraisal also relied on additional hypothetical scenarios that were inconsistent and insufficient to consider a change to the petitioner’s appraisal and the discounts concluded in the report. In addition, the Tax Court noted that the IRS appraiser failed to provide support for the valuations, and also did not provide evidence that his appraisal methodology was subject to peer review.
The Tax Court concluded that the IRS failed to provide sufficient evident to support its expert appraiser’s conclusion that the interests of the LLCs were undervalued and that the petitioner’s gifts of the assets to the two trusts were likewise undervalued. The Tax Court rejected the IRS position that the petitioner had underreported gift tax by $4.4 million and also rejected the IRS penalties of $600,000.
IRAs and the Constitution
Conard v. Comr., 154 T.C. No. 6 (2020)
So that people are disincentivized from using their retirement savings for things other than retirement, the IRS hits withdrawals before age 59-1/2 with a 10 percent penalty. Exceptions to the penalty apply, but even if a taxpayer fits within an exception the amount withdrawn still must be reported into income. Exemptions include distributions made post-death; because the account owner is total and permanently disabled, to cover qualified post-secondary education expenses; distributions made after being called to active military duty for 180 days; or within a year of a child’s birth or adoption.
The U.S. Tax Court recently dealt with a constitutional challenge to such penalty exemptions. In the case, the petitioner had not yet reached age 59-1/2 at the time the she received a distribution from a qualified retirement plan. Consequently, the IRS assessed the 10 percent early withdrawal penalty of I.R.C. §72(t). She sought review of the asserted tax deficiency and challenged the additional tax on the basis that the application of the tax to her early distribution violated the Constitution’s Fifth Amendment Due Process Clause because exceptions exist to the penalty that are applicable to taxpayers that haven’t reached age 59-1/2, such as for disability, etc.
The Tax Court disagreed, applying the rational basis test (low-level scrutiny) to evaluate the constitutionality of the Code provision. The Tax Court determined that test applied because the provision did not invade a substantive constitutional right or freedom or involve a suspect classification. As a result, the constitutionality of the provision could only be overcome by an explicit demonstration that the statute established hostile and oppressive discrimination against particular persons and classes. The Tax Court noted that the petitioner did not claim that the penalty provision concerned a substantive constitutional right or freedom or involved a suspect classification. Age is not a suspect classification for purposes of equal protection. Thus, the provision was presumed constitutional if it had a legitimate governmental purpose. The Tax Court noted that Committee Reports concerning the provision provided that the statute aimed “to provide means for financing retirement” and that penalties for early withdrawals were “designed to insure that retirement plans will not be used for other purposes.” An exemption from the penalty for disability, for example, satisfied a legitimate objective of encouraging taxpayers to provide for times of inability to work.
Huge FBAR Penalty Imposed
In recent years, some farmers and ranchers have started operations in locations other than the United States. Others may have bank accounts in foreign jurisdictions. Still others may serve as an agent under a power of attorney for someone that has a bank account in a foreign jurisdiction. In that event, every year, under the Bank Secrecy Act, anyone that owns or has an interest in or signature authority over certain foreign accounts such as bank accounts, brokerage accounts and mutual funds, must report the account(s) by filing a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114. The proper box must also be checked on Schedule B of Form 1040. Failure to do so can trigger a penalty. Willful failure to do so can result in a monstrous penalty. A recent case points out how bad the penalty can be for misreporting.
In the case, the taxpayer had a foreign bank account with aggregate highest balance of $1.9 million, $770,000 and $1.76 million for the three tax years at issue. Form 1040, Schedule B contains a question with a box to be checked asking whether the taxpayer had a financial interest in or signature authority over a financial account located in a foreign country. The box on Schedule B was checked “No” which was the default in the software that the return preparer used. The taxpayer also did not file an FBAR Form for any of the three years. The FBAR Form is required to be filed when the aggregate account balance exceeds $10,000.
The IRS claimed that the taxpayer had constructive knowledge of his reporting requirements by signing his tax returns which included a reference to the FBAR on Schedule B, and that the naming his sister's Canadian address on the accounts was an act of concealment. The taxpayer argued that he was simply negligent and there was no will failure to file the FBARs. The Court examined the definition of willfulness for purposes of FBAR filing and concluded that the taxpayer could have easily determined the need to file the FBAR. Accordingly, the court held that the taxpayer willfully failed to file the FBAR Form and assessed penalties for the years at issue in the amount of $988,245.
Lakes Have Constitutional Rights?
Drewes Farms Partnership v. City of Toledo, No. 3:19 CV 434, 2020 WL 966628 (N.D. Ohio Feb. 27, 2020) No. 3:19 CV 434 2020 U.S. Dist. LEXIS 36427 (N.D. Ohio Feb. 27, 2020)
The genesis of this case actually began in a bar in Toledo (no word on whether the bar was across from the depot). Apparently, the inebriated were commiserating over the pollution of Lake Erie. Ultimately, the ideas of that night got formulated into a ballot question at a special election for the citizens of Toledo concerning whether Lake Erie should be granted legal rights that people have. It was the first rights-based legislation in the U.S. aimed at protecting an ecosystem – Lake Erie, its tributaries and the species that live there.
When election time came, sufficient Toledo citizens voted to add the “Lake Erie Bill of Rights” (LEBOR) to the city’s charter in early 2019. The LEBOR prohibited any infringement of the “rights” of Lake Erie to “exist, flourish, and naturally evolve” without explaining the kind of conduct that would infringe those “rights.” The plaintiff, a farming operation that grows crops in four counties near Toledo and Lake Erie, sued to invalidate the LEBOR on constitutional grounds for lack of due process as being void for vagueness. The court agreed and vacated the LEBOR in its entirety.
There are always developments involving agriculture. It’s good to stay informed.
Wednesday, March 11, 2020
Normally, federal estate tax is due nine months after death. For estates that are illiquid, such as many taxable farm and ranch estates, there is a useful option. Upon satisfying two requirements, the estate executor can elect under I.R.C. §6166 to pay the federal estate tax attributable to the decedent’s interest in a closely-held business in installments over (approximately) fifteen years.
The two eligibility tests that must be satisfied for an estate to qualify for installment payment of federal estate tax are: (1) the decedent must have an interest in a closely-held business (I.R.C. §6166(a)(1)); and (2) the interest in the closely held business must exceed 35 percent of the value of the decedent’s adjusted gross estate. I.R.C. §6166(a)(1). An “interest in a closely-held business” means an interest as a proprietor in a trade or business carried on by a proprietorship; an interest as a partner in a partnership carrying on a trade or business; or stock in a corporation carrying on a trade or business. I.R.C. §6166(b)(1). Only those assets actually utilized in the trade or business are to be included in the decedent's interest in the closely held business. Treas. Reg. §20.6166A-2(c).
Does ownership of real property constitute a trade or business? That’s an important question for farmers and ranchers. Real estate (and associated real property structures) often is the largest asset (in terms of value) of the gross estate.
Owning real property as a “trade or business” for purposes of deferring federal estate tax – it’s the topic of today’s post.
Farming Activities, I.R.C. §6166 and “Trade or Business”
Real estate that the decedent holds passively will not qualify for deferral under I.R.C. §6166. For example, a mere royalty interest in oil and gas property is insufficient to constitute a trade or business. Rev. Rul. 61-55, 1961-1 C.B. 713. The real estate must be used by the decedent in the active conduct of a trade or business. Over the years, the IRS has provided guidance on where the line is drawn between the passive holding of real estate and the use of it in the trade or business of farming. In addition, the determination of whether the decedent had an interest in a closely-held business is made immediately before the decedent’s death. I.R.C. §6166(b)(2)(A).
1975 IRS Ruling. In 1975, the IRS laid out its position on the determination of a trade or business in a farm context under I.R.C. §6166. Rev. Rul. 75-366, 1975-2 C.B. 472. The ruling, is still applicable for determining the existence of a trade or business in the I.R.C. §6166 context. The facts of Rev. Rul. 75-366 involved a crop-share lease where the decedent as landlord paid 40 percent of the expenses incurred under the lease and received 40 percent of the crops. The IRS found it critical that the decedent’s income under the lease was based on the farm’s productivity rather than simply being a fixed rental amount. The decedent had also actively participated in farm management decisionmaking concerning the crops to plant and how the farming operation should participate in federal farm programs. The decedent also made trips to the farm on almost a daily basis to inspect the crops and discuss farming operations with the tenant farmers. He also sometimes delivered supplies to the farm. Based on these facts, the decedent’s involvement was deemed sufficient to constitute an interest in a closely held business for purposes of I.R.C. §6166 because the decedent was engaged in the trade or business of farming. The ruling also pointed out that a “plain vanilla” cash rent lease would be unlikely to constitute an interest in a trade or business.
1980s private rulings. The IRS followed-up its 1975 Revenue Ruling with several private letter rulings in the early 1980s. In Priv. Ltr. Rul. 8020101 (Feb. 25, 1980), the IRS concluded that a 97-year old farmer did not use his farmland in the trade or business of farming where he had given his livestock to his children less than a year before he died and then “leased” his land to them. He was not actively farming at the time of his death due to his health. The IRS based its conclusion on the basis that the livestock had been gifted before death and the children were not required to make rental payments for the land (in return for paying the real estate taxes and operating costs). They also didn’t manage the farm as the decedent’s agents. It’s interesting to note that for the year of the decedent’s death, the federal estate tax exemption was $134,000 and the maximum estate tax rate was 70 percent.
Contrast that private letter ruling with Priv. Ltr. Rul. 8020143 (Feb. 26, 1980). Here, the IRS determined that a decedent was engaged in the trade or business of farming where he cultivated, operated and managed farms for profit, either as the owner or tenant, and the rental income that he received was based on production (crop-share) rather than being a fixed amount. The decedent paid all of the property taxes, paid for maintaining fences and structures on the farm, and also paid for ditching, draining and general farmland maintenance. He also paid a share of farm input costs and other operating costs. He was also engaged in management decisions by determining what crops would be planted, the timing of planting and how the crops would be marketed. His decisionmaking involvement directly affected his economic return.
In the context of I.R.C. §6166, the management activities of an employee or agent are imputed to the owner of the land. For example, in Priv. Ltr. Rul. 8133015 (Apr. 29, 1981), the decedent operated two farms until becoming incapacitated by a stroke almost five years before he died. At that time, the decedent’s wife began actively managing the farms, but neither the decedent nor the decedent’s spouse performed any physical labor on the farms. The farms were crop-share leased to different tenants. The IRS determined that the decedent owned an interest in the farms via his wife (she was deemed to be managing the farms on his behalf) and was deemed to be engaged in the trade or business of farming.
A similar result was reached in Priv. Ltr. Rul. 8244003 (May 1, 1981), where the farm was operated by the decedent’s daughter and son-in-law on a crop-share basis. The decedent was elderly and infirm. The IRS concluded that it was immaterial that the decedent didn’t pay self-employment tax on her income from the farm. For purposes of I.R.C. §6166, payment of self-employment tax was determined to be irrelevant on the issue of whether the decedent was engaged in the trade or business of farming. See also Priv. Ltr. Rul. 8432007 (Apr. 9, 1984).
In Priv. Ltr. Rul. 8515010 (Jan. 8, 1985), the IRS concluded that the cash rental of a pasture and barn failed did not constitute the trade or business of farming and, thus, did not qualify as interests in a closely-held business. The decedent’s only involvement with respect to the pasture and barn was to provide routine maintenance. Conversely, where a decedent leased an orchard for a fixed rental to a family corporation (of which the decedent was the majority shareholder) that conducted farming operations, the decedent was deemed to be engaged in the trade or business of farming because he was determined to be closely involved in both the leasing of his farm properties and the running of the family corporation. Gettysburg National Bank v. United States, No. 1:CV-90-1607, 1992 U.S. Dist. LEXIS 12152 (M.D. Pa. Jul. 17, 1992).
More private rulings. In Tech. Adv. Memo. 9403004 (Oct. 8, 1993), the IRS concluded that the decedent was not engaged in the trade or business of farming where he received a fixed rental amount for leasing land. It was deemed to be a passive income-producing investment asset. In Tech. Adv. Memo. 9635004 (May 15, 1996), the decedent operated a cattle ranch at the time of his death with his son via a partnership owned two-thirds by the decedent and one-third by the son. There was no question that the cattle ranch was an active trade or business or that the decedent actively participated in all aspects of the ranch’s management and operation. Both the decedent and his son owned land individually that was used in the ranching business. The partnership paid the real estate taxes on the land as well as the cost of maintaining fences and insurance. No rent was paid to either the decedent or his son. The IRS determined that the land the decedent owned that the partnership used in the cattle ranching business was used in the trade or business of farming for purposes of I.R.C. §6166. The IRS based its conclusion on the fact that the decedent’s activities were conducted in the overall scope of his income-producing cattle ranching business and the real estate was a fundamental part of the overall ranching business. The IRS also noted that the decedent owned the land at the time of his death. These were all important key factors and persuaded the IRS even though the partnership didn’t own the land.
The multi-factor test. In 2006, IRS clarified that, to be an interest in a trade or business under I.R.C. §6166, a decedent must conduct an active trade or business or must hold an interest in a partnership, LLC or corporation that itself carries on an active trade or business. Rev. Rul. 2006-34, 2006-1 C.B. 1171. In the ruling, IRS set forth a list of non-exclusive factors to determine whether a decedent’s interest is an active trade or business. The factors are: (1) the amount of time the decedent (or agents or employees) spent in the business; (2) whether an office was maintained from which the activities were conducted or coordinated and whether regular office hours are maintained; (3) the extent to which the decedent was actively involved in finding new tenants and negotiating and executing leases; (4) the extent to which the decedent provided landscaping, grounds care or other services beyond the furnishing of the leased premises; (5) the extent to which the decedent personally made, arranged for or supervised repairs and maintenance on the property; and (6) the extent to which the decedent handled tenant requests for repairs and complaints.
In addition, the IRS stated in Rev. Rul. 2006-34 that an independent contractor (or other third-party) can conduct some of the activities and the underlying activity can still constitute a trade or business unless the third-party activities simply constitute holding investment property.
The present $11.58 million exemption for federal estate tax means that very few farms and ranches will be subject to the tax. That makes installment payment of federal estate tax largely irrelevant. But, for those that do face federal estate tax liability, the opportunity to pay the tax over time rather than in full within nine months after death can be very important. In addition, if the political winds change and the exemption collapses, many family farms and ranches could be subject to the tax. It’s also important to remember that under present law, the exemption automatically drops significantly for deaths after 2025.
The closely-held business requirement as applied to real estate and as defined by use in the active conduct of a trade or business, is a large component of eligibility for land in a farming or ranching operation. Land leases should be something other than a straightforward cash lease with at least active involvement in decision making by the decedent-to-be, or an agent or employee of the decedent-to-be. Self-employment tax is not a crucial factor, but passive rental arrangements such as cash rent leases, are not eligible. For assets leased to business entities, the test is applied separately to the business entity and the leased assets. Land held in a revocable living trust is eligible for installment payment of federal estate tax if it is a “grantor” trust.
Monday, March 9, 2020
Many farming and ranching operations provide meals for employees and receive a tax-break for doing so. But, the late 2017 tax law – the Tax Cuts and Jobs act (TCJA) modified the rules. In 2018, the IRS provided guidance on changed rules and how to distinguish between deductible meals and entertainment expense which is no longer deductible under the TCJA. That guidance was issued as a precursor to formal regulations on the issue. Now the Treasury Department has issued proposed regulations addressing the TCJA changes and where the lines are to be drawn.
Meal and entertainment expense tax treatment – that’s the topic of today’s post.
Line-Drawing – The TCJA
Meals. As noted above, the TCJA changed the rules on deductible meals and entertainment. For farming and operations, the tax rules governing meals often comes into play at harvest. An example would be for part-time workers that are employed at times of planting and harvest. These part-time employees may be fed lunches on the farm. Before 2018, meals were normally deductible to an employer at 50 percent of the cost of the meals. But, where the meals are provided on the employer’s premises (i.e., at the farm) and for the convenience of the employer, the meals are 100 percent deductible by the employer and the employees do not have to report any of the amount of the meals as income. The 100 percent deduction is because farm workers generally work in remote areas where eating facilities are not near, and the farm employer finds it a more productive use of time to supply meals at the farm.
Under the TCJA, the 50 percent rule still generally applies to allow an employer to deduct 50 percent of the (non-extravagant) food and beverage expenses associated with operating the business (e.g., meals consumed by employees on work travel). I.R.C. §274(k). But, for amounts incurred and paid after Dec. 31, 2017, and until Dec. 31, 2025, the TCJA expands the 50% limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. I.R.C. §274(n)(1). That means that the 100 percent deduction for the meals provided the part-time farm employees in the above example is reduced to 50 percent. The 50 percent limitation remains in place through 2025 for meals (food and beverages) that aren’t “lavish or extravagant” and the taxpayer or employee of the taxpayer is present when the meal is furnished. I.R.C. §274(k)(2). Of course, the 50 percent cut-down can be avoided by treating the food and beverages as compensation to the employee (i.e., wages for withholding purposes).
After 2025, none of the cost of meals is deductible.
Entertainment. Through 2017, deductions for entertainment were generally disallowed unless they were directly related to the taxpayer’s business or directly preceded or followed a substantial bona fide business discussion. In those instances, entertainment expenses were deductible at the 50 percent level. Under the TCJA, effective for tax years after 2017, no deduction is allowed for any activity that is generally considered to be entertainment, amusement, or recreation that is purchased as a business expense. Likewise, no deduction is allowed for membership dues for any club organized for business, pleasure, recreation, or other social purposes. Similarly, no deduction is allowed associated with a facility or portion thereof used in connection with the provision of entertainment, amusement or recreation.
But what if meals and entertainment are interconnected in a business context? As noted, before 2018, 50 percent of the cost of business meals and entertainment purchased for business purposes was deductible. Now, entertainment expenses are not deductible even if they are incurred in a business context, unless they can satisfy an exception contained in I.R.C. §274(e). This creates an issue of how to distinguish between deductible meals and non-deductible entertainment when they are provided together. Clearly, taxpayers have an incentive under the TCJA for categorize expenses as “meals” rather than “entertainment.”
In 2018, the IRS issued Notice 2018-76, 2018-42 IRB to assist taxpayers in determining where the line was between deductible meals and nondeductible entertainment. The guidance in the Notice can be relied on until final regulations are issued.
The notice clarifies that taxpayers may deduct 50 percent of a business meal expense that meets these five requirements:
- The expense must be an ordinary and necessary expense business expenses as defined by I.R.C. §162(a);
- The expense must not be “lavish or extravagant” based on the particular situation;
- The taxpayer, or an employee of the taxpayer, must be present at the “meal”;
- The meal must be provided to a current or potential business customer, client, consultant, or similar business contact; and
- If the meal is provided in conjunction with entertainment, the meal expenses must be “stated separately” from the entertainment expenses.
Based on the Notice, it’s clear that meals expenses should not be inflated to make up for the loss of entertainment-related deductions. Separately purchasing meals and entertainment is important. The deduction for meals can be lost if the meals and entertainment are purchased together unless the “stated separately” requirement is satisfied.
On February 21, 2020, the IRS issued proposed regulations on the deductible meal/nondeductible entertainment issue. REG-100814-19. The proposed regulations generally follow Notice 2018-76, which can be relied upon until the regulations are finalized. Under the proposed regulations, taxpayers may deduct 50% of an otherwise allowable business meal expense if:
- The expense is an ordinary and necessary business expense under Sec. 162(a) paid or incurred during the tax year when carrying on any trade or business;
- The expense is not lavish or extravagant under the circumstances;
- The taxpayer or an employee of the taxpayer is present when the food and beverages are furnished;
- The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and
- For food and beverages provided during or at an entertainment activity, they are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.
“Food or beverage” expense is defined as “…all food and beverage items, regardless of whether characterized as meals, snacks or other types of food and beverages, and regardless of whether the food and beverages are treated as de minimis fringes under section 132(e). Prop. Treas. Reg. §1.274-12(b)(1). When food and beverages are provided to a potential business contact, the food and beverages must be provided to a “person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.” Prop. Treas. Reg. §1.274-12(b)(3). The proposed regulations also apply this standard to employer-provided meals and when meals are provided to employees and nonemployee business associates at the same event.
To provide a means for IRS to determined that food and beverage costs have not been inflated, the proposed regulations require that the venue’s typical selling cost for items the food and beverages sold must be listed if they were purchased apart from any entertainment. Prop. Treas. Reg. §1.274-11(b)(1)(ii). If the typical selling price is not listed, the reasonable approximate value must be provided. However, the proposed regulations also state that if a single invoice is used for food and beverage costs and entertainment, the amount for food and beverages must be billed separately to be eligible for any deduction. Id.
So what is nondeductible “entertainment” under the proposed regulations? It’s “any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at bars, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family.” Prop. Treas. Reg. §1.274-11(b)(1)(i). It doesn’t matter that expenses for such activities is associated with the taxpayer’s trade or business – it’s still “entertainment.” “Entertainment” can also include activities that fall within the definition that are engaged in to satisfy personal living needs of the taxpayer and the taxpayer’s family. Thus, for example, the expenses associated with the spring fishing trip on Lake Michigan to provide salmon for the family for the next year could now be nondeductible entertainment expenses. But what about the cost of the two-week pack trip into the Teton Wilderness Area with clients and potential clients? Is that cost now fully nondeductible?
TCJA changed the rules for deducting meals and entertainment. Of course, substantiating meal expenses is key, and some meals remain 100 percent deductible under specific exceptions contained in I.R.C. §274(e). See I.R.C. §274(d). The proposed regulations are voluminous, contain many examples and are now subject to a public comment period. The IRS will hold a public hearing on comments received on April 7, 2020 in Washington, D.C. After the hearing, the proposed rules could become finalized. The proposed regulations apply to tax years beginning on or after the date they are published in the Federal Register as final regulations. Before that time, however, they can be relied on for expenses incurred after 2017. Also, taxpayers can continue to rely on Notice 2018-76 until the proposed regulations are finalized.
Thursday, March 5, 2020
Registration is now open for this summer’s national ag tax and estate/business planning conference in Deadwood, South Dakota. The conference is set for July 20-21 at The Lodge at Deadwood. In today’s post I briefly summarize the conference, the featured speakers and registration.
Deadwood, South Dakota - July 20-21, 2020
The conference will be in Deadwood, South Dakota on July 20 and 21. The event is sponsored by the Washburn University School of Law. The Kansas State University Department of Agricultural Economics is a co-sponsor. Some of the morning and afternoon breaks are sponsored by SkySon Financial and Safe Harbour Exchange, LLC. The location is The Lodge at Deadwood. The Lodge is relatively new, opening in 2009. It is located just west of Deadwood on a bluff that overlooks the town. You can learn more about The Lodge here: https://www.deadwoodlodge.com/hotel. The Lodge has great conference facilities and also contains the Deadwood Grille featuring Western dining. For families with children, The Lodge contains an indoor water playland. There is also transportation from The Lodge to Main street in Deadwood where the shops and local attractions are located. Deadwood is in the Black Hills area of western South Dakota. Nearby is Mt. Rushmore, Crazy Horse, Custer State Park, Devil’s Tower and Rapid City. The closest flight connection is via Rapid City. The Deadwood area is a beautiful area, and the weather in late July should be fabulous.
On Day 1, July 20, joining me on the program will be Paul Neiffer. Paul has been doing the summer seminars with me for several years now and is affiliated with CliftonLarsonAllen, LLP. We enjoy working together to provide the best in ag tax education that you can find. We will discuss new cases and IRS developments; GAAP Accounting; restructuring credit lines; deducting bad debts; forgiving installment sale debt and some passive loss issues. We will also get into advanced tax planning issues associated with the qualified business income deduction of I.R.C. Sec. 199A as well as net operating loss issues under the new rules; FSA advanced planning and like-kind exchanges when I.R.C. §1245 property is involved.
Also with us as a Day 1 speaker is the honorable Judge Elizabeth Paris of the U.S. Tax Court. She will provide an informative session on litigating a case before the U.S. Tax Court and the special rules and procedures of the court – what you need to know before filing a case with the Tax Court. Judge Paris has issued opinions in several important ag cases during her tenure on the court, including Martin v. Comr., 149 T.C. 293 (2017), and is a great speaker. You won’t want to miss her session.
I will lead off Day 2, July 21, with coverage of the most recent ag-related cases and rulings impacted farm and ranch estate and business planning. Also joining me on Day 2 will be Prof. Jeffrey Jackson, a colleague of mine at Washburn University School of Law. He will present a session on gun trusts for holding firearms and the unique issues that passing firearms at death can present. Prof. Jackson will discuss what a gun trust is and how it works, what it cannot do, and client counseling with respect to passage of firearms by gift or at death. Prof. Jackson's presentation will be followed by a session involving a comprehensive review of the new rules surrounding retirement planning after the SECURE act by Brandon Ruopp, an attorney from Marshalltown, Iowa.
Also making a presentation on Day 2 will be Marc Vianello. Marc is a CPA and the managing member of Vianello Forensic Consulting, LLC. He is an experienced financial professional with and intensive 30-year history as a forensic accountant and expert witness regarding damages in highly complex litigation, including breach of contract, intellectual property (patent, Lanham, trade secret, copyright), business valuation, franchise, agriculture, Qui Tam and class action, personal injury, employment, casualties, financial crimes, and all other types of income and valuation damages. Marc also has an extensive background regarding the computation of estate and gift tax discounts for lack of marketability. Marc’s presentation will focus on how practitioners can utilize forensic accounting techniques and expert testimony to bolster a client’s position against the IRS on audit as well as in court.
Other topics that I will address on Day 2 include the common estate planning mistakes of farmers and ranchers; post-death management of the farm or ranch business; and the valuation of farm chattels and marketing rights.
Day 2 will conclude with an hour session on ethics. Prof. Shawn Leisinger of Washburn School of Law will present a session on the ethical issues related to risk I the legal context and how to ethically advise clients concerning risk decisions.
If you are unable to join us in-person for the two-day event in Deadwood, the conference will be broadcast live over the web. The webcast will be handled by Glen McBeth. Glen handles Instructional Technology at the law library at the law school. Glen has broadcast the last few summer seminars and does a tremendous job producing a high-quality webcast.
A room block has been established at The Lodge for conference attendees under Washburn University School of Law. The rate is $169 per night and is valid from July 17 through July 22. The room block will release on June 19. The Lodge does not have an online link for reservations, but you may call the front desk at (877) 393-5634 and tell them they need to make reservations under the Washburn University Law School room block. As noted, the room block begins the weekend before the seminar begins so that you can arrive early and enjoy the weekend in Deadwood and the Black Hills area before conference if you’d like.
Washburn’s law school will also be holding an alumni event at The Lodge that corresponds with the summer seminar. There will be a social event for law school alumni and registrants of the summer seminar on Sunday evening, July 19. That event will be followed the next day with a CLE seminar focusing on law and technology. This CLE event will also be at The Lodge and will run simultaneously with Day 1 of the two-day summer seminar on July 20. The summer seminar will continue on July 21.
If your business is interested in sponsoring a breakfast, break or lunch, and having vending space at the conference, please let me know. It’s a great event to interact with practitioners that represent the legal and tax needs of farmers and ranchers from across the country that are involved in many aspects of agriculture.
If you have farm or ranch clients that you work with on tax, estate or business planning, this conference is an outstanding opportunity to receive specialized training in ag tax in these areas and interact with others. The conference is also appropriate for agribusiness professionals, rural landowners and agricultural producers.
More detailed information about the conference and registration information is available here: http://washburnlaw.edu/employers/cle/farmandranchtax.html. I look forward to seeing you in Deadwood or having you participate via the web.
Tuesday, March 3, 2020
The cases and rulings of relevance to agricultural producers, ag businesses and rural landowners continue to churn out. In today’s post a take a brief look at three of them – a couple of bankruptcy-related cases and a case involving a claim of constitutional takings.
“Shared Responsibility” Payment Is Not a “Tax”
United States v. Chesteen, No. 19-30195 (5th Cir. Feb. 20, 2020), rev’g., No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019).
In a bankruptcy proceeding, some unsecured creditors receive a priority in payments over other unsecured creditors. These are termed “priority claims” and they are not subject to being discharged in bankruptcy. Priority claims are grouped into 10 categories with descending levels of priority. 11 U.S.C. §507(a)(1)-(10). One of those priority claims is for “allowed unsecured claims of governmental units” to the extent the claims are for “a tax on or measured by income or gross receipts…”. 11 U.S.C. §507(a)(8). But, does that provision apply to the penalty that had to be paid through 2018 for not having an acceptable form of government-mandate health insurance under Obamacare – the so-called “Roberts Tax”? The U.S. Court of Appeals for the Fifth Circuit recently answered that question.
In the case, the debtor filed Chapter 13 bankruptcy. The IRS filed a proof of priority claim for $5,100.10, later amending the claim to $5,795.10 with $695 of that amount being an excise tax under I.R.C. §5000A as a result of the debtor’s failure to maintain government mandated health insurance under Obamacare. The debtor objected to the $695 amount being a priority claim that could not be discharged, and the bankruptcy court agreed, finding that the “Roberts Tax” under Obamacare was not a priority claim, but rather a dischargeable penalty in a Chapter 13 case. On appeal, the federal trial court reversed, holding that the penalty was a tax that was a non-dischargeable priority claim. The trial court noted that the creditor bore the burden to establish that the Roberts Tax was a priority claim and noted that it was the purpose and substance of the statute creating the tax that controlled whether the tax was a tax or a penalty. The trial court noted that a tax is a pecuniary burden levied for the purpose of supporting government while a monetary penalty is a punishment for an unlawful act or omission. On this point, the trial court noted that Chief Justice Roberts, in National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), upheld the constitutionality of Obamacare on the basis that the “shared responsibility payment” was a tax paid via a federal income tax return and had no application to persons who did not pay federal income tax. The trial court noted that the amount was collected by the IRS and produced revenue for the government. It also did not punish an individual for any unlawful activity and, the trial court noted, the IRS has no criminal enforcement authority if a taxpayer failed to pay the amount.
On further review, the appellate court reversed, reinstating the bankruptcy court’s determination. The appellate court held that the “Roberts Tax” was not entitled to priority in bankruptcy because it was not among the types of taxes listed in the bankruptcy code to have priority treatment under 11 U.SC. §507(a)(8)(E)(i). The appellate court noted that the “Roberts Tax” could not be a priority tax claim in a debtor’s bankruptcy estate because the “tax” applied only when a person failed to buy the government-mandated health insurance, rather than when a transaction was entered into. As such, the “Roberts Tax” was a penalty that could be discharged in bankruptcy. The appellate court also noted that the “tax” zeroed out the “tax” beginning in 2019, thereby nullifying any tax effect that it might have had.
Cram-Down Interest Rate Determined
In re Country Morning Farms, Inc., No. 19-00478-FPC11, 2020 Bankr. LEXIS 307 (E.D. Wash. Feb. 4, 2020).
Under the reorganization provisions of the Bankruptcy Code (Chapters 11, 12 and 13), a debtor can reorganize debts and pay for most (but not all) secured property by paying the present value of the collateral (what the collateral is presently worth) rather than the entire debt. The procedure for doing this is commonly known as a “cram down” – the terms of the repayment are forced upon the creditor. The debtor must pay the present value of the collateral (the creditor’s allowed secured claim) via the reorganization bankruptcy. Because the repayment of the written-down debt will be paid over time in accordance with the reorganization plan, an interest rate is attached to ensure that the creditor receives the present value of the claim. But, what is the appropriate interest rate in such a setting and how is it determined? Over the years, courts struggled in determining the appropriate interest rate to use in a reorganization bankruptcy cram-down setting. The U.S. Supreme Court settled the waters with a decision in 2004 by using the “Prime Plus” method. The issue of the appropriate interest rate was again as issue in a dairy bankruptcy case from the state of Washington.
In the case, the debtor filed Chapter 11 bankruptcy and the debtor and the bank could not agree on the appropriate interest rate to be used in the debtor’s reorganization plan. The parties agreed that the “Prime Plus” method set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004) was the appropriate method to determine the “cram down” interest rate.” The parties agreed that the prime rate was presently 4.75 percent and that an additional amount as a “risk factor” should be added to the prime rate. The debtors proposed a 6 percent interest rate, based on the risk associated with their dairy business. The bank claimed that the appropriate interest rate was 7.75 percent – the highest rate factor under the Till analysis. The bank cited the length of the plan, the volatility of the dairy market, the debtor’s capital structure, and conflicting projections from an expert when determining the appropriate risk factor. The court determined that the appropriate interest rate was 7 percent which raised the interest rate on some of the debtor’s loans and lowered it on others.
Reversion to Agricultural Use Classification Not a Taking
Bridge Aina Le’a, LLC v. State Land Use Commission, No. 18-15738, 2020 U.S. App. LEXIS 5138 (9th Cir. Feb. 19, 2020).
Sometimes, a governmental body enacts a statute or promulgates a regulation that restricts a private property owner’s use of their property. The restriction on land use may be so complete that, in effect, the restriction amounts to the government “taking” the property. However, these regulatory restrictions on private property usage do not involve a physical taking of the property but can still give rise to Fifth Amendment concerns and trigger the payment of “just compensation” to the landowner. The legal issues concerns the point at which a defacto regulatory taking has occurred.
In a key case decided in 1978, the U.S. Supreme Court set forth a multi-factored balancing test for determining when governmental regulation of private property effects a taking requiring compensation. In Penn Central Transportation Co. et al. v. New York City, the 438 U.S. 104 (1978), the Court held that a landowner cannot establish a “taking” simply by being denied the ability to exploit a property interest believed to be available for development. Instead, the Court ruled that in deciding whether particular governmental action effects a taking, the character, nature and extent of the interference with property rights as a whole are the proper focus rather than discrete segments of the owner’s property rights. Later, the Court determined that the touchstone for deciding when a regulation is a taking is whether the restriction on property usage is functionally equivalent to a physical taking of the property. Lingle, et al. v. Chevron U.S.A. Inc., 544 U.S. 528 (2005). The issue of a regulatory taking came up in a recent case from Hawaii.
Under the facts of the recent case, 1,060 acres of undeveloped land on the northeast portion of the Island of Hawaii were designated as conditional urban use. For the 40 prior years, the tract was part of a 3,000-acre parcel zoned for agricultural use. In 1987, the landowner at the time sought to develop a mixed residential community of the 1,060 acres as the first phase of development on the entire 3,000 acres. The landowner petitioned the defendant to reclassify the 1,060 acres as urban. The defendant did so in 1989 on development conditions that ran with title to the land. The land remained undeveloped at the time the plaintiff acquired it in 1999. In 2005, the defendant amended the condition so that fewer affordable housing units needed to be developed. Developmental progress was hampered by the requirement that the plaintiff prepare an environmental impact statement for the development project.
In late, 2008, the defendant ordered the plaintiff to show cause for the nondevelopment. In the summer of 2010, some affordable housing units had been constructed, but upon inspection they were determined to not be habitable. The developer then stated that it lacked the funds to complete the development. In 2011, the defendant ordered the land’s reversion to its prior agricultural use classification due to the unfulfilled representations that the land would be developed. The land was given its conditional urban use classification based on those representations. The plaintiff was one of the landowners and challenged the reversion as illegal, and that it amounted to an unconstitutional regulatory taking of the land. The trial court jury found for the plaintiff on the constitutional claim and the trial court denied the defendant’s motion for a judgment as a matter of law.
On further review, the appellate court reversed The appellate court stated held that no taking had occurred under the multi-factor analysis of Penn Central Transportation Company v. City of New York, 438 U.S. 104 (1978), because the reclassification did not result in the taking of all of the economic value of the property. Rather, the land retained substantial economic value, albeit at a much lesser amount than if it were classified as urban and developed. An expert valued the land at approximately $40 million as developed land and $6.36 million with an agricultural use classification. The appellate court held that the $6.36 million was neither de minimis nor derived from noneconomic uses. Thus, the defendant was entitled to judgment as a matter of law on the issue that a complete economic taking had occurred. It had not. The appellate court also held that the reversion did not interfere substantially with the plaintiff’s investment-backed expectations given that the development conditions were present at the time the plaintiff acquired the property and the plaintiff could expect them to be enforced. The appellate court also determined that the defendant acted properly in protecting the plaintiff’s due process rights by holding hearings over a long period of time. Thus, the appellate court concluded, no reasonable jury could conclude that the reversion effected a taking under the Penn Central factors. The appellate court vacated the trial court’s judgment for the plaintiff and reversed the trial court’s the trial court’s denial of the defendant’s motion for judgment as a matter of law, affirmed the trial court’s dismissal of the plaintiff’s equal protection claim and remanded the case.
The developments of relevance to agricultural interests keep rolling in. There will be more discussed in future posts.
Friday, February 28, 2020
Just over a year ago, the Treasury issued corrected Final Regulations concerning the Qualified Business Income Deduction (QBID) of I.R.C. §199A. Those final regulations were intended to clear up some of the then-existing confusion over certain aspects of the QBID. One thing that the Final Regulations did not do, however, was provide a precise definition of what constitutes a “trade or business” for QBID purposes. The 20 percent QBID applies to ordinary income from a qualifying “trade or business” that is not conducted by a C corporation. But what qualifies as a trade or business? It’s a trade or business defined as such under I.R.C. §162 (except for the trade or business of performing services as an employee). This question keeps coming up in emails and calls that I receive. It seems as if the factual scenarios are endless.
“Trade or business for QBID purposes – it’s the topic of today’s post.
The term “trade or business” in the Code ranges from “no involvement” for purposes of farm income averaging in I.R.C. §1301 to material participation on a regular, continuous and substantial basis for purposes of the passive activity loss rules of I.R.C. §469. But, the definitional standard for the QBID is I.R.C. §162. I.R.C. §162 states, “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…”. I.R.C. §162. In an early case attempting to define a trade or business activity, the U.S. Supreme Court distinguished between a trade or business and an investment activity and concluded that engaging in an activity merely for pecuniary gain or to increase personal holdings without devoting a major portion of time to the activity did not amount to a trade or business activity. Snyder v. Comr., 295 U.S. 134 (1935). In addition, the taxpayer in Snyder was not truly engaged in buying and selling securities for a living.
Snyder indicates that merely engaging in an activity with intent to make a profit is not a trade or business without the presence of other factors. This remains an argument that the IRS incorrectly asserts with respect to Conservation Reserve Program (CRP) rental income where IRS has attempted to claim since 2003 that a landowners signature on a CRP contract is sufficient to constitute a trade or business resulting in the CRP payments being subject to self-employment tax in the landowner’s hands. CCM 200325002 (Jun. 20, 2003). It lost that argument in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g., 140 T.C. 350 (2013), but issued a non-acquiescence (A.O.D. 2015-002, I.R.B. 2015-41 (Oct. 13, 2015)) and incorrectly states the status of the law in Publication 225 where it claims that CRP rents must always be reported on Schedule F and be subjected to self-employment tax (except for taxpayers that are also receiving Social Security retirement or disability payments).
Simply stated, more than a signature on a contract is required for an activity to rise to the level of a trade or business. The U.S. Supreme Court has consistently held for many years that the determination of whether a taxpayer is carrying on a trade or business “requires an examination of the facts of each case.” In Higgins v. Comr., 312 U.S. 212 (1941), the Court held that managing and preserving one’s personal estate was not a business activity. The Court reached the same result in City Bank Farmers Trust v. Helvering, 313 U.S. 121 (1941) when it held that simply collecting interest and clipping coupons coupled with very few reinvestments did not constitute a trade or business. More recently, the Court said that a full-time gambler who wagered for himself personally was engaged in a trade or business for purposes of self-employment tax based on the entire facts of the taxpayer’s situation. Comr. v. Groetzinger, 480 U.S. 23 (1987). In Groetzinger, the court said that the presence of a trade or business activity was to be determined based on the facts of each case and that its presence was to be determined based on whether the taxpayer’s involvement in the activity is regular and continuous, and whether the primary purpose of the activity is for income or profit. Both of those factors must be present for a trade or business to exist. Importantly, the Final QBID regulations cite to these two tests of Groetzinger. See also S.C.A. Memo. 200120037 (Mar. 30, 2001).
In 1988 (the year after the Supreme Court decided Groetzinger), the Tax Court elaborated on Groetzinger in a hobby loss case involving an Illinois horse breeding activity and pointed out (for purposes of deducting expenses under I.R.C. §162) that the taxpayer must be engaged in the activity with the primary purpose and intent of making a profit. Seebold v. Comr., T.C. Memo. 1988-183. Whether a taxpayer has a profit intent, the Tax Court said, is to be determined based on an objective analysis of the factors of the situation and not on the taxpayer’s personal statement(s) of intent.
What About Land Leases?
For farmers and ranchers, a primary question is whether a land rental arrangement will generate a QBID. While the answer to the question is fact-based, the Final Regulations contain four factors designed to guide taxpayers and courts on whether a real estate activity rises to the level of a trade or business. The first factor focuses on the type of real estate involved – whether it is commercial, residential, condominium or personal. The second factor addresses the number of properties (or tracts) the taxpayer leases out. The third factor looks at the degree of daily involvement of the landlord in the rental activity. That involvement can be either personally or via an agent. Because the trade or business standard for I.R.C. §199A routes through I.R.C. §162 rather than I.R.C. §1402, imputation of an agent’s activity is not blocked as it is under I.R.C. §1402. The fourth factor concerns the type of the lease – the length of the lease and whether it is a triple-net lease, etc.
Planning points. Simply renting land out under a cash lease with the landlord doing nothing more than collecting the rent is not enough to qualify the rental income as qualified business income (QBI). While a single rental can qualify as a trade or business (see Hazard v. Comr., 7 T.C. 372 (1946), the landlord must do more than collect the rent check. See, e.g., Neill v. Comr., 46 B.T.A. 197 (1942). The same is true for passive investments in oil and gas interests – merely collecting the royalty income from the investment is not a trade or business activity. While a triple-net lease would normally not result in the landlord being engaged in a trade or business activity with respect to the rental activity under the Groetzinger test of the QBID regulations (for lack of satisfying the regularity and continuity requirement), such a lease is not automatically disqualified from generating QBI. But, a triple-net lease will likely have to be modified or aggregated with other qualifying activities to qualify the income for the QBID In addition, under Notice 2019-7, 2019-09 I.R.B. 740 and associated Rev. Proc. 2019-38, 2019-42 I.R.B. 942 the IRS created a safe harbor for rental real estate activities on an annual basis. Treas. Reg. §1.199A-1 through Treas. Reg. §1.199A-6. The final rental safe harbor was issued in September of 2019. A triple net lease is not disqualified from using the optional safe harbor. Failure to satisfy the safe harbor requirements is not fatal to a determination that the rental activity fails the trade or business standard.
The rub for many farm landlords is to create QBI from rental income without triggering self-employment tax. On this point, it is important to note that the requirement for self-employment tax is material participation under the lease. That’s a different standard than the trade or business standard for QBI which is profit intent along with regularity and continuity. Another way of stating this is that a rental activity can produce QBI without triggering self-employment tax. That’s a key point. Some minimal involvement in the rental activity is required to convert cash rent into QBI. Entering into a written lease with the tenant that details the minimal involvement (such as consultation on cropping decisions; mowing of lanes; fence maintenance; inspecting the property, etc.) by the landlord is important. Maintaining a calendar of activities and involvement of the landlord (even via an agent) concerning the rental is also key.
I.R.C. §162 establishes a test for the existence of a trade or business that is a lower hurdle than that applicable for self-employment tax. Most farm/ranch land rental income will likely be deemed to be a trade or business under the I.R.C. §162 standard and qualify as QBI. However, existing lease agreements may need to be modified and put in writing if presently an oral. Documenting landlord involvement is critical. At the same time, making sure a landlord’s involvement is not significant enough to trigger self-employment tax is also essential to many farm landlords.
Wednesday, February 26, 2020
The economic loss of livestock for an agricultural producer is difficult. In a prior post I discussed the USDA’s livestock indemnity program. https://lawprofessors.typepad.com/agriculturallaw/2017/03/livestock-indemnity-payments-what-they-are-and-tax-reporting-options.html. That program can provide some financial relief when livestock die because of adverse weather conditions or attacks by animals that the Federal Government has reintroduced into the wild. But a significant concern is the tax treatment of livestock death losses. Can a loss deduction be claimed? If so, what is the character of the loss? How is the loss reported on the tax return?
The tax rules surrounding death of livestock – that’s the focus of today’s post.
Required Holding Period
The tax consequences of dead livestock are tied to how long the taxpayer “held” the livestock. The tax consequences upon death of livestock that are held for draft, dairy, breeding or sporting purposes differ depending on whether the taxpayer held the animals for 12 months or more (24 months or more for cattle and horses) that if they were not held for that requisite time period. If they have been held for the required holding period, they are “I.R.C. §1231 property.” Why is being I.R.C. §1231 property beneficial? It allows a taxpayer to receive tax-favored treatment for I.R.C. §1231 property gains that exceed I.R.C. §1231 property losses. Thus, if an I.R.C. §1231 asset can be sold for a value greater than its original cost basis, it can be taxed at a favorable capital gains rate. But, if a loss results, it is a fully deductible ordinary loss rather than a capital loss capped at $3,000 against ordinary income with any excess carried over to the following year.
I.R.C. §1231 property includes depreciable property and real property (e.g. buildings and equipment) used in a trade or business and generally held for more than one year. As noted, some types of livestock, coal, timber and domestic iron ore are also included in the definition of I.R.C. §1231 property. But, the category of I.R.C. §1231 property does not include inventory; property held for sale in the ordinary course of business; artistic creations held by their creator; or, government publications.
Gains and losses under I.R.C. §1231 due to casualty or theft are excluded from the netting process unless the gains exceed the losses. In that situation, both the gain and loss are calculated with any other I.R.C. §1231 gains and losses. If casualty losses exceed gains, the excess is treated as an ordinary loss. This all means that gain or loss that is triggered upon death may be included in the I.R.C. §1231 netting process.
If draft, dairy, breeding or sporting purpose livestock has been held for less than 12 months (24 months for cattle and horses) as of the time of the animal’s death, the gain or loss is not an I.R.C. §1231 gain or loss. It is reported on Part II of Form 4797. In this instance, it makes no difference whether the animal’s death was caused by casualty or disease.
Death Due to Casualty
Losses resulting from casualty-caused deaths are netted with the taxpayer’s other business casualty gains and losses to determine whether they will be included in the I.R.C. §1231 netting process. If the casualty gains exceed the casualty losses, the net gain is included with other I.R.C. §1231 gains and is netted against I.R.C. §1231 losses for the year. If the casualty losses exceed the casualty gains, the net loss is not included in the I.R.C. §1231 netting process. Rather, it’s allowed as an ordinary deduction for income tax purposes but not for self-employment tax purposes.
(Facts): In the spring of 2019, a “bomb cyclone” completely destroyed Slim’s barn and killed the 25 dairy cows that were in the barn. At the time of the weather event, assume that Slim’s income tax basis in the barn was $50,000 and its fair market value was $100,000. Slim received a $90,000 insurance payment for the destroyed barn. Thus, Slim has $40,000 gain as a result. As for the cows in the barn at the time of the casualty, assume that they were worth $20,000 immediately before the casualty and that Slim’s basis in the cows was $8,000. He didn’t receive any insurance proceeds attributable to the cows. Thus, Slim sustained an $8,000 loss on the cows.
(Result): Slim will report the loss of his barn and cows and the insurance payment for the barn on Form 4684. Neither his barn nor the cows will be subject to depreciation recapture because Slim claimed straight-line depreciation on the barn and there is no gain on the cows. Slim will report the net casualty gain on Form 4797, Part I, line 3. There it is netted with any other I.R.C. §1231 gains and losses that Slim incurred during the tax year.
Tax planning opportunities. If Slim has a net I.R.C. §1231 gain for the tax year, his loss on the cows will reduce the gain that would be taxed as capital gain. If he has a net I.R.C. §1231 loss for the year, his loss on the cows will increase the net I.R.C. §1231 loss, which is fully deductible as an ordinary loss. Under another rule, gain that is realized from casualty to business property can be rolled into replacement property. I.R.C. §1033. The replacement property must be purchased within two years of the end of the tax year of the involuntary conversion. I.R.C. §1033(a)(2)(B)(i). Thus, if Slim replaces the barn, he can roll the gain into the new barn and the loss from the cows would not be netted against the gain from the barn. The loss would avoid the I.R.C. §1231 netting process and be deducted against ordinary income. If Slim had a net loss on the barn (perhaps because the insurance pay-out was less), he would report the net loss from the casualty on Form 4684 but would not net it with his I.R.C. §1231 gains and losses for the tax year. Rather, it is reported on Part II of Form 4797 (or directly on Form 1040 if Form 4797 is not otherwise needed) where it will reduce ordinary income not subject to self-employment tax.
If Slim had triggered gain on the loss of the livestock, he could have elected to postpone gain recognition by under the involuntary conversion rule by investing the proceeds in livestock that are similar in service or use to the livestock that died. I.R.C. §1033(a). Normally, the livestock must be purchased by the end of the second tax year after the year the livestock died. If Slim makes the election to postpone the gain, but then does not purchase replacement livestock within the required timeframe, he will have to amend his return for the year of death to report the gain. The definition of “livestock” for purposes of I.R.C. §1231 applies for purposes of the involuntary conversion rule. Treas. Reg. §1.1231-2(a)(2).
If the cows had died as the result of a presidentially declared disaster, Slim could elect to deduct the loss for the year preceding the year of the loss. I.R.C. §165(i). Slim would accomplish this by amending the prior year’s return. Claiming the loss in the prior year could reduce the net I.R.C. §1231 gain for the current year which is taxed as capital gain. That could allow the loss to be deducted from ordinary income if Slim didn’t have any casualty or theft gains on that prior year’s return.
While the above example indicated that depreciation recapture was not triggered, what if a casualty does trigger depreciation recapture? If that happens, the recaptured depreciation is reported as ordinary income on Part III of Form 4797. It does not become part of the I.R.C. §1231 netting process.
Death Due to Disease
Disease is not a casualty. To be treated for tax purposes as a casualty, the loss must be “sudden, unexpected and unusual.” See, e.g., Rev. Rul. 72-592, 1972-2 C.B. 101. Disease is too gradual in nature to be treated as a casualty. Instead, it is an involuntary conversion and if the diseased livestock qualify as I.R.C. §1231 property, the gain or loss from the death is netted with other I.R.C. §1231 transactions for the tax year. The tax reporting of the livestock death would be in Part I of Form 4797 (unless depreciation recapture is present).
Livestock deaths can be economically devastating for a agricultural operation. However, understanding the associated tax rules and the related planning opportunities can help soften the blow.
Monday, February 24, 2020
For medium-sized and larger farming operations that grow crops covered by federal farm programs, a general partnership is often the entity of choice for the operational part of the business because it can aid in maximizing federal farm program benefits for the farming operation. I have discussed this issue in prior posts – how to maximize farm program benefits in light of the overall planning goals and objectives of the family farming operation.
Partnerships, however, can present rather unique and complex tax issues. The “flow-through” feature of partnership taxation and tax basis of a partnership interest – these are the topics of today’s post.
Partnerships are not subject to federal income tax. I.R.C. §701. The partnership’s income and expense is determined at the entity (partnership) level. Then, each partner takes into account separately on the partner’s individual return the partner’s distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit. I.R.C. §702. This sounds simple enough, but the facts of a particular situation can make the application of the rule something other than straightforward.
For example, in Lipnick v. Comr., 153 T.C. No. 1 (2019), the petitioner’s father owned interests in partnerships that owned and operated rental real estate. In 2009, the partnerships borrowed money (in the millions of dollars) and distributed the proceeds to the partners. The loans had a 5.88 percent interest rate and a note secured by the partnership’s assets, but no partner was personally liable on the notes. The father deposited the proceeds of the distributions in his personal account, and he later invested the funds in money market and other investment assets which he also held in his personal accounts until his death in late 2013. The partnerships incurred interest expense on the loans from 2009-2011, and the father treated his distributive share of the interest on the loans that the partnerships paid that passed through to him as “investment interest” on Schedule A of his individual return. By doing so, he deducted the investment interest to the extent of his net investment income. See I.R.C. §163(d)(1).
In mid-2011, the father transferred his partnership interests to the petitioner with the petitioner agreeing to be bound by the operating agreement of each partnership. However, the petitioner did not become personally liable on any of the partnership loans. The gifts relieved the father of his shares of the partnership liabilities and he reported substantial taxable capital gain as a result.
The father also owned minority interests in another partnership that owned and operated rental real estate. In early 2012, this partnership borrowed $20 million at a 4.19 percent interest rate and distributed the proceeds to the partners. Partnership assets secured the associated note, but no partner was personally liable on the note. Again, the father deposited the funds in his personal account and then invested the money in money market funds and other investment assets that he held in his personal accounts until death. Under the terms of his will, he bequeathed his partnership interest to the petitioner.
The loans remained outstanding during 2013 and 2014, and the partnerships continued to pay interest on them with a proportionate part passed through to the petitioner. The petitioner treated the debts as allocable to the partnerships’ real estate assets and reported the interest expense on his 2013 and 2014 individual returns (Schedule E) as regular business interest that offset the passed-through real estate income from the partnerships. On Schedule E, the interest expense was netted against the income from each partnership with the resulting net income reported on Forms 1040, line 17. The IRS disagreed, construing the interest as investment interest (“once investment interest, always investment interest”) reportable on Schedule A with the effect of denying any deduction because the petitioner didn’t have any investment income.
The Tax Court disagreed with the IRS position. The Tax Court noted that the partnership debt was a bona fide obligation of the partnership and the petitioner’s partnership interest was encumbered at the time it was gifted to him. The Tax Court also pointed out that the petitioner did not receive any distributions of loan proceeds to him and he didn’t use any partnership distributions to make investment-related expenditures. The Tax Court determined that the proper treatment of the petitioner was that he made a debt-financed acquisition of the partnership interests that he acquired from his father. Under I.R.C. §163(d) the debt proceeds were to be allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest was to be allocated in the same fashion. Treas. Reg. §1.163-8T(c)(1).
Under the tracing rule of the regulation, debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. While the tracing rule is silent concerning its application to partnerships and their partners, the IRS has provided guidance. Notice 89-35, 1989-1 C.B. 675. In that guidance, the IRS provided that if a partner uses the proceeds of a debt-financed distribution to acquire property held for investment, the corresponding interest expense that the partnership incurs and is passed on to the partner will be treated as investment interest. But, the Tax Court held that the petitioner was not bound to treat the interest expense passed through to him in the same manner as his father. The Tax Court noted that the petitioner, instead of receiving debt-financed distributions, was properly treated as having made a debt-financed acquisition of his partnership interests for purposes of I.R.C. §163(d). He also made no investment expenditures from distributions that he received. See Treas. Reg. §1.163-8T(a)(4)(i)(C). Furthermore, because the partnerships’ real estate assets were actively managed in the operation of the partnerships, they didn’t constitute investment property. The Tax Court also held as irrelevant the fact that the petitioner was not personally liable on the debts. That fact did not mean that his partnership interest was not “subject to a debt” for purposes of Subchapter K. It was enough that he had acquired his partnership interests subject to the partnership debts.
A taxpayer’s income tax basis in an asset is important to know. Basis is necessary to compute gain on sale, transfer or other disposition of the asset. The starting point for computing basis is tied to how the taxpayer acquired the asset. In general, for purchased assets, the purchase price establishes the taxpayer’s basis. If the property is received by gift, the donor’s basis becomes the donee’s basis. For property that is acquired by inheritance, the value of the inherited property as of the date of the decedent’s death pegs the basis of the asset in the recipient’s hands. The same general rules apply with respect to a partnership interest when establishing the starting point for computing basis. But, as with other assets, the basis in a partnership interest adjusts over the time of the taxpayer’s ownership of the interest. For example, the basis in a partnership interest is increased by contributions to the partnership as well as taxable and tax-exempt income. It is decreased by distributions, nondeductible expenses and deductible losses. I.R.C. §705. But, the deductibility of a partner’s distributive share of losses is limited to the extent that the partner has insufficient basis in the partner’s partnership interest. I.R.C. §704(d).
Sec. 754 election
When a partnership distributes property or transfers the partner’s partnership interest (such as when a partner dies), the partnership can elect under I.R.C. §754 to adjust the basis of partnership property. See, e.g., Priv. Ltr. Ruls. 201909004 (Dec. 3, 2018); 201919009 (Aug. 9, 2018); and 201934002 (May 16, 2019). This election allows a step-up or step-down in basis under either I.R.C. §734(b) or I.R.C. §743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return. In late 2017, the IRS proposed to amend Treas. Reg. §1.754-1(b)(1) to eliminate the requirement that an I.R.C. §754 election be signed by a partner of the electing partnership. REG-116256-17, 82 Fed. Reg. 47408 (Oct. 12, 2017).
I.R.C. §743 requires a partnership with an I.R.C. §754 election in place or with a substantial built-in loss to adjust the basis of its property when a partnership interest is transferred. I.R.C. §743(d). A partnership has a substantial built-in loss if the partnership's basis in its property exceeds the fair market value by more than $250,000. Id. But, do contingent liabilities count as “property” for purposes of I.R.C. §743? The answer is not clear. Treas. Reg. §1.752-7 treats contingent liabilities as I.R.C. §704(c) property, but the I.R.C. §743 regulations do not come right out and say that contingent liabilities are “property” for purposes of I.R.C. §743.
The IRS addressed the lack of clarity in 2019. In Tech. Adv. Memo. 201929019 (Apr. 4, 2019), two partnerships with the same majority owner merged. The merging partnership was deemed to have contributed all of its assets and liabilities in exchange for an interest in the resulting partnership. Then the interest in the resulting partnership was distributed to the partners in complete liquidation. The resulting partnership had a substantial built-in loss – the result when either the adjusted basis in the partnership property exceeds its fair market value by more than $250,000 or the transferee partner is allocated a loss of more than $250,000 if the partnership sells its assets for fair market value immediately after the merger.
I.R.C. §743(b) requires a mandatory downward inside-basis adjustment in this situation, but the question presented was whether it applies to a deemed distribution of an interest. The IRS determined that it did, taking the position that a deemed distribution of an interest of the resulting partnership was to be treated as a sale or exchange of the interest of the resulting partnership. See I.R.C. §§761(e) and 743.
As for the adjusted basis computation in the transferred partnership interest for the transferee partner, the IRS said that the resulting partnership’s liabilities (including contingent ones) must be included in the transferee partner’s basis in the partnership interest. They are also to be included in the transferee partner’s basis in the transferred partnership interest. Likewise, they are to be included in the transferee partner’s share of the resulting partnership’s liabilities to the extent of the amount of the I.R.C. §731(a) gain that the transferee partner would recognize absent the netting rule of Treas. Reg. §1.752-1(f). But, deferred cancellation-of-debt income (under I.R.C. §108(i)) is not to be included in calculating the transferee partner's share of previously taxed capital because this type of income is not taxable gain for purposes of I.R.C. §743.
General partnerships can be a very useful entity for the operational entity of a farm. Liability protection can be achieved by holding the partnership interests in some form of entity that limits liability – such as a limited liability company. But, with partnerships comes tax complexity. When a partnership interest is transferred (by sale, gift or upon death) the tax consequences can become complicated quickly. The same is true when partnerships are merged. Understanding how the flow-through nature of a partnership works, and how basis is computed and adjusted in a partnership is important when such events occur.
Thursday, February 20, 2020
A key aspect of transitioning assets and family business interests to the next generation is maintaining family harmony. Often, that is accomplished when an estate plan is properly put together and takes effect seamlessly at death. When that doesn’t occur is when disharmony among family members can occur and disrupt the transition to the next generation. Sometimes family dynamics prevent a smooth transition. Other times, improper planning or technical errors in the estate plan are the cause of unfulfilled expectations. In still other situations, the estate planning techniques utilized don’t end up functioning as planned. Some recent court decisions illustrate just a snippet of the issues that can arise at death.
Some recent estate and trust court decisions – that’s the topic of today’s post.
A TOD Account as a Fraudulent Transfer?
Heritage Properties v. Walt & Lee Keenihan Foundation, 2019 Ark. 371 (2019)
The plaintiff in this case was a creditor in the decedent’s estate. Before death, the decedent created a brokerage account with $500,000 and designated the defendant as the transfer-on-death (TOD) recipient. The decedent died 18 months after establishing the account at a time when the account value was $1.1 million. Upon the decedent’s death, the $1.1 million in the account transferred automatically to the defendant outside of the decedent’s probate estate. The plaintiff filed a claim against the decedent’s estate for $850,000 which made the estate insolvent. The plaintiff sued the estate in the local trial court rather than the probate court, claiming that the TOD account resulting in a transfer of the $1.1 million to the defendant was a fraudulent transfer designed to defeat the plaintiff’s claim.
The trial court dismissed the case for lack of jurisdiction, standing and lack of sufficient evidence. On further review, the state Supreme Court held that the trial court did have jurisdiction as a court of general jurisdiction and that the plaintiff had standing to directly pursue the estate for return of an allegedly fraudulent transfer. The Court couched its reasoning on the fact that the TOD account was not part of the probate estate. The Court also clarified that the plaintiff didn’t have to show that the decedent had actual intent to defraud the creditor. Instead, the court concluded, the plaintiff only needed to prove that the decedent made the transfer and "intended to incur, or believed or reasonably should have believed that she would incur, debts beyond her ability to pay as they became due." That’s a rather low standard of proof to overcome.
Doll v. Post, 132 N.E.3d 34 (Ind. Ct. App. 2019)
The decedent created a trust in 2010 and amended it before his death in 2018. The trust made specific bequests to the plaintiff, two other individuals, a masonic lodge, and Shriners hospital. The trust contained a residuary clause that stated: “Residue of Trust Property: The Trustee shall hold, distribute and pay the remaining principal and undistributed income in perpetuity; subject, however, to limitations imposed by law. All the powers given by law and the provision[s] of the [T]rust may be exercised in the sole discretion of the Trustee without prior authority above or subsequent approval by any court.”
One of the people who was to receive a specific bequest could not be located. At the time of the decedent’s death, approximately $4,600 remained in the residuary, and the trustee distributed it to charity. The plaintiff moved to intervene arguing that the residuary clause failed, and the remainder should pass to her.
The trial court found that the trust document was ambiguous, and entertained outside evidence. Based on that extrinsic evidence, the court found that the decedent’s intent was to create a charitable trust and that the trustee’s act was proper. On appeal, the appellate court reversed and remanded. The appellate court determined that the trust document did not give the trustee the unfettered authority to distribute the residuary, and that the trustee was bound to follow local law. Local law specified that if the decedent’s intent was not explicit the trustee should select a beneficiary "from an indefinite class," identify a beneficiary with "reasonable certainty," or find a beneficiary capable of being "ascertained." The appellate court determined that the trustee could not find such a beneficiary and that the trust was not purely a charitable trust because some of the named beneficiaries were individuals.
The appellate court also determined that the cy pres doctrine did not apply. The cy pres doctrine allows a court to amend the terms of a charitable trust as closely as possible to the original intention of the testator or settlor to prevent the trust from failing. But, the cy pres doctrine did not apply, the appellate court reasoned, because the trust did not not have general granting language stating the trust’s purpose was charitable, and the charitable portions of the trust were fulfilled with the specific bequests. Consequently, the residuary clause unambiguously failed to designate a beneficiary with reasonable certainty or a beneficiary capable of being ascertained and failed as a matter of law. The appellate court ordered the trustee to hold the residue of the estate and distribute it in accordance with state intestacy law.
Homestead Provision Applicable in Will Construction Battle
Chambers v. Bockman, 2019 Ohio 3538 (Ohio Ct. App. 2019)
The decedent and surviving spouse plaintiff married in 2009. The couple maintained separate residences for the most part. The decedent owned his home on a 1.08-acre tract. Adjacent to this tract but separated by a fence was the decedent’s 55-acre tract where he raised cattle and horses. The decedent owned a third tract adjacent to the plaintiffs’ own home that was used as a rental property. The decedent died in June of 2017. The defendant was appointed executor of the estate. One portion of the decedent’s will specifically left the rental property to the plaintiff. The other portion of the will in dispute stated: “All of the rest, residue and remainder of my property, real, personal and/or mixed, of which I shall die seized, or to which I may be entitled, or over which I shall possess any power of appointment by Will at the time of my decease and wheresoever situated, whether acquired before or after the execution of this, my Will, to my friend, [defendant], absolutely and in fee simple.”
The decedent’s home and farm were appraised as one property and valued at $378,000. In mid-2018, the plaintiff filed a complaint in the probate court to purchase the decedent’s home and farm pursuant to state statute. The defendant countered that the home and farm did not qualify as a “mansion house” under applicable state law because the plaintiff never lived there; the will devised the home and the farm to the defendant; and the plaintiff was not entitled to purchase the home. The probate court, holding for the plaintiff, determined that residency was not required for the statute to apply; the bequest to the defendant was a general bequest that was not specific as to the home and farm; and the plaintiff was entitled to purchase the home and farm for $378,000. The appellate court affirmed.
While the appellate court agreed that the plaintiff could purchase the home if it were a “mansion home,” the court determined that it merely had to be a “home of the decedent” rather than the residence of the surviving spouse. It satisfied that requirement. The appellate court also upheld the trial court’s finding that the decedent did not specifically devise the real estate to the defendant. The farm being adjacent to the home meant that the two properties were operated as one and that the plaintiff could buy both the home and the farm.
Even the best planning can result in unanticipated consequences upon death.
Tuesday, February 18, 2020
The law impacts agricultural operations, rural landowners and agribusinesses in many ways. On a daily basis, the courts address these issues. Periodically, I devote a post to a “snippet” of some of the important developments. Today, is one of those days.
More recent developments in agricultural law and taxation – it’s the topic of today’s post.
IRS Rulings on Portability.
Priv. Ltr. Ruls. 201850015 (Sept. 5, 2018); 20152016 (Sept. 21, 2018); 201852018 (Sept. 18, 2018); 201902027 (Sept. 24, 2018); 201921008 (Dec. 19, 2018); 201923001 (Feb. 28, 2019); 201923014 (Feb. 19, 2019); 201929013 (Apr. 4, 2019).
Portability of the federal estate tax exemption between married couples comes into play when the first spouse dies and the taxable value of the estate is insufficient to require the use of all of the deceased spouse's federal exemption (presently $11.58 million) from the federal estate tax. Portability allows the amount of the exemption that was not used for the deceased spouse's estate to be transferred to the surviving spouse's exemption so that the surviving spouse can use the deceased spouse's unused exemption plus the surviving spouse’s own exemption when the surviving spouse later dies. Portability is accomplished by filing Form 706 in the deceased spouse’s and is for federal estate tax purposes only. Some states that have a state estate tax also provide for portability at the state level. That’s an important feature for those states – it’s often the case that a state’s estate tax exemption is much lower than the federal exemption.
Sometimes a tax election is not made on a timely basis. Over the past year, the IRS issued numerous rulings on portability of the federal estate tax exemption and the election that must be made to port the unused portion of the exemption at the death of the first spouse over to the surviving spouse. In general, each of the rulings involved a decedent that was survived by a spouse, and the estate did not file a timely return to make the portability election. The estate found out its failure to elect portability after the due date for making the election. The IRS determined that where the value of the decedent's gross estate was less than the basic exclusion amount in the year of decedent's death (including taxable gifts made during the decedent’s lifetime), “section 9100 relief” was allowed. Treas. Reg. §§301.9100-1; 301.9100-3
The rulings did not permit a late portability election and section 9100 relief when the estate was over the filing threshold, even if no estate tax was owed because of the marital, charitable, or other deductions. In addition, it’s important to remember that there is a 2-year rule under Rev. Proc. 2017-34, 2017-26 I.R.B. 1282 making it possible to file Form 706 for portability purposes without section 9100 relief
Not Establishing a Lawyer Trust Account Properly Results in Taxable Income.
Isaacson v. Comr., T.C. Memo. 2020-17.
Attorney trust accounts are critical to making sure that money given to lawyers by clients or third-parties is kept safe and isn’t comingled with law firm funds or used incorrectly. But most people (even some new lawyers) don’t fully understand attorney trust accounts. An attorney trust account is basically a special bank account where client funds are stored for safekeeping until time for withdrawal. The funds function to keep client funds separate from the funds of the lawyer or law firm. For example, a trust account bars the lawyer from using a client’s retainer fee from being used to cover law firm operating costs unless the funds have been “earned.” But, whether funds have been “earned” has special meaning when tax rules come into play – think constructive receipt here. This was at issue in a recent Tax Court case.
In the case, a lawyer received a contingency fee upon settling a case. He deposited the funds in his lawyer trust account but did not report the deposited amount in his income for the tax year of the deposit claiming that his fee was in dispute and, thus, subject to a substantial limitation on his rights to the funds. The IRS disagreed and claimed that the account was not properly established as a lawyer trust account under state (CA) law. The IRS also pointed out that the petitioner commingled his funds with his clients’ funds which gave him access to the funds. The IRS also asserted that the petitioner should have reported the amount in income even if he later had to repay some of the amount. The Tax Court agreed with the IRS on the basis that the lawyer failed to properly establish and use the trust account and because the he had taken the opposite position with respect to the fee dispute in another court action. The income was taxable in the year the IRS claimed.
Semi-Trailer in Farm Field Near Roadway With Advertising Subject to Permit Requirement.
Counties, towns, municipalities and villages all have various rules when it comes to billboard and similar advertising. Sometimes those rules can intersect with agriculture, farming activities and rural land. That intersection was displayed in a recent case.
In the case, the defendant owned farm ground along the interstate and parked his semi-trailer within view from the interstate that had a vinyl banner tied to it that advertised a quilt shop on his property. The plaintiff (State Transportation Department) issued the defendant a letter telling him to remove the advertising material. The defendant requested an administrative hearing. The sign was within 660 feet of the interstate and was clearly visible from the interstate. The defendant collected monthly rent of $300 from the owner of the quilt shop for the advertisement. The defendant never applied for a permit to display the banner. The defendant uses the trailer for farm storage and periodically moves it around his property. The administrative hearing resulted in a finding that the trailer was being used for advertising material and an order was adopted stating the vinyl sign had to be removed. The defendant did not appeal this order, but did not remove the banner. The plaintiff sued to enforce the order. After the filing of the suit, the defendant removed the vinyl sign only to reveal a nearly identical painted-on sign beneath it with the same advertising. The plaintiffs amended their complaint alleging that the painted-on sign was the equivalent of the vinyl sign ordered to be removed and requesting that the trial court order its removal. The trial court found that the trailer with the painted-on sign was not advertising material as the semi-trailer was being used for agricultural purposes and was not an advertisement. The court did concede that the semi-trailer was within 660 feet of the right-of-way of the interstate; was clearly visible to travelers on the highway; had the purpose of attracting the attention of travelers; defendant received a monthly payment for maintaining the sign. On further review, the appellate court reversed and remanded. The appellate court concluded that the trailer served a dual purpose of agricultural use and advertising and that there was no blanket exemption for agricultural use. The trailer otherwise satisfied the statutory definition as an advertisement because of its location, visibility, and collection of rental income. The appellate court concluded that the defendant could use the trailer for agricultural purposes in its current location, but that advertising on it was subject to a permit requirement.
Lack of Basis Information in Appraisal Summary Dooms Charitable Deduction for Conservation Easement Donation.
Oakhill Woods, LLC v. Comr., T.C. Memo. 2020-24.
The tax Code allows an income tax deduction for owners of property who relinquish certain ownership rights via the grant of a permanent conservation easement to a qualified charity (e.g., to preserve the eased property for future generations). I.R.C. §170(h). But, abuses of the provision are not uncommon, and the IRS has developed detailed rules that must be followed for the charitable deduction to be claimed. The IRS audits such transactions and has a high rate of success challenging the claimed tax benefits.
In this case, the petitioner executed a deed of conservation easement on 379 acres to a qualified land trust in 2010. The deed recited the conservation purpose of the easement. The petitioner claimed a $7,949,000 charitable deduction for the donation. Included with the petitioner’s return was an appraisal and Form 8283 which requires, among other things, basis information concerning the gifted property or an attached reasonable cause explanation of why the information was not included with the return. Basis information was not included on Form 8283, and the petitioner attached a statement taking the position that such information was not necessary. The IRS denied the deduction for noncompliance with Treas. Reg. §1.170A-13(c)(2). The Tax Court agreed with the IRS, noting that the lack of cost basis information was fatal to the deduction as being more than a minor and unimportant departure from the requirements of the regulation. The Tax Court cited its prior opinion in Belair Woods, LLC v. Comr., T.C. Memo. 2018-159. The Tax Court also rejected the petitioner’s argument that Treas. Reg. §1.170A-13(c)(4)(i)(D) and (E) was invalid. The petitioner claimed that the basis information was required with the return and not the appraisal summary, but the Tax Court rejected this argument because a “return” includes all IRS forms and schedules that are required to be a part of the return. As such, Form 8283 was an essential part of the return. In addition, the Tax Court noted that the underlying statute absolutely required basis information to be included with the appraisal summary and, in any event, the IRS’ interpretation of the statute via the regulation was reasonable.
Cram-Down Interest Rate Determined.
In re Country Morning Farms, Inc., No. 19-00478-FPC11, 2020 Bankr. LEXIS 307 (E.D. Wash. Feb. 4, 2020).
A "cramdown" in a reorganization bankruptcy allows the debtor to reduce the principal balance of a debt to the value of the property securing it. 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. 11 U.S.C. §1129(b)(2)(A). But, how is present value determined? The U.S. Supreme Court offered clarity in 2004. The matter of determining an appropriate discount rate was involved in a recent bankruptcy case involving a Washington dairy operation.
The debtor filed Chapter 11 bankruptcy and couldn’t agree with a creditor (a bank) on the appropriate interest rate to be used in the debtor’s reorganization plan. The parties agreed that the “Prime Plus” method set forth in Till v. SCS Credit Corp., 541 U.S. 465 (2004) was the appropriate method to determine the “cram down” interest rate.” The parties agreed that the prime rate was presently 4.75 percent and that an additional amount as a “risk factor” should be added to the prime rate. The debtor proposed a 6 percent interest rate, based on the risk associated with the dairy business. The bank claimed that the appropriate interest rate was 7.75 percent – the highest rate factor under the Till analysis. The bank cited the length of the plan, the volatility of dairy market, the debtor’s capital structure, and conflicting projections from an expert when determining the appropriate risk factor. The court determined that the appropriate interest rate was 7 percent which raised the interest rate on some of the debtor’s loans and lowering it on others.
There’s never a dull moment in the world of ag law and ag tax. These are just a few developments in recent weeks.
Friday, February 14, 2020
Washburn University School of Law in conjunction with the Department of Agricultural Economics at Kansas State University is sponsoring a farm income tax and farm estate/business planning seminar in Deadwood, South Dakota on July 20 and 21. This is a premier event for practitioners with an agricultural clientele base, agribusiness professionals, farmers and ranchers, rural landowners and others with an interest in tax and planning issues affecting farm and ranch families.
For today’s post I detail the agenda for the event.
Monday July 20
The first day of the conference begins with my annual update of developments in farm income tax from the courts and the IRS. I will address the big ag tax issues over the past year. That session will be followed up with a session on GAAP accounting and the changes that will affect farmer’s financial statements. Topics that Paul Neiffer of CliftonLarsonAllen discuss will include revenue recognition and lease accounting changes.
After the morning break, I will examine several farm tax topics that are of current high importance – tax issues associated with restructuring credit lines; deducting bad debts; forgiving installment sale debt; and selected passive loss issues. Paul will follow up my session with an hour of I.R.C. §199A advanced planning that can maximize the qualified business income deduction for clients.
After the luncheon, U.S. Tax Court Judge Elizabeth Paris will speak for 90 minutes on practicing before the U.S. Tax Court. She will present information all attorneys and CPAs need to consider if they are interested in representing clients in the U.S. Tax Court. She will cover topics including the successful satisfaction of Tax Court notice pleading requirements; multiple exclusive jurisdictions of the Tax Court; troubleshooting potential conflicts and innocent spouse issues; utilizing S-Case procedures to a client’s advantage; and available Tax Court website resources.
I will follow the afternoon break with a discussion of issues associated with net operating losses and excess business losses. I will take a look at how the late 2017 tax legislation changed the rules for net operating losses and excess business losses – how the modified rules work; carrybacks and carryforwards; limitations; relevant guidance; business and non-business income; and entity sales. After my session, Paul will be back to discuss Farm Service Agency Advanced Planning and how to maximize a farm client’s receipt of ag program payments without sacrificing them at the altar of self-employment tax savings.
For the final session of the day I will discuss I will discuss real estate trades when I.R.C. §1245 property (such as grain bins and hog confinement buildings and other structures) is involved in the exchange. address the rules to know, how to identify and avoid the traps and the necessary forms to be filed
Tuesday July 21
I will begin the second day of the conference by providing an update of key developments in the courts and the IRS over the past year that impact estate, business and succession planning for farmers and ranchers. It will be a fast-paced survey of cases and rulings that practitioners must be aware of when planning farm and ranch estates and succession plans. My opening session will be followed by a an hour session on how to incorporate a gun trust into an estate plan. Prof. Jeff Jackson of Washburn Law School will lead the discussion and explore the basic operation of a gun trust to hold firearms and the mechanics of such a trust’s operation. Jeff will discuss the reasons to create a gun trust; their effectiveness as an estate planning tool to hold firearms; common myths and understandings about what a gun trust can do; special rules associated with gun trusts; and client counseling issues associated with gun trusts.
After the morning break, Brandon Ruopp, a private practitioner from Marshalltown, Iowa, will provide a comprehensive review of the rules concerning contributions, rollovers, and required minimum distributions for IRA's and qualified retirement plans following the passage of the SECURE Act in late 2019. I will follow Brandon’s session with a brief session on the common estate planning mistakes that farm and ranch families make that can be easily avoided if they are spotted soon enough. With the many technical rules that govern estate and business planning, sometimes the “little things” loom large. This session addresses these common issues that must be addressed with clients.
After the luncheon, I will provide a brief session on the post-death management of the family farm or ranch business. I will discuss the issues that must be dealt with after the death of family member of the family business. This session will also examine probate administration issues that commonly arise with respect to a farm or ranch estate, including the application of Farm Service Agency rules and requirements. Also addressed will be distributional and tax issues; issues associated with partitioning property; handling marital property and disclaimers; potential CERCLA liability; and issues associated with estate tax audits.
Next up will be Marc Vianello, a CPA in the Kansas City area who is well-renown in the area of valuation discounting. Marc’s session will provide a summary of Marc’s research into the market evidence of discounts for lack of marketability. The presentation will challenge broadly used methodologies for determining discounts for lack of marketability, and illustrate why such discounts should be supported by probability-based option modeling.
Following the afternoon break, I will discuss the valuation of farm chattels and marketing rights and the basic guidelines for determining the estate tax value of this type of farm property.
The final session of the day will be devoted to ethics. Prof. Shawn Leisinger at Washburn Law School will present an interesting session on ethical issues related to risk in a legal context and how to understand and advise clients. Shawn’s presentation will look at how different people, and different attorneys, approach risk taking through a live exercise and application of academic risk approaches to the outcomes. Then, the discussion looks at how an attorney can get competent and ethically advise clients concerning risk decisions in practice. Participants will be challenged to contemplate how their personal approach to risk may impact, or fail to impact, client decisions and choices.
Law School Alumni Reception and CLE
On Sunday evening, July 19, Washburn Law School, in conjunction with the conference will be holding a law school alumni function. Conference attendees are welcome to attend the reception. On Monday, July 20, a separate CLE event will be held for law school alumni at the same venue of the conference. Details on the alumni reception and the CLE topics will be forthcoming.
Registration for the conference will be available soon. Be watching my website – www.washburnlaw.edu/waltr for details as well as this blog. The conference will be held at the Lodge at Deadwood. https://www.deadwoodlodge.com/ A room block has been established for the weekend before the conference and for at least a day after the conference ends.
I hope to see you at Deadwood in July. If you’re looking for high quality CPE/CLE for farm and ranch clients, this conference will be worth your time.
Wednesday, February 12, 2020
Transferring real estate is often an essential aspect of farm and ranch estate and business planning. But, what does it take to effectively transfer title to real estate? Centuries ago in England, a ceremony was held on the land to be transferred and the seller would physically hand some of the soil to the buyer to commemorate the transfer of title to the buyer. That ceremony is not done today, but other requirements must be satisfied to signify that title has been transferred. Clearly a real estate deed must be signed, and the grantor must have the present intent to deliver the deed. But, based on the facts of a particular situation, those requirements may not be as straightforward as they might seem.
Transferring title to real estate – the signing and delivery requirements. These are the topics of today’s post.
The Signing Requirement
A real estate deed must be signed to be effective to convey title. That seems like a simple requirement to satisfy. However, facts can complicate the matter and raise a question of just exactly who must sign the deed. This was on display in a recent case. In In re Estate of Tatum, 580 S.W.3d 489 (Tex. Ct. App. 2019), a married couple had ten children. In 1982 they executed a warranty deed for their 134-acre farm, reserving a life estate in each of them and leaving a remainder interest to each of the children equally. One of the children died in 1999, with his interest passing to his surviving spouse. Later in 1999, the mother requested that the attorney draft a deed conveying the deceased son’s remainder interest back to the parents. This deed listed all ten children (including the surviving spouse of the pre-deceased child) as grantors, and it claimed to convey the farm in fee simple back to the parents. The deed made no reference to the undivided future interests of the children. There was no request that each child (and the surviving spouse of the pre-deceased child) sign the deed, but they understood that the deed would not be effective unless all of them signed it. Two of the children never signed the deed.
The father died in 2000. In 2001 and 2002 four of the children executed affidavits rescinding their signatures. In 2003 the mother and the children had a meeting requesting that the children transfer their interest to one of the children. Five of the children transferred their interest to this child resulting in that child holding a 6/10ths interest in the farm. An agreement could not be reached with the four remaining children. The mother then filed the 1999 deed in March of 2004.
The mother died in 2016 with a will that was based on the assumption that she owned 80 percent of the farm, because of the 1999 deed that eight of children signed. The estate executor sought a probate court determination that the 1999 deed transferred 80 percent of the remainder interest to the parents and that the affidavits were ineffective rescissions. Some of the children counterclaimed seeking validity and enforceability of the 1999 deed and 2001 and 2002 affidavits rescinding their signatures. Other children argued that the deed was never fully executed and delivered so it never became effective to convey any interest in the property.
The probate court granted the executor’s motion for summary judgment and determined that the 1999 deed was "valid, effective, and enforceable against the eight grantors who signed" and was unambiguous. On appeal, the appellate court reversed and remanded.
The only issue on appeal was whether the probate court erred in granting the executor’s motion for summary judgment. The defendant children claimed that there was a genuine issue of material fact as to whether the 1999 deed was enforceable because not all of the children had signed it. The appellate court determined that the evidence revealed an oral understanding among the children that the deed required all of their signatures. This created, the appellate court reasoned, a condition precedent that wasn’t inconsistent with the deed. The deed was silent concerning whether all of the children needed to sign or if it would convey an individual interest. Further the deed described the property as a fee simple absolute, and did not describe the individual interest of the children. Since each of the children owned a one tenth interest, the only way for a full fee simple absolute to be transferred was for all of the children to sign the deed. The appellate court determined that the children had proffered sufficient evidence of the oral condition precedent to raise a genuine issue of material fact.
The Delivery Requirement
Not only must a deed be signed, it must be delivered to be effective to pass title. However, intention to deliver is the controlling element in determining whether a purported delivery is effective to transfer the real estate. For example, in Masek v. Estate of Masek, No. A-10-279, 2010 Neb. App. LEXIS 196 (Neb. Ct. App. Dec. 28, 2010), title to farmland was held not to have transferred due to the lack of the transferor’s present intent to deliver the deed. The deed had been executed in 1977, but was not recorded and later discovered in the transferor’s desk upon his death in 2007. Other facts showed that the transferor exercised ownership and control of the farm until he died.
While no particular form of delivery or ceremony is necessary, any event that clearly manifests the grantor's intent to deliver is effective to convey title. Thus, it is not necessary for a physical transfer of the deed to take place if the grantor has the present intent to part with legal control of the property. In other words, if delivery is not accepted, that has no bearing on the transferor’s present intent to deliver the deed. Conversely, a physical transfer of the deed is not effective to convey title if the delivery is not completed with the requisite intent.
Because of the requirement of a present intent to deliver, any conveyance where the grantor intends to withhold from the grantee complete ownership until the performance of some condition or the happening of some event is a conditional delivery and is ineffective to convey the associated real estate. For example, a deed delivered to a third party with instructions to record it upon the grantor's death is ineffective to transfer title. A deed cannot be used to transfer property at death as can a will unless the statutory requirements for an effective will are satisfied. The formalities for deeds and wills are different. As a result, a deed that fails to transfer title because the grantor did not have the present intent to deliver is seldom treated as a valid will even if the grantor's intent would be furthered.
For instance, in Giefer v. Swenton, 23 Kan. App. 2d 172, 928 P.2d 906 (1996), the decedent owned a small farm. His wife had already died, leaving him with their seven adult children – one son and six daughters. In the fall of 1990, the decedent executed a deed to the farm which conveyed a 1/7 interest in it to each of his children as tenants in common. His will was executed the same day. He didn’t physically transfer the deed to the children, instead holding it until early 1993. At that time, he told one of the daughters to record it. About five months later, he executed a second will leaving the farm to all of the children, but it also contained a provision giving the son the absolute right to buy the farm from his sisters for $400 per acre. About three weeks after executing the second will, the decedent died. All of the daughters except one sold their interest in the farm to their brother. This issue in the case was whether the decedent died owning the family farm or deeded it away before his death. In other words, the issue was whether the deed had been properly delivered.
The court determined that the deed had been effectively delivered when it was recorded. That’s the rule in Kansas – recordation constitutes delivery. Manual delivery to the grantee is not necessary. Here, the deed was recorded at the decedent’s express direction. The court also noted that the deed contained no reservations or qualifications, and that it was clear that the decedent knew what he wanted to do about deeding the farm – he did not want to own the farm at the time of his death. That outcome had an impact on the son.
While it may seem simple to transfer real estate, there can be unique sets of facts that can complicate the signing and delivery requirements. In many situations, a well-trained real estate attorney can provide sound advice to help avoid problems that might arise.
Monday, February 10, 2020
I have done prior posts on conservation easements. In one post I dealt with the perpetuity requirement that must be satisfied for the donor to obtain a tax deduction for the easement that is donated to a qualified charity. In that post, I discussed perpetuity in the context of subordination agreements and deed recordation. But what if the easement is extinguished by a court or there are conditions on the grant or there is a merger of property interests involving the easement. All of these can impact the perpetuity requirement and cause the donor to lose out on the anticipated tax deduction.
Conservation easements are clearly in the “bulls-eye” of IRS scrutiny and the perpetuity requirement is causing practitioners and donors trouble.
Drilling down deeper on the perpetuity requirement associated with the donation of a permanent conservation easement – it’s the topic of today’s post.
The Perpetuity Requirement
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)(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.
The “dirt” is in the details concerning the technical requirements that must be satisfied for the easement donation to meet the perpetuity requirement and generate a charitable contribution deduction for the donor. What are some of those details?
Mortgage. If the donated easement is subject to a mortgage, the mortgagee must subordinate its rights in the property to the rights of the easement holder. In Palmolive Bldg. Investors, LLC v. Comr., 149 T.C. 380 (2017), the IRS disallowed a $33.41 million charitable deduction attributable to the donation of a façade easement over a historic building in Chicago because the mortgage holders were entitled to insurance proceeds in preference to the land trust. The Tax Court agreed, holding that the preference given to the motgagees on the insurance proceeds violated the perpetuity requirement. See Treas. Reg. §§1.170A-14(g)(2); (g)(6)(ii).
Changes and court orders. If some future unanticipated change in the conditions surrounding the easement makes the conservation use of the property impossible or impractical, a court may extinguish the conservation purposes and require the property to be sold. In that event, to preserve the tax deduction for the donor, the donee organization must receive a certain part of the sale proceeds as established by a formula. This requirement is to ensure that the donation is “perpetual” even in the event the easement is extinguished.
For example, 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. Under Treas. Reg. §1.170A(g)(6)(i)-(ii), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. 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.
More recently, the Tax Court decided Railroad Holdings, LLC, et al. v. Comr., T.C. Memo. 2020-22. In the case, 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. §1,70A-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.
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 Treas. Reg. 1.170A-14(g)(6)(ii), making the charitable deduction unavailable. See, e.g., Priv. Ltr. Rul. 200836014 (Sept. 5, 2008); PBBM-Rose Hill, Ltd. v. Comr., 900 F.3d 193 (5th Cir. 2018). This is perhaps the most common audit issue for IRS when examining permanent conservation easement donations.
Amendments. A very common clause in deeds granting permanent conservation easements is one that allows the parties to agree to amend the deed at some point in the future. However, the IRS position is that such deed language violates the perpetuity requirement, even if the right to amend is designed to protect the conservation purposes and ensure that they remain perpetual by making the donated easement flexible to respond to changed circumstances.
Merger. A dominant estate can merge with a lesser estate if the two estates become commonly owned. When that happens, the lesser estate is extinguished. Thus, for example, if a land trust acquires the fee simple interest in conservation easement property, the easement is extinguished. The IRS views the possibility of merger as allowing the parties to extinguish the easement without a judicial proceeding if permitted under state law. In the IRS view, that is a violation of the perpetuity requirement, and raises a question whether contractually prohibiting the dominant and lesser estates to merge is permissible under state property law. The IRS position raises a question as to the possibility of drafting deed language that avoids problems with the IRS on this issue.
Miscellaneous. Recent court decisions and IRS rulings have also touched on other aspects of the perpetuity requirement. For example, in C.C.A. 202002011 (Nov. 26, 2019), the IRS stated that a conservation easement deed may contain a clause specifying that if the easement holder fails to respond within a certain time to a request by the property owner regarding a proposed use that the request is considered to be denied. The IRS noted that because a constructive denial is not a decision by the easement holder based on the merits of the property owner’s request, it is not final or binding on the easement holder, and the property owner can resubmit the same or a similar request for approval. The IRS determined that such clause language does not violate the perpetuity requirements of I.R.C. §170(h).
In TOT Property Holdings, LLC v. Comr., Docket No. 005600-17 (U.S. Tax Ct. Dec. 13, 2019), the petitioner engaged in a syndicated easement transaction whereby it claimed a $6.9 million charitable contribution deduction for an easement on 637 acres of a 652-acre parcel donated to a land conservancy. The IRS denied a charitable deduction due to the easement deed not satisfying the perpetuity requirement and imposed a 40 percent gross valuation misstatement and negligence penalties. The Tax Court agreed, determined that the actual value of the easement donation was less than 10 percent of what was originally reported on the petitioner’s return. In the process, the Tax Court gave more credibility to the approach of the appraiser for the IRS.
The IRS takes a close look at donated conservation easements. It simply does not like the granting of a significant tax deduction while the donor continues to use the underlying property in largely the same manner as before the easement on the property was donated. Thus, all of the requirements necessary to obtain the deduction must be followed. That includes satisfying the perpetuity requirement. IRS is definitely is on the look-out for what it believes are abusive transactions involving charitable contributions of easements.
The IRS has also produced an audit technique guide concerning the donation of permanent conservation easements. That guide should be reviewed by parties interested in donating permanent easements. It is accessible here: https://www.irs.gov/pub/irs-utl/conservation_easement.pdf
Thursday, February 6, 2020
Farmers, ranchers and agribusinesses engage in various transactions and arrangements on a daily basis, perhaps often without much thought given to the legal consequences if the arrangement or transaction goes awry. In those situations, when the unexpected happens, it’s useful to know what legal recourse might be available. Better yet, it’s good to know what the rules are in advance of something happening.
In today’s post, I look at two recent cases that illustrate common situations in agriculture that present interesting legal entanglements.
One type of ag lien, and getting the debtor’s name precisely correct on a lending document – these are the topics of today’s post.
Application of a Harvester’s Lien
States have lien statutes that can apply in various situations. Often they can come into play when one party that supplies services or goods doesn’t get paid and a state lien statute allows the aggrieved party to apply a lien to particular property or income of the non-paying party to secure repayment. But, each type of lien is unique and the particular requirements of the applicable lien statute must be followed closely. One such lien was at the heart of an Iowa case recently.
In Kohn v. Muhr, No. 18-2059, 2019 Iowa App. LEXIS 1064 (Iowa Ct. App. Nov. 27, 2019), a father farmed with his son – a common occurrence in agriculture. Each of them owned land separately, but they farmed with the father’s equipment on all of the land. The father farmed between 6,500 and 8100 acres, and the son approximately 7,000 to 7,500 acres of land. The son paid his father $400,000 for equipment and other expenses. The father contacted a custom harvester in the fall of 2016 to harvest 2,000 acres of corn. Before the work started, the father provided the custom harvester with crop-insurance maps specifying the fields to be harvested. The maps identified the son as the insured party. The father instructed the custom harvester to deliver the corn to multiple elevators in the father’s name. Stored grain was also delivered in the son’s name to elevators and an ethanol plant. Harvest did not conclude until April 8 or 9, 2017, because of weather. Neither the plaintiff nor son paid the custom harvester for the harvesting within 10 days of completion of the harvesting, and the custom harvester filed a lien against both the father and the son for the non-payment.
The father refused payment due to performance issues, and the harvester issued a demand letter. A couple of months later, the father and his bank requested that the harvester remove the father from the lien arguing that the crop was the son’s. The lien was preventing the father from making a margin call. A few days later, the son paid the harvester for the harvesting services and the lien was extinguished. The father then sued the harvester for wrongful filing of a financing statement to secure the lien, claiming that his commodity contracts were involuntarily liquidated and that he incurred financial damages when reestablishing his place in the grain trading market after the lien was extinguished. The father requested statutory and punitive damages. The harvester counterclaimed for breach of contract, seeking reimbursement for reasonable expenses and a declaratory judgment that the filing of the financing statement was authorized under state law. Both parties filed for summary judgment.
The trial court found that the father was a “debtor” under the Iowa Code §571.1B, and that the harvester had personally contracted for the harvesting services, took possession of the grain at the elevator, and commingled the harvested grain in the on-farm storage. The trial court granted partial summary judgment in favor of the harvester as to the properness of the lien filing.
The appellate court affirmed. On appeal, the father claimed that he was not a “debtor” that a lien could be filed against but was merely an agent for his son. The appellate court rejected this argument because it hadn’t been raised at the trial court level. While the harvester worked the son’s property, it was the father that contacted the harvester to arrange for the harvesting and other work. The father was the party responsible for ensuring the property at issue was harvested. The appellate court deemed the situation to be comparable to a contractor/subcontractor arrangement to provide services on the son’s property. As such, the father was “a person for whom the harvester render[ed] such harvesting services” and was a “debtor” under the applicable statute against which the harvester’s lien could apply.
The Importance of Getting A Debtor’s Name Precisely Correct
Ag business sometimes finance purchases of their inventory by farmers and ranchers. Other times, such purchases are financed by a lender such as a bank. In all situations, to “perfect” it’s interest in the debtor’s collateral, it is imperative that the debtor’s name be spelled correctly. The states set forth various rules for determining the parameters of what a correct spelling means. This is an important point, because claiming an interest in collateral involves filing a document informing the public of the creditor’s interest in the debtor’s collateral. So, if the debtor’s name isn’t correct, another potential creditor checking the public record may not find the first lender’s interest and lend the debtor additional funds that otherwise wouldn’t have been loaned.
A recent Kansas case illustrates how important it is to get a debtor’s name correct on a publicly filed lending instrument. In In re Preston, No. 18-41253, 2019 Bankr. LEXIS 3864 (Bankr. D. Kan. Dec. 20, 2019), the debtor filed Chapter 12 bankruptcy in the fall of 2018 and his proposed reorganization plan treated a creditor’s security interest in the debtor’s non-titled personal property (including a combine and header) as unperfected (and, hence, unsecured) on the basis that the creditor’s filed financing statements did not correctly state the debtor’s name. In 2015, the debtor had purchased a combine and header from the creditor on an installment basis. The creditor filed a UCC-1 financing statement to perfect its purchase money lien in the combine and a separate financing statement to protect its lien in the header. Both financing statements listed the debtor’s name as "Preston D.Dennis" (with a period but no space). “Preston” was included in the box for Surname, and "D.Dennis" was in the box for “First Personal Name.” The "Additional name(s)/initial(s)" box was blank. The debtor referred to himself as "D. Dennis Preston" (with a period and a space) and his driver's license displayed his name as "Preston D Dennis" (without a period but with a space). The "Additional name(s)/initial(s)" box was blank.
The debtor’s argument that the creditor’s security interest in the combine and header were unsecured was based on the failure to satisfy Kan. Stat. Ann. §84-9-503 (both the collateral and the debtor were located in Kansas). That provision states that, for individual debtors with a Kansas driver’s license or identification card, the name of the debtor is sufficiently stated “only if the financing statement provides the name of the individual which is indicated on the driver’s license or identification card.” Kan. Stat. Ann. §84-9-503(a)(4). While minor errors or omissions on a financing statement will not cause a security interest to fail, a financing statement is deemed to be seriously misleading (and unperfected) if it doesn’t list the debtor’s name exactly as listed on the debtor’s driver’s license or identification card. Kan. Stat. Ann. §84-9-506(b). But, if the financing statement could be found by performing a search using the filing office’s standard search logic, it is not “seriously misleading” even if it fails to comply with Kan. Stat. Ann. §84-9-503(a)(4). The debtor claimed that the creditor’s interests were unsecured for failure to comport with Kansas law and because a search of the debtor’s name as denoted on the financing statements using standard search logic did not reveal the interests.
The bankruptcy court agreed with the debtor, finding that that the debtor’s name as indicated on the financing statements which did not match the debtor’s driver’s license was seriously misleading. The financing statements should have stated Preston as Debtor's surname, D as his first name, and Dennis as his middle name. The lack of a space and the period were material. The bankruptcy court rejected the creditor’s argument, made without authority, that a driver’s license does not identify the fields as "first," "personal," or "middle," and there is nothing to indicate that periods and spaces change what constitutes a name. The result was that the creditor’s security interests in the combine and header were unperfected, and the bankruptcy court sustained the debtor’s objection to the creditor’s proof of claim. A space and a period proved to be a very costly mistake – a several hundred-thousand-dollar mistake.
The two cases discussed today illustrate rather common scenarios in agriculture. But, they have rather serious ramifications. One slip-up on the law can really cause substantial problems for a farming or ranching operation, or even an agribusiness.