Thursday, September 19, 2019
The Internal Revenue Code (Code) suspends the statutory timeframe for claiming a tax refund for the period of time that an individual is suffering a financial disability. I.R.C. §6511(h). It’s an important statutory provision that can provide relief in the event of unforeseen circumstances. But definitions matter and there is a key exception to the statutory time suspension.
The suspension of the timeframe for claiming a tax refund – it’s the topic of today’s post.
Under I.R.C. §6511 for all taxes for which a return must be filed, a claim or refund must be filed within: (1) three years of the time the return was filed, except, if the return was filed before it was due, then the claim must be filed within three years of the return's due date; (ii) two years from the time the tax was paid, if that period ends later; or, (iii) two years from the time the tax was paid, if no return's filed by a taxpayer required to file a return. I.R.C. §6511(b)(2).
However, those timeframes are suspended for the time period that an individual is “financially disabled.” An individual is “financially disabled” if the individual cannot manage his financial affairs by reason of his medically determinable physical or mental impairment, and the impairment can be expected to result in death, or has lasted, or can be expected to last, for a continuous period of not less than 12 months. I.R.C. §6511(h)(2)(A). Upon the individual’s death, the suspension period ends, and if a joint return is filed, each spouse’s financial disability must be separately determined. C.C.A. 200210015 (Nov. 26, 2001).
The statute has no application to corporations because it, by its terms, applies to an “individual.” That’s the case even for a solely owned corporation where the owner is financially disabled. See, e.g., Alternative Entertainment Enterprises, Inc. v. United States, 277 Fed. Appx. 590 (6th Cir. 2008). The statute also only applies to the limitation periods that are listed in the provision. That means, for example, that it won’t extend the limitations periods for other provisions of the Code such as for net operating losses or loss carrybacks (now only for farmers), etc. See, e.g., McAllister v. United States, 125 Fed. Cl. 167 (2016).
The statute also doesn’t apply to an estate. This point was made clear in a recent case. In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered I.R.C. § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.
The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in I.R.C. §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes.
In all situations, as you probably could guess, a taxpayer is not considered to be financially disabled unless the taxpayer can prove that the statutory requirements are met to the satisfaction of the government. I.R.C. §6511(h)(2)(A).
The courts have fleshed-out the edges on the statute. For example, in Brosi v. Comr., 120 T.C. 5 (2003), the petitioner claimed that the reason he didn’t file was because he was too busy providing care to his mother working for an airline. The Tax Court held he wasn’t entitled to relief because he didn’t personally suffer any physical or mental impairment. The same result occurred in Pleconis v. Internal Revenue Service, No. 09-5970 (SDW) (ES), 2011 U.S. Dist. LEXIS 88471 (D. N.J. 2011). In that case, the taxpayer failed to show that he was financially disabled from 2001-2007 because the evidence showed that even during the periods when he underwent surgeries, he was able to manage his finances, and his conditions had improved by January of 2006. In another case, a taxpayer that missed 60 days of work due to high blood sugar didn’t qualify as “financially disabled. Bhattacharyya v. Comr., 180 Fed. Appx. 763 (9th Cir. 2006).
Authorized “agent”? The statute clearly states that an individual cannot satisfy the statute to be treated as “financially disabled” when there is a spouse or an authorized agent that can handle the individual’s financial affairs for the individual, whether they choose to do so or not. I.R.C. §6511(h)(2)(B). See also, Pull v. Internal Revenue Service, No. 1:14-cv-02020-LJO-SAB, 2015 U.S. Dist. LEXIS 39562 (E.D. Cal. 2015); Plati v. United States, 99 Fed. Cl. 634 (2011). This is the case even when the power to act on the individual’s behalf exists under a durable power of attorney, but the agent has not acted and has agreed not to act on the individual’s behalf until the individual wants the agent to act or otherwise becomes “disabled.” See, e.g., Bova v. United States, 80 Fed. Cl. 449 (2008).
The issue of the presence of an authorized agent came up again in a recent case. In Stauffer v. Internal Revenue Service, No. 18-2105, 2019 U.S. App. LEXIS 27827 (1st Cir. Sept. 16, 2019), an individual who filed suit on behalf of his father’s estate claimed that the IRS had improperly denied his 2013 claim for his father’s 2006 tax refund as untimely. He claimed that the tax refund claim time limitation was suspended because of his father’s financial disability. The trial court dismissed the claim because the son held a durable power of attorney that authorized him to act on his father’s behalf with respect to his father’s financial matters. It made no difference whether he ever actually had acted on his father’s behalf. The mere fact that the durable power of attorney had been executed and was in effect was enough to bar the application of the statute. On appeal, the appellate court agreed.
Financial hardship brings its own set of complications to other areas of life. The Code provides some relief from the filing deadlines. But, the relief only applies to an “individual” and only if that individual is suffering from a financial disability. If someone else is authorized to act on the financial affairs of the individual, the individual cannot be financially disabled. These points should be kept in mind.
Tuesday, September 17, 2019
The Clean Water Act (CWA) has often been in the agricultural news in recent years. Most of that attention has focused on the Waters of the United States” (WOTUS) rule, including the recent regulatory redefinition of the rule. But there’s another issue that’s been lurking in the background, and it involves farm field drainage.
Are return flows to a watercourse from agricultural drainage activities exempt from the CWA permit requirements? It’s the topic of today’s post.
With the enactment of the federal water pollution control amendments of 1972 (more commonly known as the CWA, the federal government adopted a very aggressive stance towards the problem of water pollution.
The CWA essentially eliminates the discharge of any pollutants into the nation's waters without a permit. The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. Point source pollution is the concern of the federal government. Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field. Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.
Importantly, in 1977, the Congress amended the CWA to exempt return flows from irrigated agriculture as a point source pollutant. Thus, irrigation return flows from agriculture are not considered point sources if those “...discharges [are] composed entirely of return flows from irrigated agriculture.” See, e.g., 33 U.S.C. §1342(l)(1); 40 C.F.R. §122.3. See also, Hiebenthal v. Meduri Farms, 242 F. Supp. 2d 885 (D. Or. 2002). This statutory exemption was elaborated in a 1994 New York case, Concerned Area Residents for the Environment v. Southview Farm, 34 F.3d 114 (2d Cir. 1994). In that case, the court noted that when the Congress exempted discharges composed “entirely” of return flows from irrigated agriculture from the CWA discharge permit requirements, it did not intend to differentiate among return flows based on their content. Rather, the court noted, the word “entirely” was intended to limit the exception to only those flows which do not contain additional discharges from activities unrelated to crop production.
In Pacific Coast Federation of Fishermen’s Associations v. Glaser, No. 17-17310, 2019 U.S. App. LEXIS 26938 (9th Cir. Sept. 6, 2019), the plaintiffs (various fishing activist groups) filed a CWA citizen suit action claiming that the defendant’s (U.S. Bureau of Reclamation) Grasslands Bypass Project in the San Joaquin Valley of California was discharging polluted water (water containing naturally-occurring selenium from soil) into a WOTUS via a subsurface tile system under farmland in California’s Central Valley without a CWA permit. The plaintiffs directly challenged the exemption of tile drainage systems from CWA regulation via “return flows from irrigated water” on the basis that groundwater discharged from drainage tile systems is separate from any irrigation occurring on farms and is, therefore, not exempt. After the lower court initially refused to grant the government’s motion to dismiss, it later did dismiss the case noting that the parties agreed that the only reason the project existed was to enable the growing of crops requiring irrigation, and that the drainage of contaminated water only occurred due to irrigated agriculture. The lower court noted that the plaintiffs failed to plead sufficient facts to support a claim that some discharges were unrelated to agricultural crop production. Later, the plaintiffs retooled their complaint to claim that not all of the irrigated water that was discharged through the tile systems came from crop production. Rather, the plaintiffs claimed that some of the discharges that flowed into groundwater were from former farmlands that now contained solar panels. It was this “seepage” from the non-farmland that the plaintiffs claimed was discharged in the farm field tile system and caused the system to contain pollutants that didn’t come exclusively from agricultural crop irrigation. The lower court found the tile system to be within the exemption for “return flows from irrigation,” noting that “entirely” meant “majority” because (in the court’s view) a literal interpretation of the amended statutory language would produce an “absurd result.”
The appellate court reversed. The appellate court held that discharges that include irrigation return flows from activities “unrelated” to crop production are not exempt from the CWA permit requirement. To the appellate court, “entirely” meant just that – “entirely.” It didn’t mean “majority” as the lower court had determined.
What’s the impact of the appellate court’s decision? After all, shouldn’t the appellate court be praised for construing a statute in accordance with what the law actually says? What was the concern of the lower court of a literal interpretation of the statute? For starters, think of the burden of proof issue. Does the appellate court’s decision mean that a plaintiff must prove that some discharges come from non-agricultural irrigation activities, or does it mean that upon an allegation that irrigation return flows are not “entirely” from agricultural crop production that the farmer must prove that they all are? If the latter is correct, that is a next-to-impossible burden for a farmer. Such things as runoff from public roadways and neighboring farm fields can and do often seep into a farmer’s tile drainage system. If that happens, at least in the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington), a farmer’s discharges will require a CWA permit. This is the “absurd result” that the lower court was trying to avoid by construing “entirely” as “majority.”
The appellate court remanded the case to the lower court for further review based on the appellate court’s decision. However, the point remains that the appellate court determined that the exception for return flows from agriculture only applies when all of the discharges involved comes from agricultural sources. That’s why the case is important to any farmer that irrigates crops and should be paid attention to.
Friday, September 13, 2019
Not all contractual transactions for agricultural goods function smoothly and without issues. From the buyer’s perspective, what rights does the buyer have if the seller breaches the contract? One of the ways in which a breach can occur is if the contracted-for goods fail to conform to the contract requirements. That can be a particularly important issue for contracts involving agricultural goods. Ag goods, such as crops and livestock, are not standard, “cookie-cutter” goods. They vary in quality; size; shape; germination rate; and moisture content, for example. All of those aspects can lead to possible non-conformity issues.
Non-conforming agricultural goods – when is a nonconformity significant enough to constitute a breach. Contracts and non-conforming ag goods – it’s the topic of today’s post.
Non-Conformity and the Right of Rejection
A buyer has a right to reject goods that do not conform to the contract. Under the Uniform Commercial Code (UCC), a buyer may reject nonconforming goods if such nonconformity substantially impairs the contract. A buyer usually is not allowed to cancel a contract for only trivial defects in goods. Triviality is highly fact dependent. It is tied to industry custom, past practices between the parties and the nature of the goods involved in the contract.
For example, in Hubbard v. UTZ Quality Foods, Inc., 903 F. Supp. 444 (W.D. N.Y. 1995), a manufacturer of potato chips rejected shipments of potatoes for failure to conform to the contract based on the color of the potatoes. The contract provided that the potatoes had to meet certain quality standards. The buyer was entitled to reject the potatoes if they failed to do so. The potatoes had to meet USDA standards for No. I white chipping potatoes. They had to have a minimum size and be free from bruising, rotting and odors which made them inappropriate for use in the processing of potato chips. The main issue was the color of the potatoes. That issue was decided in accordance with industry custom. Based on industry custom, the court held that the failure to conform substantially impaired the contract and justified the manufacturer’s refusal to accept the potatoes. The defect was not merely trivial.
In a more recent case, Albrecht v. Fettig, 27 Neb. App. 371 (2019), the plaintiff raised Red Angus cattle with operations touching every stage of cattle production, including a feedyard. The plaintiff contacted the defendant (who was not the plaintiff’s usual cattle buyer) to purchase calves for the yard. In May of 2015 the defendant purchased cattle for the plaintiff, with the load consisting mostly of black cattle. The plaintiff accepted the load but stated that he would reject any subsequent load if it consisted primarily of black cattle. Two months later, the defendant purchased another batch of cattle for the plaintiff, promising that there would only be “five or so black hides this time.” The contract for this transaction stated "APPROX 150 - HD," that would be "80% Red Angus cross [and] 20% Bl[ac]k Angus cross steers" at a base average weight of 780 pounds. The price was specified as “$235 per hundredweight with a $0.15 slide.” The contract specified a delivery window of between October 10 and 25, 2015. In early October the defendant contacted the plaintiff with an additional 10 head at $185 per hundredweight. The defendant felt that these 10 head would fall under the “approx” in the contract but notified the plaintiff out of courtesy. The plaintiff never looked at the cattle before delivery.
The cattle were delivered to the plaintiff late at night on October 14, after it was dark outside. The next morning, the plaintiff saw the cattle in the daylight and observed that there were many black-hided steers. The plaintiff stated that he "knew there was more than 20 percent without even counting them...” From a video taken of the cattle the Plaintiff counted 88 red steers, 68 black steers, and 4 “butterscotch” steers. That amounted to 160 head of cattle that were 55 percent red hided, 42.5 percent black hided, and 2.5 percent Charolais influenced. The plaintiff called the defendant on October 15, expressing frustration and displeasure at receiving so many black steers. The defendant offered to take back the black steers, leaving the plaintiff with 88 head of red steers. The plaintiff rejected the offer. The next day, after discussions with family and an attorney, the plaintiff rejected the load. The defendant sent trucks to pick up the rejected cattle on October 17, and the plaintiff requested the $6,000 deposit back. Another agreement for the deposit and trucking costs to be covered by the defendant was also signed on October 17. The defendant never attempted to cure the issue before the specified October 25 date. The defendant kept and fed the cattle himself and later sold them for a loss. On November 9, the plaintiff texted the plaintiff to inquire about the $6,000 deposit refund. The defendant replied that he had filed a lawsuit and that his attorney instructed him not to discuss the matter.
On November 11, the plaintiff sued for breach of the July 15 contract to recover the $6,000 deposit, yardage fees, feed costs and labor and miscellaneous costs associated with loading the cattle for the return trip. The defendant counterclaimed that the plaintiff breached the July 15 contract by refusing to accept delivery of cattle. The defendant requested that the court award damages in the amount of the value lost on the cattle between their delivery and their eventual sale on December 5, 2015, along with associated costs and expenses. The trial court found that the plaintiff did not breach the sale contract and could reject all or part of the delivery. The trial court also found that the defendant failed to cure under the contract before October 25th and the only cure attempted, to take the black calves, would have breached the quantity amount of the contract. The trial court ordered the defendant to refund the $6,000 deposit and 12 percent prejudgment interest on the $6,000 deposit from October 17, 2015, and 12 percent post-judgment interest. The trial court also ordered the defendant to pay incidental damages based on the costs incurred in caring for the cattle on his property from October 14-17, totaling $449.53, and post-judgment interest at the rate of 3.61 percent until paid in full. The defendant filed a motion to alter or amend arguing that prejudgment interest was inappropriate and that a post judgment interest rate of 12 percent was also inappropriate. After a hearing the trial court agreed, dropping the prejudgment interest and setting post-judgment interest at 3.61 percent. Both parties appealed.
The appellate court affirmed the award of the refund of the $6,000 deposit to the plaintiff, and incidental damages for the cost of caring for the cattle between the time of delivery and their return. The appellate court also awarded court costs to the plaintiff, and the denial of prejudgment interest. The appellate court determined that the plaintiff was entitled to reject delivery notwithstanding the contract's additional ground for rejection if the cattle were unmerchantable. The contract, the appellate court noted, was specific as to quantity and weight but the hide colors were more than a trivial variation and the defendant had time post-rejection to correct the error and deliver the correct color of cattle. The appellate court took the issue of interest under advisement.
Inspecting Nonconforming Goods
A buyer has a right before acceptance to inspect delivered goods at any reasonable place and time and in any reasonable manner. The reasonableness of the inspection is a question of trade usage and past practices between the parties. If the goods do not conform to the contract, the buyer may reject them all within a reasonable time and notify the seller, accept them all despite their nonconformance, or accept part (limited to commercial units) and reject the rest. Any rejection must occur within a reasonable time, and the seller must be notified of the buyer's unconditional rejection. For instance, in In re Rafter Seven Ranches LP v. C.H. Brown Co., 362 B.R. 25 (B.A.P. 10th Cir. 2007), leased crop irrigation sprinkler systems failed to conform to the contract. However, the buyer indicated an attempt to use the systems and did not unconditionally reject the systems until four months after delivery. As a result, the buyer was held liable for the lease payments involved because the buyer failed to make a timely, unconditional rejection.
The buyer’s right of revocation is not conditioned upon whether it is the seller or the manufacturer that is responsible for the nonconformity. UCC § 2-608. The key is whether the nonconformity substantially impairs the value of the goods to the buyer.
A buyer rejecting nonconforming goods is entitled to reimbursement from the seller for expenses incurred in caring for the goods. The buyer may also recover damages from the seller for non-delivery of suitable goods, including incidental and consequential damages. If the buyer accepts nonconforming goods, the buyer may deduct damages due from amounts owed the seller under the contract if the seller is notified of the buyer’s intention to do so. See, e.g., Gragg Farms and Nursery v. Kelly Green Landscaping, 81 Ohio Misc. 2d 34; 674 N.E.2d 785 (1996).
Timeframe for Exercising Remedies
The UCC allows buyers a reasonable time to determine whether purchased goods are fit for the purpose for which the goods were purchased, and to rescind the sale if the goods are unfit. Whether a right to rescind is exercised within a reasonable time is to be determined from all of the circumstances. UCC §1-204. The buyer’s right to inspect goods includes an opportunity to put the purchased goods to their intended use. Generally, the more severe the defect, the greater the time the buyer has to determine whether the goods are suitable to the buyer.
Statute Of Limitations
Actions founded on written contracts must be brought within a specified time, generally five to ten years. For unwritten contracts, actions generally must be brought within three to five years. In some states, however, the statute of limitations is the same for both written and oral contracts. A common limitation period is four years. Also, by agreement in some states, the parties may reduce the period of limitation for sale of goods but cannot extend it.
Most contractual transactions for agricultural goods function smoothly. However, when there is a problem, it is helpful to know the associated rights and liabilities of the parties.
Wednesday, September 11, 2019
This month’s installment of court developments concerning agriculture in the courts covers recent developments involving the valuation of a timber enterprise; obtaining a tax refund for an estate due to a financial disability; the calculation of a casualty loss; and the growing of hemp.
Ag law and tax developments in the courts – it’s the topic of today’s post.
Estate Tax Valuation
At issue in Estate of Jones v. Comr., T.C. Memo. 2019-101 were the proper valuations, as of May 28, 2009, of limited partner units in a timber business and stock shares in a sawmill. The decedent died in 2014, having established the sawmill business in 1954 and expanding it substantially since then. The decedent bought about 25,000 acres of timber in 1989 and an additional 125,00 acres in 1992. Later in 1992, the decedent formed the limited partnership to invest in, acquire, hold and manage timberlands and real estate and incur debt. The decedent transferred the timberland, which was considered to be the sawmill’s inventory, to the limited partnership in exchange for an interest in the entity.
The decedent began doing some succession planning in 1996 with the intent of keeping the business in the family as a successful operation. That plan included making gifts of interests in the businesses to family members, including significant blocks of stock. Upon the decedent’s death, the IRS challenged the valuation for gift tax purposes of the 2009 transfers of limited partnership interests and interests of the S corporation that owned the sawmill. Transfer of the limited partnership units was also restricted via a buy-sell agreement that contained a right-of-first refusal. Thus, the determination of fair market value of the 2009 transfers had to account for lack of marketability, lack of control, lack of voting rights of an assignee and reasonably anticipated cash distributions allocable to the gifted interests.
The IRS valued the transfers utilizing a net asset value approach and the estate’s expert used a discounted cash flow approach for both the timberland and the mill. The Tax Court agreed with the valuation arrived at by the estate’s expert, a far lower amount than what the IRS had arrived at.
There are many underlying details concerning the valuation approaches that I am not discussing here. The major point is, however, that taking care to follow well-established valuation procedures and keeping good records is essential. The Tax Court will often adopt the approach that is most precise and is substantiated.
Refund Claims Due To Financial Disability
I.R.C. §6511(h) establishes a statute of limitations for filing a claim for refund due to financial disability. The provision provides “an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” I.R.C. §6511(a)-(c) specifies that, “In the case of an individual, the running of the periods specified in subsections (a), (b), and (c) shall be suspended during any period of such individual’s life that such individual is financially disabled.” In Carter v. United States, No. 5:18-cv-01380-HNJ, 2019 U.S. Dist. LEXIS 134035 (N.D. Ala. Aug. 9, 2019) a decedent’s estate sought relief on the basis that the estate’s personal representative was financially disabled for a period of time entitling the estate to file a claim for refund after the time period set forth in I.R.C. §6511(a). The estate claimed that it should be treated as in individual for relief purposes. The estate sought a refund of federal estate tax tied to the value of bank stock that the decedent held at the time of death which made up 45 percent of the gross estate value. Unknown at the time of death was that a fraud had been committed against the bank which ultimately led to the bank being shut down and the stock rendered worthless. The personal representative was traumatized by the events, suffering emotional distress which rendered her unable to manage the estate which was substantiated by a physician who maintained that the representative’s disabilities triggered § 6511(h)’s equitable tolling provision so as to excuse the untimely filing of the refund claim.
The court disagreed with the estate’s position, holding that the term “individual” in I.R.C. §6511(h)(1) did not apply to an estate. The court pointed out that I.R.C. §7701(a)(1) defines a person as “an individual, a trust, estate, partnership, association, company or corporation.” The court reasoned that this made it clear that the Congress saw individuals and estates as distinct types of taxpayers, and the use of the term individual in IRC §6511(h) limited the relief to natural persons. The court also noted that even if the estate’s claim weren’t time-barred, it would fail on its own merits because estate tax value is based on the value as of the date of death or the alternate valuation date of six months after death. Simply because the fact of the bank fraud arose post-death didn’t change the fact that it wasn’t known at the time of death and the stock was being actively traded at death, the measuring date for federal estate tax purposes.
Calculating a Casualty Loss
While the casualty loss deduction rules have been modified for tax years beginning after 2017, the underlying manner in which a casualty loss is to be computed remains largely the same. Those rules involve documenting the value of the property before the casualty; determining the value after the casualty; income tax basis; and the amount of insurance proceeds received. It’s a big issue for agriculture particularly because of the exposure of agricultural property to weather. A recent Tax Court case illustrates how a casualty loss is computed.
In Taylor II v. Comr., T.C. Memo. 2019-102, the petitioner claimed a casualty loss on his 2008 return for damage from a hurricane. An insurance company paid over $2.3 million in claims, and the claimed deduction was $888,345. The petitioner reported a basis in the property of $6.5 million, insurance reimbursement of $2.3 million and a pre-casualty fair market value of $15,442,059 and a post-casualty fair market value of $12,250,000. The pre-casualty FMV was based on the 2009 listing price of the property reduced for time spent on the market. No testimony was provided as to post-casualty FMV.
The Tax Court (Judge Paris) noted that to compute a casualty loss deduction, the pre and post-FMV values of the impacted property must be computed and the property basis must be established. The Tax Court noted that decline in value can alternatively be established via the regulations under I.R.C. §165 if the taxpayer has repaired the property damage resulting from the casualty, the taxpayer may use the cost of repairs to prove the loss of value to the property from the casualty. In that instance, the taxpayer must show that (a) the repairs are necessary to restore the property to its condition immediately before the casualty, (b) the amount spent for such repairs is not excessive, (c) the repairs do not care for more than the damage suffered, and (d) the value of the property after the repairs does not as a result of the repairs exceed the value of the property immediately before the casualty. The Tax Court noted that the record did not establish that the valuations were based on competent appraisals, and didn’t indicate how the petitioner’s CPAs determined the pre or post-casualty FMV of the property, even though the pre-casualty FMV was consistent with the value reported to the insurance company. The Tax Court concluded that the appraisals were not reliable measures of the taxpayer's casualty loss and didn’t rely on them. In addition, the taxpayer received insurance payments that exceed the cost of repairs. That meant that a casualty loss deduction couldn’t be claimed based on the regulations. The Tax Court disallowed any casualty loss deduction.
Growing of Hemp
The 2018 Farm Bill allows for hemp (not marijuana) production and allows states and Indian tribes to opt for either primary regulatory authority, or USDA authority over any proposed hemp production. Under the primary authority option, a state may submit its own plan to the U.S. Secretary of Agriculture (Secretary). Once a plan is submitted, the Secretary has 60 days to approve or deny the plan. Under the “USDA option,” hemp can be produced under a plan established by the USDA, but the plan must still be submitted to and approved by the Secretary. The Farm Bill provides that the Secretary has explicit authority to set regulations and guidelines that relate to the implementation to both the primary regulatory authority option or the USDA option. On February 27, 2019, the USDA issued a notice that the agency had begun gathering information to promulgate rules and regulations related to the 2018 Farm Bill and the production of hemp in the United States.
In Flandreau Santee Sioux Tribe v. United States Department of Agriculture, No. 4:19-CV-04094-KES, 2019 U.S. Dist. LEXIS 95188 (D. S.D. Jun. 6, 2019), the plaintiff, an Indian tribe, submitted its own proposed hemp production plan in March of 2019. The Secretary issued a letter in stating that the plan would be approved or denied within 60 days after hemp production regulations were finalized – likely in the fall of 2019. On May 6, the plaintiffs submitted a letter to USDA requesting a waiver of regulatory requirements so that the plaintiff could plant hemp during the 2019 growing season. A meeting was held to discuss the waiver. Later that month the plaintiff sued for a temporary restraining order or preliminary injunction seeking to force the USDA to grant the hemp planting waiver.
A hearing on the temporary restraining order was held in June. After the hearing, the court denied the plaintiff’s motion. The court determined that the plaintiff’s motion was not yet ripe and that the plaintiff was not likely to ultimately succeed on the merits of its claim. The court noted that the Farm Bill gave the Secretary broad discretion with respect to hemp production. In addition, the 60-day window to approve or reject plans did not begin until the USDA finalized regulations. The court also noted that there was no monetary remedy built into the law because the USDA was not required to pay compensation for economic losses. The court also determined that the plaintiff’s potential economic losses did not outweigh the impact on the USDA if the injunction were to be granted. The court noted that the issuance of an injunction would force the USDA to act before it could carefully lay out the regulations on hemp production. Such haste in allowing production could have detrimental long-term effects.
There’s never a dull moment in ag law and tax.
Monday, September 9, 2019
When facing financial trouble and bankruptcy, don’t forget about the taxes. While Chapter 12 bankruptcy contains a provision allowing for the deprioritization of taxes, there is no comparable provision for other types of bankruptcies. But, for Chapter 7 and 11 filers, there is a possibility that taxes could be dischargeable in bankruptcy. That’s because under those bankruptcy code provisions, a new tax entity is created at the time of bankruptcy filing.
But, discharging taxes in bankruptcy is a tricky thing. It involves timing and, perhaps, not filing successive cases.
The discharge of tax liability in bankruptcy – it’s the topic of today’s post.
The Bankruptcy Estate as New Taxpayer
As noted, for Chapter 7 (liquidation bankruptcy) or Chapter 11 (non-farm reorganization bankruptcy), a new tax entity separate from the debtor is created when bankruptcy is filed. That’s not the case for individuals that file Chapter 12 (farm) bankruptcy, or Chapter 13 bankruptcy, and for partnerships and corporations under all bankruptcy chapters. In those situations, the debtor continues to be responsible for the income tax consequences of business operations and disposition of the debtor's property. Thus, payment of all the tax triggered in bankruptcy is the responsibility of the debtor. The only exception is that Chapter 12 filers can take advantage of a special rule that makes the taxes a non-priority claim. 11 U.S.C. §1232.
Categories of taxes. The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or Chapter 11 case.
- Category 1 taxes are taxes where the tax return was last timely due more than three years before filing. If an extension was filed, an individual’s return can last be timely filed on October 15th. In this case, the tax is dischargeable provided the bankruptcy is filed on or after October 16th three years after the year the tax return was filed. These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return.
- Category 2 taxes are the taxes due within the last three years. These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors.
- Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing. If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate. If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.
- Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate. Taxes due are paid by the bankruptcy estate as an administrative expense. If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor. Most bankruptcy trustees abandon assets if the taxes incurred will make the bankruptcy estate administratively insolvent.
- Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.
The election to close the debtor’s tax year. In general, the bankrupt debtor’s tax year does not change upon the filing of bankruptcy. But, debtors having non-exempt assets that will be administered by the bankruptcy trustee may elect to end the debtor’s tax year as of the day before the bankruptcy filing.
Making the election creates two short tax years for the debtor. The first short year ends the day before bankruptcy filing and the second year begins with the bankruptcy filing date and ends on the bankrupt’s normal year-end date. If the election is not made, the debtor remains individually liable for income taxes for the year of filing. But, if the election is made, the debtor’s income tax liability for the first short year is treated as a priority claim against the bankruptcy estate, and can be collected from the estate if there are sufficient assets to pay the bankruptcy estate’s claims through the eighth priority. If there are not sufficient assets to pay the income tax, the remaining tax liability is not dischargeable, and the tax can be collected from the debtor at a later time. The income tax the debtor owes for the years ending after the filing is paid by the debtor and not by the bankruptcy estate. Thus, closing the debtor’s tax year can be particularly advantageous if the debtor has substantial income in the period before the bankruptcy filing. Conversely, if a net operating loss, unused credits or excess deductions are projected for the first short year, a short year election should not be made in the interest of preserving the loss for application against the debtor’s income from the rest of the taxable year. Even if the debtor projects a net operating loss, has unused credits or anticipates excess deductions, the debtor may want to close the tax year as of the day before bankruptcy filing if the debtor will not likely be able to use the amounts, the items could be used by the bankruptcy estate as a carryback to earlier years of the debtor (or as a carryforward) and,
But, in any event, if the debtor does not act to end the tax year, none of the debtor’s income tax liability for the year of bankruptcy filing can be collected from the bankruptcy estate. Likewise, if the short year is not elected, the tax attributes (including the basis of the debtor’s property) pass to the bankruptcy estate as of the beginning of the debtor’s tax year. Therefore, for example, no depreciation may be claimed by the debtor for the period before bankruptcy filing. That could be a significant issue for many agricultural debtors.
Consider the following example:
Sam Tiller, a calendar year/cash method taxpayer, on January 26, 2019, bought and placed in service in his farming business, a new combine that cost $400,000. Sam is planning on writing off the entire cost of the new combine in 2019. However, assume that during 2019, Sam’s financial condition worsens severely due to a combination of market and weather conditions. As a result, Sam files Chapter 7 bankruptcy on September 5, 2019.
If Sam does not elect to close the tax year, the tax attributes (including the basis of his property) will pass to the bankruptcy estate as of the beginning of Sam’s tax year (January 1, 2019). Therefore, Sam would not be able to claim any of the depreciation for the period before he filed bankruptcy (January 1, 2016, through September 4, 2019).
The Timing Issue - Illustrative Cases
As you have probably already figured out, timing of the bankruptcy filing is critical to achieving the best possible tax result. Unfortunately, it’s often the case that tax considerations in bankruptcy are not sufficiently thought out and planned for to achieve optimal tax results. Unfortunately, this point is illustrated by a couple of recent cases.
Filing too soon. In Ashmore v. Comr., T.C. Memo. 2017-233, the petitioner claimed that his 2009 tax liability, the return for which was due on April 15, 2010, was discharged in bankruptcy. He filed Chapter 7 on April 8, 2013. That assertion challenged whether the collection action of the IRS was appropriate. As indicated above, the Tax Court noted that taxes are not dischargeable in a Chapter 7 bankruptcy if the return can last be timely filed within three years before the date the bankruptcy was filed. Because the petitioner filed bankruptcy a week too soon, the Tax Court held that his 2009 taxes were not dischargeable and could be collected. As a result, the IRS settlement officer did not abuse discretion in sustaining the IRS levy. In addition, the Tax Court, held that the IRS did not abuse the bankruptcy automatic stay provision that otherwise operates to bar creditor actions to collect on debts that arose before the bankruptcy petition was filed.
The Tax Court’s conclusion in Ashmore is not surprising. The three-year rule has long been a part of the bankruptcy code. Indeed, in In re Reine, 301 B.R. 556 (Bankr. W.D. Mo. 2003), the debtor filed the Chapter 7 bankruptcy petition more than three years after filing the tax return, but within three years of due date of return. The court held that the debtor’s tax debt was not dischargeable.
The peril of multiple filings. In Nachimson v. United States, No. 18-14479-SAH, 2019 Bankr. LEXIS 2696 (Bankr. W.D. Okla. Aug. 23, 2019), the debtor filed Chapter 7 on October 25, 2018 after not filing his tax returns for 2013 through 2016. Immediately after filing bankruptcy, the debtor filed an action claiming that his past due taxes were discharged under 11 U.S.C. §523(a)(1). After extension, the debtor’s 2013 return was due on October 15, 2014. His 2014 return was due April 15, 2015. The 2016 return was due on April 15, 2016. The 2016 return was due April 15, 2017. The debtor had previously filed bankruptcy in late 2014 (Chapter 13), but the case was dismissed on January 14, 2015 after lasting 80 days. He then filed a Chapter 11 case on November 5, 2015, but it was dismissed on April 13, 2016 after 160 days. After that dismissal, he filed another Chapter 11 case on October 20, 2016, but it was dismissed on December 30, 2016 after 71 days. He filed the present Chapter 7 case, as noted, on October 25, 2018. Thus, as of October 25, 2018, he had been in bankruptcy proceedings from October 15, 2014 through October 25, 2018 -311 days.
11 U.S.C. §523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any income tax debt for the periods specified in 11 U.S.C. §507(a)(8). One of the periods contained in 11 U.S.C. §507(a)(8)(A)(i), is the three-year period before the bankruptcy petition is filed. Importantly, 11 U.S.C. §507(a)(8)(A)(ii)(II) specifies that an otherwise applicable time period specified in 11 U.S.C. §507(a)(8) is suspended for any time during which a governmental unit is barred under applicable non-bankruptcy law from collecting a tax as a result of the debtor’s request for a hearing and an appeal of any collection action taken or proposed against the debtor, plus 90 days; plus any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans.
So, what does all this mean? It means that when a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) and the three-year look-back rule is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.
Here, the debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period. He wanted a rather straightforward application of the three-year rule. However, the IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. But the court determined that the real issue was whether the look-back period extended back 401 (311 plus 90) days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A).
The court noted that the Congress, in 2005, amended 11 U.S.C. §507(a)(8) to codify the U.S. Supreme Court decision of Young v. United States, 535 U.S. 43 (2002) where the Supreme Court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. In addition, the Congress amended the statute to tack-on another 90 days to the extension. See, In re Kolve, 459 B.R. 376 (Bankr. W.D. Wisc. 2011). The look-back period automatically tolls upon the filing of a previous case. See, e.g., In re Clothier, 588 B.R. 28 (Bankr. W.D. Tenn. 2018). Thus, instead of suspending the look-back period, it extends it and allows the priority and nondischargeability of tax claims to reach further into the past. Thus, the court in the present case determined that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period (80 + 160 + 71 +90) reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case.
Bankruptcy planning should necessarily account for taxes. The cases point out that timing of the filing of the bankruptcy petition is critical, and that successive filings can create tremendous complications. Competent legal and tax counsel is a must, in addition to competent bankruptcy counsel.
Thursday, September 5, 2019
The Endangered Species Act (ESA) establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531, et seq. The ESA has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the ESA extend to individual members of the species when they are on private land where many endangered species have some habitat.
In late July of 2018, the U.S. Fish and Wildlife Service (USFWS) and the National Marine Fisheries Service (NMFS) issued three proposed rules designed to modify certain aspects of the ESA. Public comment on the proposed rules was accepted until September 24, 2018. On August 12, 2019, the agencies announced the finalization of the regulations.
The ESA regulatory changes and their relevance to agriculture – that’s the topic of today’s post.
The regulatory modifications to the ESA stem from early 2017 when President Trump signed an executive order (Exec. Order 13777, “Enforcing the Regulatory Reform Agenda”) requiring federal agencies to revoke two regulations for every new rule issued. The order also required federal agencies to control the costs of all new rules within their budget. In addition, the order barred federal agencies from imposing any new costs in finalizing or repealing a rule for the remainder of 2017 unless that cost were offset by the repeal of two existing regulations. Exceptions were included for emergencies and national security. Beginning in 2018, the order required the director of the White House Office of Management and Budget to give each agency a budget for how much it can increase regulatory costs or cut regulatory costs. The order was touted as the “most significant administrative action in the world of regulatory reform since President Reagan created the Office of Information and Regulatory Affairs (OIRA) in 1981."
The ESA has long been considered critical to species protection, but it has also been one of the most contentious environmental laws largely because of its impact on the usage of private as well as public land. The judicial and legal costs of enforcing the ESA are quite high, as both environmental and industry groups have historically brought litigation to protect their interests on account of the ESA.
As for private land, about half of ESA listed species have at least 80 percent of their habitat on private lands. This has given concern to landowners that the presence of a listed species on their land will result in land use restrictions, loss in value, and possible involvement in third-party lawsuits.
Under the ESA, “fish and wildlife” species are defined as any member of the animal kingdom, including without limitation any mammal, fish, bird...amphibian, reptile, mollusk, crustacean, arthropod, or other invertebrate. 16 U.S.C. § 1532(8). “Plants” are defined as any member of the plant kingdom. 16 U.S.C. § 1532(14). An “endangered species” is a species which is in danger of extinction throughout all or a significant part of its range other than a species determined by the USFWS to constitute a pest whose protection under the provisions of the Act would present an overwhelming and overriding risk to humans. 16 U.S.C. § 1532(6). A “threatened species” is a species which is likely to become endangered within the foreseeable future throughout all or a significant portion of its range. 16 U.S.C. § 1532(20). The term “species” includes any subspecies of fish or wildlife or plants and any distinct population segment of any species of vertebrate fish or wildlife which interbreeds when mature. 16 U.S.C. § 1532(16).
The Secretary of the Interior (Secretary) determines when a species is to be listed as either threatened or endangered. Presently, there are about 1,700 species listed under the ESA as either endangered or threatened. The listing decision historically has been made on the basis of the best available scientific and commercial data without reference to possible economic or other impacts after the USFWS conducts a review of the status of the species. 16 U.S.C. § 1533(b)(1)(A); 50 C.F.R. 424.11. There is, however, no statutory threshold definition or quantification of the level of data necessary to support a listing decision. Indeed, the information supporting a listing decision need not be credible; only the “best available.”
The USFWS considers species for listing on its own initiative, but the ESA also provides a listing petition process for “interested persons” to force evaluation and listing of a species. Within 90 days of receiving a petition for listing, the USFWS must determine whether the petition presents substantial information to warrant listing of the species. If the USFWS concludes that the petitioned action is warranted, it then conducts a review of the species' status and must determine within one year of the receipt of the petition whether to propose formally the species for listing. The Secretary's decision to list a species as endangered or threatened is based upon the presence of at least one of the following factors; (1) the present or threatened destruction, modification, or curtailment of a species' habitat or range; (2) the over-utilization for commercial, sporting, scientific or educational purposes; (3) disease or predation; (4) the inadequacy of existing regulatory mechanisms; or (5) other natural or manmade factors affecting a species' continued existence. The USFWS may decline to list a species upon publishing a written finding either that listing is unwarranted or that listing is warranted, but that the USFWS lacks the resources to proceed immediately with the proposal. Under the ESA, all USFWS decisions to decline listing a species are subject to judicial review.
When a species is listed as endangered or threatened, the Secretary must consider whether to designate critical habitat for the species. “Critical habitat” is the specific area within the geographical range occupied by the species at the time of listing that is essential to the conservation of the species. Critical habitat may also include specific areas outside the geographical area occupied by the species at the time it is listed if the USFWS determines that such areas are essential for conservation of the species. However, critical habitat need not include the entire geographical range which the species could potentially occupy. 16 U.S.C. § 1532(5). In making a critical habitat determination, the USFWS must consider economic impacts and other relevant impacts, as well as best scientific data. See, e.g., New Mexico Cattle Growers Association. v. United States Fish and Wildlife Service, 248 F.3d 1277 (10th Cir. 2001). The USFWS may exclude any area from critical habitat if the benefits of the exclusion outweigh the benefits of specifying the area as critical habitat, unless the USFWS determines on the basis of best scientific and commercial data available that the failure to designate an area as critical habitat will result in the extinction of the species.
The Final Rules
In general. The final rules are entitled, “Endangered and Threatened Wildlife and Plants; Revision of the Regulations for Listing Species and Designating Critical Habitat.” 83 Fed. Reg. 35,193 (Aug. 12, 2019). The final rules will be codified at 50 C.F.R. pt. 424 and clarify the procedures and criteria that are used to add or remove species from the endangered and threatened species lists and how their critical habitat is designated. The new rules also eliminate the rule that, by default, extended many prohibitions on endangered species to those species that only had threatened stats. In addition, the final rules further define the procedures for interagency cooperation.
The listing process. The final rules modify the ESA listing process. The final rule allows for economic impacts of the potential listing, delisting or reclassifying of a species to be accounted for. The findings of anticipated economic impact must be publicly disclosed. In addition, the Secretary must evaluate areas that are occupied by the species, and unoccupied areas will only be considered “essential” where a critical habitat designation that is limited only to the geographical areas that a species occupies would be inadequate to ensure conservation of the species. In addition, for an unoccupied area to be designated as critical habitat, the Secretary must determine that there is a reasonable certainty that the area will contribute to the conservation of the species and that the area contains one or more physical or biological features essential to the conservation of the species. Also, a “threatened” listing for a species is to be evaluated in accordance with whether the species is likely to become endangered in the “foreseeable future” (as long as a threat is probable).
The final rules also require any critical habitat for a listed species designation to first take into account all areas that a species occupies at the time of listing before considering whether any unoccupied areas are necessary for the survival or recovery of the species. On that point, a determination must be made that “there is a reasonable likelihood that the area will contribute to the conservation of the species” before designating any unoccupied area as critical habitat. This is consistent with the U.S. Supreme Court opinion in Weyerhaeuser Co. v. United States Fish & Wildlife Service, 139 S. Ct. 361(2018), where the Court held that an endangered species cannot be protected under the ESA in areas where it cannot survive.
The “blanket rule.” The ESA statutory protections, including the prohibition on an “unauthorized take” of a species apply only to endangered species. However, the USFWS has automatically extended those protections to all species listed as threatened through a broad regulation known as the “blanket 4(d) rule.” The final rules remove these automatically provided protections to threatened species that are given to endangered species. As a result, the USFWS will be required to develop additional regulations for threatened species on a case-by-case basis to extend the protections given endangered species.
Agency cooperation. The final rules also provide alternative mechanisms intended to improve the efficiency of ESA consultations conducted by the USFWS and federal agencies. The revisions include a process for expedited consultation in which a federal agency and the USFWS may enter into upon mutual agreement. A 60-day limit is included for completion of informal consultations with the option to extend the consultation to no more than 120 days.
The ESA has been termed the “pit bull” of environmental law. It has a history since its enactment in 1973, and the landmark Supreme Court case of Tennessee Valley Authority v. Hill, 437 U.S. 153 (1978), of being the nation’s most controversial environmental law because of its impact on landowners and others. The final regulations are an attempt to inject additional common-sense into the application of the ESA and align it to a greater extent to its original purpose. Another intended impact is a decreased burden on farmers and ranchers. Only time will tell if these goals are actually accomplished.
Tuesday, September 3, 2019
During this time of financial stress in parts of the agricultural sector, a technique designed to assist a financially troubled farmer has come into focus. When farmland is sold under an installment contract, it’s often done to aid the farmer-buyer as an alternative to more traditional debt financing. But what if the buyer gets into financial trouble and can’t make the payments on the installment obligation and the seller forgives some of the principal on the contract? Alternately, what if the principal is forgiven as a means to pass wealth to the buyer as a family member and next generation farmer? What are the tax consequences of principal forgiveness in that situation?
The Tax consequences of forgiving principal on an installment obligation – it’s the topic of today’s post.
The Deal Case
In 1958, the U.S. Tax Court decided Deal v. Comr., 29 T.C. 730 (1958). In the case, a mother bought a tract of land at auction and transferred it in trust to her three sons-in-law for the benefit of her daughters. Simultaneously, the daughters (plus another daughter) executed non-interest-bearing demand notes payable to their mother. The notes were purportedly payment for remainder interests in the land. The mother canceled the notes in portions over the next four years. For the tax year in question, the mother filed a federal gift tax return, but didn’t report the value of the cancelled notes on the basis that the notes that the daughters gave made the transaction a purchase rather than a gift. The IRS disagreed, and the Tax Court agreed with the IRS. The notes that the daughters executed, the Tax Court determined, were not really intended to be enforced and were not consideration for their mother’s transfers. Instead, the transaction constituted a plan with donative intent to forgive payments. That meant that the transfers were gifts to the daughters. Even though the amount of the gifts was under the present interest annual exclusion amount each year, they were gifts of future interests such that the exclusion did not apply and the full value of the gifts was taxable.
Subsequent Tax Court Decisions
In 1964, the Tax Court decided Haygood v. Comr., 42 T.C. 936 (1964). Here, the Tax Court upheld an arrangement where the parents transferred property to their children and took back vendor’s lien (conceptually the same as a contractor’s lien) notes which they then forgave as the notes became due. Each note was secured by a deed of trust or mortgage on the properties transferred. The Tax Court believed that helped the transaction look like a sale with the periodic forgiveness of the payments under the obligation then constituting gifts.
What did the Tax Court believe was different in Haygood as compared to Deal? In Deal, the Tax Court noted, the property was transferred to a trust and on the same day the daughters (instead of the trust) gave notes to the mother. In addition, the notes didn’t bear interest, and were unsecured. In Haygood, by contrast, the notes were secured, and the amount of the gift at the time of the initial transfer was reduced by the face value of the notes.
A decade later the Tax Court ruled likewise in Estate of Kelley v. Comr., 63 T.C. 321 (1974). This case involved the transfer of a remainder interest in property and the notes received (non-interest- bearing vendor’s lien notes) were secured by valid vendor’s liens and constituted valuable consideration in return for the transfer of the property. The value of the transferred interests were reported as taxable gifts to the extent the value exceed the face amount of the notes. The notes were forgiven as they became due. The IRS claimed that the notes lacked “economic substance” and were just a “façade for the principal purposes of tax avoidance.”
The Tax Court disagreed with the IRS position. The Tax Court noted that the vendor’s liens continued in effect as long as the balance was due on the notes. In addition, before forgiveness, the transferors could have demanded payment and could have foreclosed if there was a default. Also, the notes were subject to sale or assignment of any unpaid balance and the assignee could have enforced the liens. As a result, the transaction was upheld as a sale.
The IRS Formally Weighs In
In Rev. Rul. 77-299, 1977-2 C.B. 343, real property was transferred to grandchildren in exchange for non-interest-bearing notes that were secured by a mortgage. Each note was worth $3,000. The IRS determined that the transaction amounted to a taxable gift as of the date the transaction was entered into. The IRS also determined that a prearranged plan existed to forgive the payments annually. As a result, the forgiveness was not a gift of a present interest.
The IRS reiterated its position taken in Rev. Rul. 77-299 in Field Service Advice 1999-837. In the FSA, two estates of decedents held farm real estate. The executors agreed to a partition and I.R.C. §1031 exchange of the land. After the exchange, the heirs made up the difference in value of the property they received by executing non-interest-bearing promissory notes payable to one of the estates. The executors sought a court order approving annual gifts of property to the heirs. They received that order which also provided that the notes represented valid, enforceable debt. The notes were not paid, and gift tax returns were not filed. Tax returns didn’t report the annual cancellation of the notes. The IRS determined that a completed gift occurred at the time of the exchange and that each heir could claim a single present interest annual exclusion ($10,000 at the time). The IRS determined that the entire transaction was a prearranged plan to make a loan and have it forgiven – a sham transaction. See also Priv. Ltr. Rul. 200603002 (Oct. 24, 2005).
The IRS position makes it clear from a planning standpoint where the donor intends to forgive note payments that the loan transaction be structured carefully. Written loan documents with secured notes where the borrower has the ability to repay the notes and actually does make some payment on the notes would be a way to minimize “sham” treatment.
The Congress enacted the Installment Sales Revision Act of 1980 (Act). As a result of the Act, several points can be made:
- Cancelation of forgiveness of an installment obligation is treated as a disposition of the obligation (other than a sale or exchange). R.C. §453B(f)(1).
- A disposition or satisfaction of an installment obligation at other than face value results in recognized gain to the taxpayer with the amount to be included in income being the difference between the amount realized and the income tax basis of the obligation. R.C. §453B(a)(1)
- If the disposition takes the form of a “distribution, transmission, or disposition otherwise than by sale or exchange,” the amount included in income is the difference between the obligation and its income tax basis. R.C. §453B(a)(2).
- If related parties (in accordance with I.R.C. §267(b)) are involved, the fair market value of the obligation is considered to be not less than its full face value. R.C. §453B(f)(2).
Impact of death. The cancellation of the remaining installments at death produces taxable gain. See, e.g., Estate of Frane v. Comr., 98 T.C. 341 (1992), aff’d in part and rev’d in part, 998 F.2d 567 (8th Cir. 1993). In Frane, the Tax Court decided, based on IRC §453(B)(f), that the installment obligations of the decedent’s children were nullified where the decedent (transferor) died before two of the four could complete their payments. That meant that the deferred profit on the installment obligations had to be reflected on the decedent’s final tax return. But, if cancelation is a result of a provision in the decedent’s will, the canceled debt produces gain that is included in the estate’s gross income. See, e.g., Priv. Ltr. Rul. 9108027 (Nov. 26, 1990). In that instance, the obligor (the party under obligation to make payment) has no income to report.
If an installment obligation is transferred on account of death to someone other than the obligor, the transfer is not a disposition. Any unreported gain on the installment obligation is not treated as gross income to the decedent and no income is reported on the decedent's return due to the transfer. The party receiving the installment obligation as a result of the seller's death is taxed on the installment payments in the same manner as the seller would have been had the seller lived to receive the payments.
Upon the holder’s death, the installment obligation is income-in-respect-of-decedent. That means there is no basis adjustment at death. I.R.C. §691(a)(4) states as follows:
“In the case of an installment obligation reportable by the decedent on the installment method under section 453, if such obligation is acquired by the decedent’s estate from the decedent or by any person by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent—
an amount equal to the excess of the face amount of such obligation over the basis of the obligation in the hands of the decedent (determined under section 453B) shall, for the purpose of paragraph (1), be considered as an item of gross income in respect of the decedent; and
such obligation shall, for purposes of paragraphs (2) and (3), be considered a right to receive an item of gross income in respect of the decedent, but the amount includible in gross income under paragraph (2) shall be reduced by an amount equal to the basis of the obligation in the hands of the decedent (determined under section 453 B).”
But, disposition (sale) at death to the obligor is a taxable disposition. I.R.C. §§691(a)(4)-(5). Similarly, if the cancelation is triggered by the holder’s death, the cancellation is treated as a transfer by the decedent’s estate (or trust if the installment obligation is held by a trust). I.R.C. §691(a)(5)(A).
No disposition. Some transactions are not deemed to be a “disposition” for tax purposes. Before the Act became law, the IRS had determined that if the holder of the obligation simply reduces the selling price but does not cancel the balance that the obligor owes, it’s not a disposition. Priv. Ltr. Rul. 8739045 (Jun. 30, 1987). Similarly, the modification of an installment obligation by changing the payment terms (such as reducing the purchase price and interest rate, deferring or increasing the payment dates) isn’t a disposition of the installment obligation. The gross profit percentage must be recomputed and applied to subsequent payments. Also, where the original installment note was replaced, the substitution of a new promissory note without any other changes isn’t a disposition of the original note. See, e.g., Priv. Ltr. Ruls. 201144005 (Aug. 2, 2011) and 201248006 (Aug. 30, 2012).
There is also no disposition if the buyer under the installment obligation sells the property to a third party and the holder allows the third party to assume the original obligor’s obligation. That’s the case even if the third party pays a higher rate of interest than did the original obligor.
Debt forgiveness brings with it tax consequences. Installment obligations are often used to help the obligor avoid traditional financing situations, particularly in family settings. It’s also used as a succession planning tool. But, it’s important to understand the tax consequences for the situations that can arise.
Friday, August 30, 2019
The fall academic semester has begun at the law school and at K-State. That means that my campus teaching duties are done for the year, and now I am fully devoted to speaking at ag law and ag tax events across the country. Actually, I finished up the calendar year’s teaching in late July and have been on the road ever since in Lawrence, Kansas, Illinois, Colorado, Montana, South Dakota and Nebraska. So where does the ag law and tax road take me this fall? What opportunities are there for you this fall to gain additional CLE/CPE credits?
Fall ag law and ag tax seminars – it’s the topic of today’s post.
In the next couple of months, the trail starts with the Washburn Law School/Kansas State University Agribusiness Symposium. This year’s event will be held in Hutchinson, Kansas on September 13 in conjunction with the state fair. Sessions this year include discussions of the legal issues association with precision agriculture and technology; water rights and how to evaluate risks that might reduce value and usefulness; tax planning issues for farmers and ranchers in light of the Tax Cuts and Jobs Act; the details of what happening in the farm economy both from a macroeconomic sense and a microeconomic one; agricultural trade issues; farm bill issues; and ethics. You can learn more about the event and register here: https://www.kfb.org/Article/2019-Kansas-State-UniversityWashburn-University-School-of-Law-Agribusiness-Symposium. This event is also available online for those that aren’t able to travel to Hutchinson.
After the Symposium, I head to Lexington, Kentucky for the presentation of an ag tax seminar and then to Illinois for ag tax seminars in Rock Island and Champaign. You can lean more about the Illinois seminars and register here: https://taxschool.illinois.edu/merch/2019farm.html. For my Iowa friends, particularly those in eastern Iowa, the Rock Island school may be a convenient location for you.
When the calendar flips to October, I will be found in Fresno, California. On October 1 I will providing four hours of ag tax content at the California CPA Society’s “Farmers Tax and Accounting Conference.” The conference is also webcast. For more information, click here: http://conferences.calcpa.org/farmers-tax-accounting-conference/.
The following two weeks show me on the road in Kansas and Nebraska with CPA firm in-house CPE training events.
Late October – Mid-December
Beginning on October 29 are the Kansas State University Tax Institutes that I am a part of. Those begin in western Kansas and move east across the state, finishing in Pittsburg on Dec. 11 and 12. The Pittsburg event is also live simulcast over the web. On December 13, Prof. Lori McMillan (also of Washburn Law) and myself will conduct a 2-hour tax ethics session live in Topeka and over the web. You can learn more about the KSU tax institutes here: https://agmanager.info/events/kansas-income-tax-institute.
I will be conducting additional two-days tax seminars in November. On November 5-6, I will be in Sioux Falls, South Dakota and on November 7-8 I will be in Omaha, Nebraska. You can learn more about those events here: https://astaxp.com/seminars/. On November 20, I will be teaching the second day of a tax seminar in Fargo, North Dakota and then doing the same again in Bismarck on November 22. These are for the University of North Dakota. More information can be obtained about these events here: https://und.edu/conferences/nd-tax-institute/.
When the calendar turns to December, I will be in San Angelo, Texas doing an all-day ag tax seminar for the Texas Society of CPAs on December 3. The next day I will be kicking off the Iowa Bar Bloethe Tax School in Des Moines with a four-hour session on farm taxation. December 6 finds me in Omaha teaching farm tax at the Great Plains Federal Tax Institute. More information about the event can be found here: https://greatplainstax.org/. As mentioned above, the two-hour tax ethics seminar will be in Topeka, Kansas on December 13. That ethics session will also be webcast.
Other events may be added in over the coming weeks. When the calendar flips to 2020, I will be in Nashville, Tennessee; San Antonio, Texas; and Boise, Idaho just to name a few locations. Make sure to check my calendar that is posted on www.washburnlaw.edu/waltr. I update the calendar often.
I hope to see you at one or more of the events this fall!
Wednesday, August 28, 2019
One of the most difficult concepts for law students, and practicing lawyers for that matter, is the Rule Against Perpetuities (RAP). The rule bars a person from using a deed or a will (or other legal instrument) to control the ownership of property well beyond their death – known as “control by the dead hand.” It’s an ancient rule of property law that is intended to enhance the marketability of property by limiting the ability to tie-up the ownership of property for too long of a time period. Wedel v. American Elec. Power Service Corp., 681 N.E.2d 1122 (Ind. Ct. App. 1997). The RAP is, essentially, grounded in public policy. See, e.g., Symphony Space, Inc. v. Pergola Properties, Inc., 88 N.Y.2d 466, 669 N.E.2d 799 (N.Y. 1996).
The RAP often comes into play in estate planning situations with respect to wills and trusts, particularly in large estates where the desire is to keep land in the family for many generations into the future. But, it can also be involved when real estate is transferred and oil production is present or might be in the future. But the Rule has been applied to oil, gas, and mineral leases, too. If some future interest in a mineral deed is granted, the RAP requires the interest to vest (the point in time when a person becomes legally entitled to what has been promised) within 21 years of the lifetimes of those living at the time of the grant. If it is possible for the vesting to happen beyond that 21 years, then the Rule voids the contingent future interest.
Indeed, in 2018, the Texas Supreme Court modified the application of the rule in the context of oil and gas, and recently the Kansas Supreme Court refused to apply the RAP to a defeasible term mineral interest (an interest that is capable of being terminated/voided) – a very common form of mineral ownership.
The implications of not applying the RAP to oil and gas interests - that’s the topic of today’s post.
The RAP originated In the late 17th century in England. In the Duke of Norfolk’s Case, 3 Ch. Cas. 1, 22 Eng. Rep. 931 (Ch. 1682), Henry, the 22nd Earl of Arundel, created an estate plan that sought to pass a portion of his property to his oldest son (who was mentally disabled) and then to his second son. Other property would pass to his second son, and then to his fourth son. Henry’s estate plan also contained provisions for shifting property many generations later if certain conditions should occur. When Henry’s second son succeeded to his older brother’s property, he didn’t want the property to pass to his younger brother. The younger brother sued to enforce his interest as created by Henry’s estate plan. The House of Lords held that the shifting condition that the estate plan created could not have an indefinite existence. The Court was of the view that tying up the ability to transfer property for too long of a time period beyond the lives of the persons that were alive at the time of the initial transfer was impermissible. Just how long was too long was not determined until 1833 in Cadell v. Palmer, 1 Cl. & Fin. 372, 6 Eng. Rep. 936 (H.L. 1832, 1833) where the court set the time limit at lives in being plus 21 years.
A similar property law concept to the RAP is the rule barring unreasonably restraints on alienation. Both concepts are based on the common law’s general distaste of restrictions on the ability to transfer property. See, e,g, Cole v. Peters, 3 S.W.3d 846 (Mo. Ct. App. 1999). But, the concepts are not identical – it is possible for an unreasonable restraint on alienation to occur without triggering the RAP.
2018 Texas Case
In Conoco Phillips Co. v. Koopmann, 547 S.W.3d 858 (Tex. Sup. Ct. 2018), the Texas Supreme Court held that the RAP did not void a 15-year non-participating royalty interest that was reserved in a deed. Accordingly, the Court changed the application of the RAP such that, at least in Texas, it will not void an oil, gas and mineral deed if, regardless of the grant or reservation (it no longer makes a difference whether the interest is created by grant or reservation), the holder of the future remainder interest is at all times ascertainable and the preceding estate was/is certain to terminate. Thus, according to the Texas Supreme Court the RAP will not apply if the future contingent interest is transferable and/or inheritable; the holder of the future interest is known or knowable at all time; and the previous estate is certain to end at some point.
Recent Kansas Case
As noted above, a recent Kansas Supreme Court decision, Jason Oil Company v. Littler, No. 118,387, 2019 Kan. LEXIS 204 (Kan. Sup. Ct. Aug. 16, 2019), involved the application of the RAP to a defeasible term mineral interest. The Court refused to apply the rule.
A defeasible term mineral interest is a durational estate that involves a mineral, royalty or nonexecutive mineral interest for a fixed term of years and for an indefinite period of time thereafter, usually so long as oil or gas is produced. That’s what was it issue in Jason Oil.
In late 1967, a grantor executed two deeds conveying tracts of real estate in the same section of the county. The east half of the section was conveyed to one grantee and the a quarter of the section was conveyed to another grantee. Both deeds stated, “"EXCEPT AND SUBJECT TO: Grantor saves and excepts all oil, gas and other minerals in and under or that may be produced from said land for a period of 20 years or as long thereafter as oil and/or gas and/or other minerals may be produced therefrom and thereunder." The grantor died a few years later and the local probate court distributed set percentages of the residue of the grantor’s estate, including the reserved mineral interest, to the grantor’s descendants.
The 20-year term expired on December 30, 1987. From that time until May 31, 2017, there was no drilling activity on either tract and no gas or mineral production. In 2016, the plaintiff sued to quiet title to both tracts. The plaintiff claimed that it held valid and subsisting oil and gas leases. One set of the grantor’s heirs claimed that they owned an interest in the minerals via the grantor’s will – the grantor owned a fee simple determinable in the mineral rights and that, as a result, they were devised an interest in the minerals. However, another set of the grantor’s heirs claimed that those mineral interests were subject to an invalidated by the RAP because they were “springing executory interests.”
Note: A springing executory interest is an interest in an estate in land created by the conditions of a grant wherein the grantor cuts short the grantor's own interest in the property in favor of the grantee, contingent upon the occurrence of a specific condition. It’s an executory (future) interest that follows an interest that the grantor held upon the happening of a stated event.
If the RAP applied to invalidate their interests, those heirs claimed that their interests should be reformed under the Uniform Statutory RAP contained in Kan. Stat. Ann. §59-3405(b) to conform to the parties’ intent and avoid violating the RAP. The other set of heirs continued to maintain that the RAP invalidated the other heirs’ interest and that the Uniform Statutory RAP was void for violating the Kansas Constitution. As a result, they claimed that they owned the minerals by virtue of the residuary clause of the grantor’s will.
The trial court held that a defeasible term mineral interest is a future estate reserved to the grantor and a reversion. As a reversion remaining to the grantor, the court concluded, it wasn’t subject to the RAP. In addition, the trial court determined that the grantor’s reserved right had not alienated the surface and mineral estates of the tracts.
The Supreme Court agreed with the trial court that the decedent reserved a defeasible term interest. However, the Supreme Court opined that the trial court “…veered off course” by finding (1) the future estate kept by the decedent in the mineral estate was a reversion and (2) the reservation of the defeasible mineral interest was a reversion and not subject to the RAP. However, the Supreme Court declined to apply the RAP concluding that the application of the RAP would be counterproductive to the purpose behind the RAP and create “chaos.” The Supreme Court held that when a grantor (the decedent in this case) creates a defeasible term (plus production) mineral interest by exception that leaves a future interest in an ascertainable person, the future interest in the minerals is not subject to the RAP. In sum, the Supreme Court held that the RAP did not apply because the interest vested during a lifetime, however it reverted back to the surface estate because of the lack of production.
Defeasible term mineral interests are prevalent with oil and gas properties. If the RAP were to apply to these interests, the RAP would invalidate the grantee’s interest. That would often be contrary to the parties’ intent. In fact, had the Kansas court applied the RAP, the future right to the on-half mineral interest upon termination would be void and the landowner (and heirs) would own it forever. Clearly, the parties in Jason Oil did not intend that result. Thus, the Court’s refusal to apply the RAP advanced the underlying public policy of protecting the transferability of interests in land.
The Kansas Supreme Court’s opinion is significant. When application of the RAP would fail to promote transferability of interests in land, it should not be applied. In addition, when a a particular form of property interest (such as a defeasible term mineral interest) has a long history of usage within a particular industry, it is not a good idea to have the RAP apply. In that situation, it would have the serious potential of disrupting titles and impairing commerce in property rights. These points are true even though the Kansas Supreme Court said it was creating a “narrow exception” to the RAP for defeasible term mineral interests. That means the public policy implications of the Court’s decision could apply in future cases.
Monday, August 26, 2019
For agricultural labor, only cash wages are subject to Social Security tax. Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax. I.R.C. §§ 3121(a)(8), 3306(b)(11). In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption. Those guidelines are still relevant in structuring in-kind wage payment arrangements.
Payment in the form of grain, soybeans, cotton or other commodities usually qualifies for the exemption. Payments in the form of livestock or livestock products cause problems but, with careful attention to the rules, should qualify for the special treatment for wages paid in-kind. Payments in a form equivalent to cash are ineligible for the in-kind wage treatment.
But, are commodity wages subject to Form W-2 reporting? They are if they are “wages.” But, are commodity wages really “wages” for W-2 reporting purposes? I got into this issue in an earlier post with respect to whether wages paid to children under age 18 are within the definition of “wages” for purposes of the 20 percent pass-through deduction of I.R.C. §199A here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html.
Commodity wages and W-2 reporting: revisiting the definition of “wages” – it’s the topic of today’s post.
I.R.C. §6051(a)(3) requires the reporting of “wages” as that term is defined in I.R.C. §3401(a). I.R.C. §3401(a) defines “wages” as “all remuneration” including all remuneration paid in a medium other than cash. That’s an all-inclusive definition. However, I.R.C. §3401(a)(2) provides an exception to that broad definition. Ag labor that is defined in I.R.C. §3121(g) is not a “wage” if it meets the definition of a “wages” under I.R.C. §3121(a). I.R.C. §3121(a) specifies that the cash value of all remuneration paid in any medium other than cash is included in the definition of “wages,” except that the term does not include (among others) wages defined in I.R.C. §3121(a)(8). That’s a key exception - it excepts remuneration paid in any medium other than cash for agricultural labor (i.e., commodity wages).
“Wages” as defined by I.R.C. §3121(a)(8)(B) provides another exception from the definition of “wages” for W-2 reporting purposes. This exception applies if the amount paid to the employee is less than $150 AND the total expenditures for ag labor is less than $2,500 for the year. Stated another way (and how the statute actually reads), cash remuneration for ag labor is exempt unless the wage amount to the payee is at least $150 or the total expenditures for ag labor is at least $2,500. The farmer doesn’t need to report any W-2 if all employees are less than $150 and the total to all employees is less than $2,500. That’s because if the exemption of I.R.C. §3121(a)(8)(B) is triggered, all cash wages paid to ag employees satisfy the definition of “wages” that are excluded from the definition of wages for W-2 reporting purposes.
Why File Form W-2?
Even though Form W-2 need not be filed to report commodity wage payments, there are good reasons to complete the Form and file it. For example, W-2 filing is necessary to allow the taxpayer to e-file the tax return. But, even if the commodity wage is not reported on Form W-2, it is reported as other income on Form 1040 if not supported by Form W-2. E-filing would still be allowed.
In addition, Form W-2 filing helps the recipient determine the correct amount of wages to report on line 1. Also, without Form W-2, the recipient may not know the value of the commodity on the date of payment. Similarly, Form W-2 helps the recipient determine the correct income tax basis of the grain sold when calculating gain or loss on the subsequent sale of the commodity that is received in lieu of wages. In addition, if the recipient does not receive a Form W-2, it will be easy for the recipient of the commodity wages to forget to report the fair market value of the commodity wages on their tax return. Also, properly reporting the commodity wages on Schedule F could qualify the taxpayer for “farmer” status if the taxpayer doesn’t have enough gross farm income to satisfy the two-third’s test for estimated tax purposes.
Commodity Wages – A Caution
A further consideration when deciding whether to pay agricultural wages in-kind is that the payment of in-kind wages may threaten an agricultural employee's eligibility for disability benefits and may reduce or eliminate the employee's retirement benefits. Agricultural employees receiving wages in-kind do not build up retirement or disability credit under the Social Security system. For that reason, many employers agree to pay part of the wages in cash and part in-kind. The cash portion would be credited for purposes of the quarters of coverage needed for disability benefits and for purposes of retirement benefits.
Also, payments in-kind for agricultural labor are not considered wages for purposes of determining the amount of earnings in retirement.
Although reporting the income on Form W-2 might be helpful to the employee, the farmer paying the commodity wage does not have a duty to do so. Value is inherently subjective. A bushel of corn in a livestock farmer’s hands, at the farm, may be valued differently when viewed from the perspective of the employee, who is responsible for handling and later selling that commodity. It is not, therefore, the farmer’s responsibility to determine the value of the commodity transferred to the employee and report that value on Form W-2.
Clearly, the Code does not require Form W-2 reporting for commodity wage payments. This comports with the Code’s longtime exclusion of agriculture from the need to determine the value of commodities that are transferred. For example, Form 1099-Misc need not be issued for crop share rents and the landlord need not report the value of the rent received in income as a crop share until it is converted to cash (or used to satisfy a liability).
Thus, while Form W-2 reporting is not required for in-kind wage payments to agricultural labor as noted above, it might be a good idea to do so in particular circumstances.
Friday, August 23, 2019
Farmers have various sources of income. Of course, grain sales and livestock sales are common and the tax rules on the treatment of such sales are generally well understood. Farmers also have other miscellaneous sources of income from such things as the sale of timber and soil and natural resources. Another source of income for some farmers and ranchers is from breeding fees.
The proper tax reporting of income from breeding fees – it’s the topic of today’s post.
Sale or Lease?
Perhaps the starting point in determining the proper tax treatment of breeding fees from the perspective of both the buyer and the seller is to properly analyze the transaction that the parties have entered into. The key question is whether a breeding fee arrangement is a lease or a sale. This is not only important from a tax standpoint, but also from a financing and secured transaction standpoint. See, e.g., In re Joy, 169 B.R. 931 (Bankr. D. Neb 1994).
The courts and the IRS have, at least to a small extent, dealt with the proper tax treatment of breeding fees. A breeding or stud fee is classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g., Jordan v. Comr., T.C. Memo. 2000-206. For example, in Duggar v. Comr., 71 T.C. 147 (1978), acq., 1979-1 C.B. 1, the petitioner entered into a “management agreement” with a cattle breeder. Under the agreement, the petitioner leased 40 brood cows and paid a fee for the artificial insemination of each brood cow as the initial step in developing a purebred herd. The agreement specified that the petitioner owned each calf at the time of birth, but did not have possession of any particular calf until after weaning – about a year after birth. The petitioner also paid a “calf maintenance” fee for each calf until the calf was weaned. After weaning and gaining possession of a calf, the petitioner could either sell the calf or pay an additional annual maintenance fee to the cattle breeder for the care of the heifers during the pre-breeding timeframe.
On his tax return, the petitioner deducted the cost of leasing the cows and maintenance fee associated with each calf for both the pre-weaning and pre-breeding stages. The IRS denied the deductions and the Tax Court agreed. The Tax Court concluded that the transaction between the petitioner and the cattle breeder was essentially the purchase of weaned calves. It couldn’t be properly characterized as the rental and care of breeding cows because the risk of loss with respect to any particular calf didn’t pass to the petitioner until after the calf was weaned. Thus, the costs that the petitioner incurred for the leasing of the cows and the maintenance of the calves before weaning had to be capitalized. However, the Tax Court did conclude that the expenses that the petitioner incurred to maintain the calves post-weaning were currently deductible.
Shortly after the Tax Court decided Duggar, the IRS issued a Revenue Ruling on the subject. The facts of the ruling are similar to those of Duggar. In Rev. Rul. 79-176, 1979-1 C.B. 123, a taxpayer on the cash method of accounting entered into a cattle breeding service agreement with another party. The agreement was specifically referred to as a lease. The agreement specified that the taxpayer “leased” cows from the herd owner. Under the agreement, any calf that was produced within a year of mating was to remain with its mother for a year after birth. When a calf was weaned the agreement termination and the calf was to be healthy and ready for breeding. Only after a calf was weaned did the taxpayer gain possession of the calf. Upon gaining possession, the taxpayer could sell the calf or place it in a herd management program.
Based on these facts, the IRS took the position that the arrangement amounted to a sales contract for the purchase of a live calf. Thus, the costs attributable to the cattle breeding, including the breeding fee and the initial cost of caring for the cow and calf until the calf was weaned, were non-deductible capital expenditures under I.R.C. §263. The calf could be depreciated over its useful life.
In contrast to the facts of Duggar and Rev. Rul. 79-176, if a taxpayer pays a breeding fee an animal bred that the taxpayer owns, the fee is deductible.
For a taxpayer that is on accrual accounting, breeding fees must be capitalized and allocated to the cost basis of the animal.
What About Embryo Transplanting?
An amount paid for embryo transplanting, including the cost of buying the embryo and costs associated with preparing the animal for transplantation and the transplant fees are deductible as “breeding fees.” Priv. Ltr. Rul. 8304020 (Oct. 22, 1982). But, if the taxpayer buys a pregnant cow the purchase price is to be allocated to the basis of the cow and resulting calf in accordance with the fair market value of the cow and the calf. In this situation, there is no current deduction for the purchase price of the cow or the portion of basis that is allocated to the calf.
What About the Owner of the Breeding Cattle?
Neither the Tax Court in Duggar, nor the IRS in Rev. Rul. 79-176 discussed the tax consequences to the owner of the breeding cattle. But, as noted above, both the Tax Court and the IRS treated that transactions involved as a sale. Because of that characterization, the owner of the breeding cattle should treat receipt of breeding fees as income from the sale of calves. If part of all of the fee is later refunded because the animal did not produce live offspring (or for any other reason) any breeding fees received should still be treated as income in the year received with a later deduction for the year that a refund is made.
Farmers and ranchers generate income in unique ways. Breeding fees arrangements are just one of those ways. Most likely, any such arrangement should be treated as a sale on the tax return. But, as noted, the correct answer is highly fact dependent.
Tuesday, August 20, 2019
Through 2016, the U.S. Treasury Department was pushing for the elimination of valuation discounts for federal estate and gift tax purposes. However, as part of the elimination of “non-essential” regulations under the Trump Administration, the Treasury announced in 2017 that it would no longer push for the removal of valuation discounts to value minority interests in entities or for interests that aren’t marketable. That means that the concept of valuation discounting is back in vogue – for those that need it. Of course, with the increase in the federal estate and gift tax applicable exclusion amount to $11.4 million (for deaths occurring and gifts made in 2019), the practice of valuation discounting is only used in select instances.
But, one area in which valuation discounting remains rather prominent is in the context of entity valuation when built-in gain (BIG) tax is involved. Can a discount be claimed for BIG tax? If so, what’s the extent of the discount? These are the topics of today’s post.
Illustration of the problem
Assume that Sam is interested in buying a tract of real estate. Sam finds two identical tracts – tract “A” and tract “B.” Sid owns tract A outright, and tract B is owned by a C corporation. Both tracts are worth $2 million and each have a cost basis of $200,000. If Sam buys tract A from Sid for $2 million and sells it five years later for $4 million, the capital gain triggered upon sale will be $2 million and the resulting tax (assuming a 20 percent effective capital gain tax rate) will be $400,000. So, the result is that Sam invested $2 million and five years later received $3.6 million when he “cashed-in” his investment.
However, if Sid owns tract B inside of a C corporation and Sam were to pay $2 million to buy 100 percent of the C corporate stock, he would receive the corporation’s stock with the land at the low $200,000 basis. Thus, upon sale of the land five years later for $4,000,000, the capital gain inside the corporation is $3.8 million). Based on a hypothetical capital gain tax rate of 20 percent, the capital gains tax liability inside the corporation is $760,000. This leaves $3,240,000 left to distribute from the corporation to Sam. Assuming Sam’s basis in the corporate stock is $2,000,000 (the amount he originally paid for the stock), Sam has additional capital gain at the shareholder level of $1,240,000. Assuming a capital gain tax rate of 20 percent, Sam must pay an additional $248,000 in capital gain tax at the shareholder level. So, the total tax bill to Sam is $1,008,000. The result is that Sam received $2,992,000 when he cashed his investment in five year later.
So, in theory, would Sam pay the same amount Sam for tract “A” as he would for tract “B”? The answer is “no.” Sam would pay an amount less than fair market value to reflect the BIG tax he would have to pay to own tract “B” outright and not in the C corporate structure. That’s the basis for the discount for the BIG tax – to reflect the fact that the taxpayer in Sam’s position would not pay full fair market value for the asset. Rather, a discount from fair market value would be required to reflect the BIG tax that would have to be paid to acquire the asset outright and not in the C corporate structure.
BIG Tax Discount - The IRS and the Courts
IRS position and early cases. The IRS maintained successfully (until 1998) that no discount for BIG tax should apply, but the courts have disagreed with that view. That all changed in 1998 when the Tax Court decided Estate of Davis v. Comr., 110 T.C. 530 (1998) and the U.S. Court of Appeals for the Second Circuit decided Eisenberg v. Comr., 155 F.3d 50 (1998). In those cases, the court held that, in determining the value of stock in a closely held corporation, the impact of the BIG tax could be considered. In Eisenberg, the appellate court directed the Tax Court (on remand) that some reduction in value to account for the BIG tax was appropriate. Ultimately, the Tax Court did not get to decide the amount of the discount, because the case settled. The IRS acquiesced in the Second Circuit’s opinion and treats the applicability of the discount for BIG tax as a factual matter to be determined by experts using generally applicable valuation principles. A.O.D. 1999-001 (Jan. 29, 1999).
The level of the discount. Initially, the courts focused on the level of the discount. But, in 2007, the United States Court of Appeals for the Eleventh Circuit in Estate of Jelke III v. Comr., 507 F.3d 1317(11th Cir. 2007), held that in determining the estate tax value of holding company stock, the company's value is to be reduced by the entire built-in capital gain as of the date of death. In 2009, the U.S. Tax Court followed suit and essentially allowed a full dollar-for-dollar discount in a case involving a C corporation with marketable securities. Estate of Litchfield v. Comr., T.C. Memo. 2009-21. In 2010, the Tax Court again allowed a full dollar-for-dollar discount for BIG tax in Estate of Jensen v. Comr., T.C. Memo. 2010-182.
The Tax Court, in 2014, held that a BIG tax discount was allowable. Estate of Richmond v. Comr., T.C. Memo. 2014-26. Ultimately, the Tax Court determined that the BIG tax discount was 43 percent of the tax liability (agreeing with the IRS) rather than a full dollar-for-dollar discount, but only because the potential buyer could defer the BIG tax by selling the securities at issue over time. That meant, therefore, that the BIG tax discount was to be calculated in accordance with the present value of paying the BIG tax over several years.
Implications for Divorce Cases
While the rulings in Jelke III, Litchfield and Jensen are important ones for estate tax valuation cases, they may not have a great amount of practical application given that very few estates are subject to federal estate tax, and of those that are taxable, only a few involve a determination of the impact of BIG tax on valuation. However, the impact of BIG tax in equitable distribution settings involving divorce may have much greater practical application. Many states utilize the principles of equitable distribution in divorce cases. Under such principles, the court may distribute any assets of either the husband or wife in a just and reasonable manner. Any factor necessary to do equity and justice between the parties is to be considered. Technically, the tax consequences to each spouse are to be considered. However, the amount (or even the allowance) of a discount for built-in capital gains tax is not well settled.
In divorce settings, courts tend to be reluctant to deduct potential tax liability from the distribution of the underlying assets. For example, a Pennsylvania court, in a 1995 opinion, refused to deduct the potential tax liability associated with the distribution of defined benefit pension plans. Smith v. Smith, 439 Pa. Super. 283, 653 A.2d 1259 (1995). The court held that potential tax liability could be considered in valuing marital assets only where a taxable event has occurred or is certain to occur within a time frame such that the tax liability can be reasonably predicted. The North Carolina Court of Appeals has ruled likewise in Weaver v. Weaver, 72 N.C. App. 409 (1985), as have courts in New Jersey (see, e.g., Stern v. Stern, 331 A.2d 257 (N.J. 1975); Orgler v. Orgler, 237 N.J. Super. 342, 568 A.2d 67 (1989); Goldman v. Goldman, 275 N.J. Super. 452, 646 A.2d 504 (1994), cert. den., 139 N.J. 185, 652 A.2d 173 (1994)), Delaware (Book v. Book, No. CK88-4647, 1990 Del. Fam Ct. LEXIS 96 (1990)), West Virginia Hudson v. Hudson, 399 S.E.2d 913 (W. Va. 1990); Bettinger v. Bettinger, 396 S.E.2d 709 (W. Va. 1990)) and South Dakota (See, e.g., Kelley v. Kirk, 391 N.W.2d 652 (1986)). But, the Oregon Court of Appeals, has indicated that a reduction for taxes should be allowed in divorce cases subject to equitable distribution rules. In re Marriage of Drews, 153 Ore. App. 126, 956 P.2d 246 (1998).
The courts have largely dismissed the IRS view that generally opposed a BIG tax discount. It’s simply not the way that buyers operate in actual transactions. In any event, when a discount for BIG tax is sought, hiring a tax expert and a valuation expert can go along way to establishing a full dollar-for-dollar discount for the BIG tax.
Friday, August 16, 2019
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “swampbuster.” Swampbuster was introduced into the Congress in January of 1985 at the urging of the National Wildlife Federation and the National Audubon Society. It was originally presented as only impacting truly aquatic areas and allowing drainage to continue where substantial investments had been made. Thus, there was virtually no opposition to Swampbuster.
But, the “dirt is in the details” as it is often said. Just how does the USDA determine if a tract of farmland contain a wet area that is subject to regulation? That’s a question of key importance to farmers. That process was also the core of a recent court opinion, in which the court painted a rather bleak and embarrassing picture of the USDA bureaucrats.
Swampbuster and the USDA’s process for determining land subject to the Swampbuster rules – that’s the topic of today’s post.
The legislation charged the soil conservation service (SCS) with creating an official wetland inventory with a particular tract being classified as a wetland if it had (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions. In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. The presence of hydrophytic vegetation, by itself, is insufficient to meet the wetland hydrology requirement and the statute clearly requires the presence of all three characteristics. B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008).
Under the June 1986 interim rules, wetland was assumed to be truly wet ground that had never been farmed. In addition, “obligation of funds” (such as assessments paid to drainage districts) qualified as commenced conversions, and the Fish and Wildlife Service (FWS) had no involvement in ASCS or SCS decisions. In September of 1986, a proposal to exempt from Swampbuster all lands within drainage districts was approved by the chiefs of the ASCS, SCS, FmHA, FCIC and the Secretary of Agriculture. However, the USDA proposal failed in the face of strong opposition from the FWS and the EPA.
The final Swampbuster rules were issued in 1987 and greatly differed from the interim rules. The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion. Added were farmed wetlands, abandoned cropland, active pursuit requirements, FWS concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill). If the drainage work was not completed by December 23, 1985, a request could be made of the ASCS on or before September 19, 1988, to make a commencement determination. Drainage districts must satisfy several requirements under the “commenced conversion” rules. A project drainage plan setting forth planned drainage must be officially adopted. In addition, the district must have begun installation of drainage measures or legally committed substantial funds toward the conversion by contracting for installation or supplies.
The final rules defined “farmed wetlands” as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). Prior converted wetlands can be farmed, but they revert to protected status once abandoned. Abandonment occurs after five years of inactivity and can happen in one year if there is intent to abandon. A prior converted wetland is a wetland that was totally drained before December 23, 1985. Under 16 U.S.C. §3801(a)(6), a “converted wetland” is defined as a wetland that is manipulated for the purpose or with the effect of making the production of an agricultural commodity possible if such production would not have been possible but for such action. See, e.g., Clark v. United States Department of Agriculture, 537 F.3d 934 (8th Cir. 2008). If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original drainage can be maintained.
Identifying a Wetland – The Boucher Saga
The process that the USDA uses to determine the presence of wet areas on a farm that are subject to the Swampbuster rules (known as the “on-site” wetland identification criteria) are contained in 7 C.F.R. §12.31. The application of the rules was at issue in the most recent opinion in a case involving an Indiana farm family’s longstanding battle with the USDA.
Facts and administrative appeals. The facts of the litigation reveal that the plaintiff (and her now-deceased husband) owned the farm at issue since the early 1980s. The farmland has been continuously used for livestock and grain production for over 150 years. The tenants that farm the land participated in federal farm programs. In 1987, the plaintiffs were notified that the farm might contain wetlands due to the presence of hydric soils. This was despite a national wetland inventory that was taken in 1989 that failed to identify any wetland on the farm. In 1991, the USDA made a non-certified determination of potential wetlands, prior converted wetlands and converted wetlands on the property. In 1994, the plaintiff’s husband noticed that passersby were dumping garbage on a portion of the property. To deter the garbage-dumping, the plaintiff’s husband cleaned up the garbage, cleared brush, and removed five trees initially and four more trees several years later. The trees were upland-type trees that were unlikely to be found in wetlands, and the tree removal impacted a tiny fraction of an acre. The USDA informed the landowners that the tree removal might have triggered a wetland/Swampbuster violation and that the land had been impermissibly drained via field tile (which it had not).
Because the land at issue was farmed, the USDA’s Natural Resources Conservation Service (NRCS) used an offsite comparison field to compare with the tract at issue for a determination of the presence of wetland. The comparison site chosen was an unfarmed depression that was unquestionably a wetland. In 2002, an attempt was made to place the farm in the Conservation Reserve Program, which triggered a field visit by the NRCS. However, a potential wetland violation had been reported and NRCS was tasked with making a determination of whether a wet area had been converted to wetland after November 28, 1990. The landowners requested a certified wetland determination, and in late 2002 the NRCS made a “routine wetland determination” that found all three criteria for a wetland (hydric soil, hydrophytic vegetation and hydrology) were present by virtue of comparison to adjacent property because the tract in issue was being farmed. The landowners were notified in early 2003 of a preliminary technical determination that 2.8 acres were converted wetlands and 1.6 acres were wetlands. The NRCS demanded that the landowners plant 300 trees per acre on the 2.8 acres of “converted wetland.”
The landowners requested a reconsideration and a site visit. Two separate site visits were scheduled and later cancelled due to bad weather. The landowners also timely notified NRCS that they were appealing the preliminary wetland determination and requested a field visit, asserting that NRCS had made a technical error. A field visit occurred in the spring of 2003 and a written appeal was filed of the preliminary wetland determination and a review by the state conservationist was requested. The appeal claimed that the field visit was inadequate. The husband met with the State Conservationist in the fall of 2003. No site visit occurred, and a certified final wetland determination was never made. The landowners believed that the matter was resolved.
The husband died, and nine years later a new tenant submitted a “highly erodible land conservation and wetland conservation certification” to the FSA. Permission was requested from the USDA to remove an old barn and house from a field to allow farming of that ground. In late 2012, the NRCS discovered that a final wetland determination had never been made and a field visit was scheduled for January of 2013 shortly after several inches of rain melted a foot of snow on the property. At the field visit, the NRCS noted that there were puddles in several fields. The NRCS used the same comparison field that had been used in 2002, and also determined that underground drainage tile must have been present (it was not).
Based on the January 2013 field visit, the NRCS made a final technical determination that one field did not contain wetlands, another field had 1.3 acres of wetlands, another field had 0.7 acres of converted wetlands and yet another field had 1.9 acres of converted wetlands. The plaintiff (the surviving spouse) appealed the final technical determination to the USDA’s National Appeals Division (NAD). At the NAD, the plaintiff asserted that either tile had been installed before the effective date of the Swampbuster rules in late 1985 or that tiling wasn’t present (a tiling company later established that no tiling had been installed on any of the tracts); that none of the tracts showed water inundation or saturation; that none of the tracts were in a depression; and that the trees that were removed over two decades earlier were not hydrophytic, were not dispositive indicators of wetland, and that improper comparison sites were used. The NRCS claimed that the tree removal altered the hydrology of the site. The USDA-NAD affirmed the certified final technical determination. The plaintiff appealed, but the NAD Director affirmed. The plaintiff then sought judicial review.
Trial court decision. The trial court affirmed the NAD Director’s decision and granted summary judgment to the government. Boucher v. United States Department of Agriculture, No. 1:13-cv-01585-TWP-DKL, 2016 U.S. Dist. LEXIS 23643 (S.D. Ind. Feb. 26, 2016). The court based its decision on the following:
- The removal of trees and vegetation had the “effect of making possible the production of an agricultural commodity” where the trees once stood and, thus, the NRCS determination was not arbitrary or capricious with respect to the converted wetland determination.
- The NRCS followed regulatory procedures found in 7 C.F.R. §12.31(b)(2)(ii) for determining wetland status on the land that was being farmed by comparing the land to comparable tracts that were not being farmed.
- Existing regulations did not require site visits during the growing season.
- “Normal circumstances” of the land does not refer to normal climate conditions but instead refers to soil and hydrologic conditions normally present without regard to the removal of vegetation.
- The ten-year timeframe between the preliminary determination and the final determination did not deprive the plaintiff of due process rights.
The appellate court reversed the trial court decision and remanded the case for entry of judgment in the plaintiff’s favor and award her “all appropriate relief.” Boucher v. United States Dep’t of Agric., No. 16-1654, 2019 U.S. App. LEXIS 23695 (7th Cir. Aug. 8, 2019). On the comparison site issue (the USDA’s utilization of the on-site wetland identification criteria rules), the USDA claimed that 7 C.F.R. § 12.31(b)(2)(ii) allowed them to select a comparison site that was "on the same hydric soil map unit" as the subject property, rather than on whether the comparison site has the same hydrologic features as the subject tract(s). The appellate court rejected this approach as arbitrary and capricious, noting that the NRCS failed to try an "indicator-based wetland hydrology" approach or to use any of their other tools when picking a comparison site. In addition, the appellate court noted a COE manual specifies that, “[a] hydrologist may be needed to help select and carry out the proper analysis" in situations where potential lack of hydrology is an issue such as in this case. However, the NRCS did not send a hydrologist to personally examine the plaintiff’s property, claiming instead that a comparison site was not even necessary. Based on 7 C.F.R. §12.32(a)(2), the USDA claimed, the removal of woody hydrophytic vegetation from hydric soils to permit the production of an agricultural commodity is all that is needed to declare the area "converted wetland."
The appellate court concluded that this understanding of the statue was much too narrow and went against all the other applicable regulatory and statutory provisions by completely forgoing the basis of hydrology that the provisions are grounded in. Accordingly, the appellate court reasoned that because hydrology is the basis for a change in wetland determination, the removal of trees is merely a factor to determine the presence of a wetland, but is not a determining factor. In addition, the appellate court pointed out that the NRCS never indicated that the removal of trees changed the hydrology of the property during the agency appeal process – a point that the USDA ignored during the administrative appeal process. The appellate court rather poignantly stated, “Rather than grappling with this evidence, the hearing officer used transparently circular logic, asserting that the Agency experts had appropriately found hydric soils, hydrophytic vegetation, and wetland hydrology…”.
The USDA-NRCS was brutalized (rightly so) by the appellate court’s decision for its lack of candor and incompetence. Those same agency characteristics were also illustrated in the Eighth Circuit decision of Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999). Perhaps much of the USDA/NRCS conduct relates to the bureaucratic unilateral decision in 1987 to change the rules to include farmed wetland under the jurisdiction of Swampbuster. That decision has led to abuse of the NAD process and delays that have cost farmers untold millions. Hopefully, the clean-out of some USDA bureaucrats as a result of the new Administration that began in early 2017 will result in fewer cases like this in the future.
Thursday, August 8, 2019
The Tax Cuts and Jobs Act of 2017 (TCJA) changed the landscape of tax-deferred exchanges under I.R.C. §1031. Personal property trades are no longer eligible for tax-deferred treatment. But, the rules governing tax-deferred exchanges of real estate didn’t change. That makes the definition of “real estate” of utmost importance. In prior posts I have addressed the issue of what constitutes like-kind “real estate” for I.R.C. §1031 purposes. See, e.g., https://lawprofessors.typepad.com/agriculturallaw/2018/10/what-is-like-kind-real-estate.html. But, what about an easement? Or, more specifically, what about a perpetual conservation easement? Do they qualify as “like-kind” to real estate such that the proceeds received from a donation/sale transaction can be used to acquire replacement real estate and the transaction be tax-deferred?
Conservation easements and the like-kind exchange rules – it’s the topic of today’s post
The Definition of “Real Estate”
Under the I.R.C. §1031 rules, “real estate” is defined very broadly. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment purposes. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in the exchange. Also, remember, post-2017, the value of personal property associated with the real estate that does not fit within the definition of “real estate” is no longer eligible for tax-deferral under I.R.C. §1031.
Easements. Defined broadly, an easement is a nonpossessory interest in another party’s land that entitles the holder of the easement the right to use the land subject to the easement in the manner that the easement specifies. Conservation easements involve development rights. There is support for the notion that development rights in land are like-kind to real estate. For instance, in Rev. Rul. 55-749, 1955-2 CB 295, the IRS determined that land was like-kind to perpetual water rights. The IRS also has taken the position that a leasehold interest in a producing oil lease that extended until the exhaustion of the oil deposit was like-kind to a fee interest in a ranch. Rev. Rul. 68-331, 1968-1 CB 352.
In addition, Rev. Rul. 59-121, 1959-1 CB 212, the IRS took the position that an easement sold was an interest in real property. Under the facts of the ruling, the taxpayer granted easements to an industrial company over his ranchland that he used for grazing livestock that were raised for sale. The easements granted were for an indefinite duration and he was paid for the easement grants. The easements provided for the construction of a dam across a creek located on the taxpayer's property in order to create a reservoir and impound water and as a depository for waste material produced as a byproduct of the company's industrial process. The easements specified that the taxpayer retained all rights to explore for and produce oil, gas, or other minerals on the land subject to the easements and he could use the land and buildings on it if he didn’t interfere with the easement rights granted. The IRS said that the funds the taxpayer received for the easement grants constituted proceeds from the sale of an interest in real property. Thus, the amount received could be applied to reduce the basis of the land subject to the easement, with any excess (recognized gain) being eligible for investment in like-kind real estate.
Later, in 1972, the IRS determined that a right-of-way easement was like-kind to real estate. Rev. Rul. 72-549, 1972-2 CB 352. In 1971, under threat of condemnation the taxpayer granted an electric power company an easement and right-of-way over part of the taxpayer’s property that he used in his trade or business. The amount received for the easement and right-of-way triggered gain to the taxpayer. The easement and right-of-way were permanent and exclusive, and the company obtained the right to construct, maintain, operate, and repair power transmission lines and electrical towers on the right-of-way. The taxpayer used the funds acquired from the easement and right-of-way grant to acquire other real estate that he would use in his trade or business. The IRS ruled that the acquired property qualified as like-kind replacement property under I.R.C. §1031.
More closely aligned with conservation easements, the U.S. Supreme Court held in 1958 that when a right or interest arises out of real estate and is for a term short of “perpetuity” (which also means a land lease of less than 30 years) and the interest is defined in terms of money, the right or interest is not like-kind to a fee simple interest in real estate. The case was the consolidation of five cases involving the conversion of future income from oil leases into present income in the form of real estate. Comr. v. P.G. Lake, Inc, et al., 356 U.S. 260 (1958). Also, in Priv. Ltr. Rul. 200901020 (Oct. 1, 2008), the IRS determined that development rights that a taxpayer transferred were like-kind to a fee interest in real estate; a real estate lease with at least 30 years remaining at the time of the exchange; and land use rights for hotel units.
On conservation and agricultural easements, the following IRS rulings are helpful guidance:
- Ltr. Rul. 9851039 (Sept. 15, 1998) – The taxpayers sought to convey a perpetual agricultural conservation easement on their farms to the state in exchange for property of like-kind. Under state law, an ag conservation easement constituted an interest in land and was deemed to be the same as covenants that ran with the land. In other words, the easement was deemed to be like-kind to a fee simple and the proceeds received from the easement grant could be reinvested in like-kind real estate under the I.R.C. §1031 rules.
- Ltr. Rul. 200201007 (Oct. 2, 2001) - The IRS concluded that a perpetual conservation easement on a ranch could be exchanged for a fee interest in other ranch property that was subject to a (negative) perpetual conservation easement. Again, one of the keys to the IRS conclusion was that under applicable state law, a perpetual conservation easement constituted an interest in real property.
- Ltr. Rul. 9232030 (May 12, 1992) – The IRS determined that the exchange of a perpetual agricultural conservation easement on a farm for a fee simple interest in other real property qualified as a tax-deferred exchange under I.R.C. §1031.
- Ltr. Rul. 9621012 (Feb. 16, 1996) – In this private ruling, a county sought to acquire a perpetual scenic conservation easement over a ranch to protect a coastline viewshed that the state wanted to protect in perpetuity. While the taxpayer retained the right to use the ranch for ranching and grazing purposes, the portion of the ranch subject to the easement could not be developed. The taxpayer was willing to make the conveyance, but only in return for property of like-kind that qualified for non-recognition treatment under I.R.C. §1031. The IRS determined that the exchange of the easement for a fee simple interest in timberland, farm land or ranch land qualified as an exchange of property that qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200649028 (Sept. 8, 2006) – This private ruling involved transferable rural land use credits under state law. The state was concerned about controlling development and developed a system whereby the owner of credits could develop property in a manner that otherwise wasn’t permissible without the credits (termed “stewardship credits”). Any use or transfer of the credits had to be publicly recorded as an easement that ran with the land in favor of the county, qualified state agency or state land trust. The credits were perpetual in nature, and state law specified that a “stewardship easement” was an interest in real property. The taxpayer involving in the private ruling sought to sell the credits to a buyer and use the proceeds of sale to buy replacement real estate via a qualified intermediary. The taxpayer would use the replacement property for productive use in the taxpayer’s trade or business or for investment purposes. The IRS determined that the transaction qualified for tax deferral under I.R.C. §1031.
- Ltr. Rul. 200805012 (Oct. 30, 2007) -Here, the IRS privately ruled that development rights were like kind, to a fee interest in property that a taxpayer relinquished in an exchange. The trade transaction was quite complex and was accomplished via a qualified intermediary
The IRS has been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment
The use of proceeds from a conservation easement donation in a transaction that will qualify as an I.R.C. §1031 exchange can be handled in a rather straightforward manner. In addition, separate exchanges can occur as to the easement and the residual interest in the real estate. Issues, if any present themselves, could occur with respect to the Natural Resource Conservation Service and its option and funding process. But those are separate matters from the deferred tax treatment of the transaction qualifying as an I.R.C. §1031 exchange.
Tuesday, August 6, 2019
In 2018, the U.S. Supreme Court, in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), handed South Dakota a narrow 5-4 win in its quest to collect taxes from online sales. The Court held that the Constitution’s Commerce Clause did not bar South Dakota from statutorily requiring remote sellers without a physical presence in the state to collect and remit sales tax on goods and services that are sold to buyers for delivery inside the state of South Dakota. In so doing, the Court distinguished and at least partially overruled 50 years of Court precedent on the issue.
But, did the Court open the floodgates for the states to tax every dollar of sales in a state from an out-of-state seller? That’s a hard case to make because the Court ruled specifically on a South Dakota statute that contained a de minimis sales requirement before state sales tax kicked-in. However, the Kansas Department of Revenue (KDOR) has now taken the position that any amount of sales by a remote seller (a seller without any physical presence in Kansas) to a Kansas buyer triggers the need of the remote seller to register with the state and pay Kansas sales tax.
The Kansas position concerning sales taxation of remote sellers and implications – the focus of today’s blog post.
Online Sales - Historical Precedent
The core constitutional issues concerning a state’s ability to impose sales (and/or use) tax on a seller with no physical presence in the state involve interstate commerce and due process. In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois. National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967). In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.”
Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992). In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.” The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.” As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state. National retailers have a presence in many states.
More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado. Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013). The trial court enjoined enforcement of the law on Commerce Clause grounds. On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court. The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction. The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds. Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016).
In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings. Hence, the South Dakota legislation.
South Dakota Legislation and Litigation
S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature. It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe.
S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law. Several out-of-state sellers that received notices did not register for sale tax licenses as the law required. Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers. The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax.
The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court. South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. 2017). On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause grounds based on the U.S. Supreme Court precedent referenced above. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. 2017). The state of South Dakota filed a petition for certiorari with the U.S. Supreme Court and the Court granted the petition.
U.S. Supreme Court Decision – The Importance of “Substantial Nexus”
Article I, Section 8 of the U.S. Constitution says that, “The Congress shall have the power...to regulate commerce…among the several states…”. That was the key point of the Court’s 1967 Bellas Hess, Inc. decision. As noted above, in that case the Court stated that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States.” In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court ruled that a state tax would be upheld if it applied to an activity having a substantial nexus with the state; was fairly apportioned; did not discriminate against interstate commerce; and, was fairly related to the services that the state provided. Later, in the Quill case, the Court determined that a physical presence in the taxing jurisdiction was what satisfied the Brady “substantial nexus” requirement.
In Wayfair, the Court determined that a “substantial nexus” could be present without the party subjected to tax having a physical presence in the taxing jurisdiction. But, the key point is that the “substantial nexus” test of Brady remains. Likewise, the other three requirements of Brady remain. A state can only impose sales (or use) tax on a remote seller without a physical presence in the state if the tax is fairly apportioned; does not discriminate against interstate commerce; and is fairly related to services that the state provides. In other words, taxing a business without a physical presence in the state cannot unduly burden interstate commerce. The Wayfair majority determined that the South Dakota law satisfied these tests because of the way it was structured – it had only a limited application due to the requirement of a de minimis a dollar amount of sales or transactions in the state; it was not applied retroactively; South Dakota was a member of the Streamlined Sales and Use Tax Agreement (SSUTA); the sellers at issue were national businesses with a large online presence; and South Dakota provided tax software to ease the administrative burden.
On August 1, 2019, the KDOR issued Notice 19-04 designed to provide “guidance” to remote sellers doing business in Kansas. https://www.ksrevenue.org/taxnotices/notice19-04.pdf In the Notice, the KDOR noted that Kansas law (Kan. Stat. Ann. §79-3702(h)(1)(F)) defines a “retailer doing business in this [Kansas]” as: “any retailer who has any other contact with this state that would allow this state to require the retailer to collect and remit tax under the provisions of the constitution and the law of the United States.” The KDOR also noted that the Kansas requires online (and other remote) sellers with no physical presence in Kansas to collect and remit “the applicable” sales and use tax on sales delivered into Kansas. KDOR indicated that remote sellers are to register and begin collecting and remitting Kansas sales and/or use tax by October 1, 2019.
The Notice, as strictly construed, is correct. The state can require a remote seller to register with the state and collect and remit sales and/or use tax “under the provisions of the constitution and the laws of the United States.” That would mean as the applicable law has been defined by the U.S. Supreme Court, including the Court’s most recent Wayfair decision – which involved a state law that contained a de minimis requirement based on amount of sales or number of transactions. However, the KDOR Notice did not specify any level of de minimis sales before sales tax was triggered. Indeed, the Director of Research and Analysis for KDOR was quoted in the Bloomberg Daily Tax Report (online) on August 1 as stating that KDOR “does not believe it needs a de minimis threshold” based on Kan. Stat. Ann. §79-3702. This is an inaccurate statement that will likely invite a legal challenge to the KDOR’s position. There simply is no protection in the Wayfair decision for KDOR’s position. The “substantial nexus” test still must be satisfied – even with a remote seller. Indeed, during the 2019 session of the Kansas legislature, a major tax bill contained de minimis requirements that mirrored the South Dakota legislation, but the Governor vetoed the bill and the Kansas House failed to override the veto. Presently, no other state has taken the position that the KDOR has taken.
The KDOR’s position amounts to a frontal assault on the Commerce Clause post-Wayfair. Presently, 23 states are “full members” of the SSUTA. For those states, Wayfair at least implies that membership in the SSUTA has the effect of minimizing the impact on interstate commerce. But, that doesn’t mean that SSUTA membership eliminates the “substantial nexus” requirement. Indeed, South Dakota was an SSUTA member and the Court still went through the “substantial nexus” analysis. Thus, it appears that any state legislation must have exceptions for small businesses with low volume transactions and sales revenue. Whether a series LLC (in some states such as Iowa) or subsidiaries of a business could be created, each with sales below the applicable threshold, remains to be seen.
On a related note, could the KDOR (or any other state revenue department) go after a portion of business income of the out-of-state business via income tax? That seems plausible. However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business (or individual – the business form does not matter because corporations have long held personhood status under the Constitution (see, Bank of the United States v. Deveaux, 9 U.S. 61 (1809); Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014)) have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property). Is that legislation now unconstitutional too? Or, is there a distinction remaining between taxing receipts as opposed to income? That may be at issue in a future Supreme Court case.
For now, it’s practically a sure bet that, unless the Kansas legislature passes a bill containing de minimis thresholds that can withstand the Governor’s veto, the state will be devoting taxpayer resources to defending a lawsuit that will challenge the state’s (as of now) unsupportable position.
Friday, August 2, 2019
It’s been about a month since I devoted a blog post to court litigation involving agricultural producers and businesses. So, it’s time to devote another post to the matter as an illustration of how often the law and the business of agriculture intersect. These posts have proven to be quite popular and instructive.
“Ag in the Courtroom” – the most recent edition. It’s the topic of today’s post.
More Bankruptcy Developments
As I have noted in numerous posts over the past couple of years, the difficult economic conditions in much of agriculture in the Great Plains and the Midwest have made bankruptcy law rise in importance. Fortunately, legislation is headed to the President’s desk that will increase the debt limit in Chapter 12 bankruptcy to $10 million and place some of the existing Chapter 12 provisions in Chapter 11 for use by non-farm small businesses. Those were needed pieces of legislation.
A recent Alabama bankruptcy case illustrates the peril of selling loan collateral without the creditors notice and consent. It’s a unique set of facts because the debtor sold the collateral, a tractor, to bail her boyfriend out of jail. In In re Reid, 598 B.R. 674 (Bankr. S.D. Ala. 2019), the Farm Service Agency (FSA) attached itself as a creditor in the debtor’s chapter 7 bankruptcy proceeding. In March of 2016 the debtor took out two FSA loans for a total of $50,000. A security agreement was also executed at the same time granting the FSA a security interest in "All farm equipment . . . and inventory, now owned or hereafter acquired by the Debtor, together with all replacements, substitutions, additions, and accessions thereto, including but not limited to the following which are located in the State of Alabama." A specific list of assets was attached, including a New Holland tractor, ten beef breeding cows, and nine calves. The debtor used the loan proceeds to purchase the equipment and livestock that was listed as collateral.
In June of the same year, the debtor was notified that she could not have cattle on the land she purchased with another loan not at issue in the case. However, the debtor was never notified of the restriction and it was not stated in the purchase contracts. Ultimately, the debtor was given thirty days to vacate the premises. Around this time, the debtor’s equipment and cattle started to go missing. The debtor was also becoming aware that her boyfriend (and father of her children) had a drug problem, and she began to suspect that he was selling the equipment and cattle for drugs. Later, the debtor attempted to stop a man from taking cattle from the property and the man said to take it up with her boyfriend. The debtor did not report the cattle or equipment as stolen. The debtor’s boyfriend was arrested about the same time for drug crimes and eluding the police. The debtor vacated the property with the only collateral remaining at the property being the New Holland tractor, which the debtor listed for sale on Facebook. The debtor testified that she sold the New Holland tractor to an unknown purchaser for between $6,000.00 and $8,000.00. But the exact price and identity of the purchaser could not be found as the debtor deleted her Facebook account. The proceeds of the tractor sale were put towards bail money for the boyfriend. The debtor never made a payment on the loans and vacated the property before the first payment was due.
The FSA attempted to recover the tractor but was unsuccessful. The FSA sought to have the bankruptcy court find the debt owed to the FSA in the amount of $52,048.56 plus interest to be non-dischargeable for fraud; fiduciary defalcation; embezzlement; and willful and malicious injury. The court averaged the alleged selling price of the tractor and rendered $7,000 non-dischargeable. The court also determined that the debtor did not fraudulently obtain the FSA loans, and did not embezzle the collateral because fraud wasn’t present. Because willful and malicious injury was present upon the debtor’s sale of the tractor without notice to the FSA and use of the proceeds for the debtor’s personal benefit, the $7,000 that the debtor received upon sale of the tractor was non-dischargeable.
The Intersection of State and Federal Regulation
Agriculture is a heavily regulated industry. Sometimes that regulation is apparent and sometimes it occurs an a rather unique manner. Sometimes it comes from the federal government and sometimes it is purely at the state and local level. In yet other situations, the regulation is an interesting (and frustrating for those subject to it) blend of federal and state/local regulation.
In 2009, the defendant in Carroll Airport Comm'n v. Danner, No. 17-1458, 2019 Iowa Sup. LEXIS 57 (May 10, 2019), planned to construct a grain leg (bucket elevator) and grain bins. In 2013, the defendant obtained the proper county zoning permits but was told of the need to comply with the airport zoning ordinances. The grain leg stands within 10,000 feet horizontally from the end of plaintiff’s runway. The structure reaches a height of 127 feet off the ground. The parties agree the grain leg intrudes within the airport's protected airspace by approximately sixty feet. After construction began it was evident that there would be issues with the airport zoning ordinances and the plaintiff asked the Federal Airport Administration (FAA) to perform an aeronautical study of the grain leg and its impact on aviation safety. The FAA issued a letter stating, "This aeronautical study revealed that the structure does exceed obstruction standards but would not be a hazard to air navigation." It also warned, “This determination concerns the effect of this structure on the safe and efficient use of navigable airspace by aircraft and does not relieve the sponsor (i.e., the defendant) of compliance responsibilities relating to any law, ordinance, or regulation of any Federal, State, or local government body.” Lastly the FAA requested that the defendant paint the structure and add red lights to the top of it. The defendant did so. The FAA also adjusted the flight patterns in and out of the airport to accommodate this structure. The plaintiff did not seek review under this determination.
Two years later, the plaintiff (the local airport commission) sued alleging the grain leg violated certain building ordinances; city and county zoning ordinances; airport commission regulations; and constituted a nuisance and hazard to air traffic. The plaintiff sought equitable relief—an injunction requiring the defendant to modify or remove the grain leg. The defendant raised an affirmative defense of federal preemption. In June 2017, the trial court found that the grain leg violated state and local zoning ordinances and constituted a nuisance and an airport hazard. The trial court found that the grain leg did not fall within the agricultural exemption to certain zoning laws and rejected the defendants’ affirmative defense that the no-hazard letter preempted state and local zoning ordinances. The appellate court affirmed, concluding that the doctrines of express, implied, and conflict preemption did not apply to the FAA no-hazard determination. On further review, the state Supreme Court affirmed. The Supreme Court concluded that the FAA no-hazard determination did not preempt local zoning ordinances, was not legally binding, and contained language notifying the defendant that compliance with local rules was required.
Rights involving surface water vary from state-to-state. In some parts of the U.S., however, a party owning land adjacent to a watercourse has what are known as “riparian” rights to the water. But, do those rights apply to man-made lakes, or just natural lakes? The issue came up recently in Incline Village Board of Trustees v. Edler, No. SC97345, 2019 Mo. LEXIS 178 (Mo. Sup. Ct. Apr. 30, 2019).
The defendants owned properties in subdivisions around a lake. One of the properties of the second subdivision abutted the lake. The properties they owned in the first subdivision did not abut the lake. During the creation of the first subdivision, restrictions were added to the land. One such restriction stated, “No structures or other improvements shall be made on or to any common area, including any body of water, other than such structures or improvements which are made by the trustees for the benefit of all lot owners. Except that, the owner of each lot which abuts any body of water, may construct one boat dock on such body of water, provided that, said boat dock extends from said lot and is first approved in writing by the trustees.” All landowners in the first subdivision were entitled to use the lake, even if they did not abut the lake. The second subdivision was not joined with the first one, but it was clear that the second subdivision was excluded from use rights on the lake. Lots in the first subdivision were subject to assessments to maintain the lakes.
The defendants built a dock on the property on the second subdivision. The trustees of the first subdivision defendants sued seeking a declaratory judgment, damages for trespass, and the removal of the dock. The district court ordered removal of the dock and determined that special circumstances existed supporting the award of attorney's fees of $70,000 in favor of the trustees.
On appeal, the appellate court determined that the lake was clearly artificial and, thus, the defendants were not riparian owners. Riparian rights are only extended to landowners adjacent to natural lakes. The appellate court also rejected the defendants’ reliance-based argument. The appellate court noted that the defendants had never had use of the lake for dock purposes or paid assessments for its maintenance. In addition, the defendants’ predecessor in title's deed to the adjacent land explicitly excepted the lake from the transfer. In addition, the plaintiffs had told the defendants of the property restrictions before the dock was built. As for attorney fees, the appellate court determined that there was not any special circumstance to merit an award of attorney fees. The plaintiff had not given any formal warning about not building the dock and the defendants had sought legal advice.
It’s never a dull moment in ag law involving ag producers, agribusinesses and rural landowners. The cases keep on rolling in.
Wednesday, July 31, 2019
My blog article of July 17 concerning the tax treatment of settlements and court judgments raised an interesting question by a reader. For review, you can read that post here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/tax-treatment-of-settlements-and-court-judgments.html. The reader wanted to know how the tax rules would apply to the Roundup jury verdict that was reached this past May.
Applying the tax Code rules to the Roundup jury verdict (and others) - that’s the topic of today’s post.
Review of the Applicable Rules
As I noted in the July 17 article, proper categorization of a court award or settlement amount is critical. Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1. However, recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness.
Tax Application to the Roundup Jury Verdict
Impact on the plaintiffs. In May, Alva and Alberta Pilliod a California jury awarded $2 billion in punitive damages and $55 million for pain and suffering as a result of their use of the common weed-killer, Roundup. From accounts that I have read and persons that I have talked to, it is estimated that if the award stands up on appeal (no sure thing), attorney fees would amount to nearly $1 billion. So, how would the tax rules apply to the total award? What would be the Pilliod’s “take-home” amount from the jury award?
It’s important to segregate the jury award for pain and suffering from the award for punitive damages. For starters, the $55 million in pain and suffering is tax-free because it is to compensate for physical injury and/or physical sickness. As for the $2 billion, that's a different story – that amount is fully taxable. So how does this break-out on the tax return? Assuming that this is the only income that the Pilliod’s have for 2019, consider the following:
At the federal level, the $2 billion would be subject to the highest marginal income tax rate of 37 percent, yielding a tax of $740,000,000. There would be a very slight off-set for the standard deduction.
Added to the $740,000,000 of federal income tax is the California state income tax. The state-level tax is a bit more complicated to compute. The top marginal rate of 12.3 percent would apply. To that top rate, an additional 1 percent “millionaire tax” is added. A taxpayer with California taxable income (i.e. as calculated on Form 540, Line 19) exceeding $1,000,000 during a given tax year is subject to the “Mental Health Services Tax.” The amount of the tax is 1% of the amount of the taxpayer’s income that exceeds $1,000,000.
However, California does not couple with the federal government on the issue of the non-deductibility of legal fees. As a result, taxable income for California tax purposes will be substantially less than taxable income at the federal level. Based on a “mocked-up” California tax return, the following results:
Gross income: $2,000,000,000
Deduction for legal fees: 857,341,000
Taxable income: $1,142,659,000
Applying the top California tax rate to the $1,142,659,000; adding in the “Millionaire’s tax” and state-level alternative minimum tax; and factoring in the standard deduction for a married couple, the result is a state-level tax of $151,416,590.
Thus, the total tax bite (federal and state) for the Pilliod’s will be approximately $851,416,590 – very close to one-half of the punitive damage award.
The Pilliod’s will also be responsible for paying attorney fees. If the accounts are correct that the amount will approach the $1 billion amount, the remaining balance of the punitive damage award that the Pilliod’s will actually pocket will be somewhere between $149,000,000 and zero.
Application to the attorneys. The attorneys involved will also have to pay tax on the amount received from the settlement. This is income that is received in the ordinary course of a trade or business, so the amount is subject to tax at the federal and state levels and is also subject to self-employment tax, payroll tax, etc.
Assuming that the attorneys receive $1,000,000,000 in fees, here’s how the tax impact breaks out:
Fed. tax rate of 37%: $370,000,000
CA tax rate of 13.3%: $133,000,000
Total tax: $503,000,000
Balance remaining: $497,000,000
Less s.e. tax; payroll tax; medicare tax, etc. – (assuming 7%: $38,081,260)
Final balance remaining: $458,918,740
In summary, of the total jury award of $2,055,000,000, the total taxes paid (federal and state) amounts to $740,000 + $151,416,590 + 541,081,260, for a total tax bite of $1,432,497,850. That’s an effective rate of 71.6%! The Pilliod’s “take-home” is the $55,000,000 of actual damages and somewhere between zero and $149,000,000 of the punitive damage award. The attorneys “take-home” is $458,918.740. On balance the plaintiffs pocket approximately 2-10 percent of the total award, the attorneys pocket approximately 19-29 percent of the total award, and the government somewhere in excess of 70 percent.
What About Syngenta Payments?
Corn farmers participating in the nationwide class action against Syngenta may begin receiving settlement payments in 2020. None of those payments are attributable to physical injury or sickness. Instead, they are related to market damage/loss. Thus, the settlement payments are fully taxable, and any attorney fees will not be deductible on the federal return.
The taxation of court awards and settlements can be surprising. In addition, the inability to deduct legal fees post-TCJA enhances the tax impact.
Monday, July 29, 2019
Under 1986 amendments to the Bankruptcy Act of 1978, Congress created Chapter 12 bankruptcies for “family farmers.” Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, Pub. L. No. 99-554, 100 Stat. 3105 (1986), adding 11 U.S.C. § 1201 et seq. Chapter 12 became a permanent part of the Bankruptcy Code effective July 1, 2005. Numerous requirements must be satisfied for a debtor to qualify for Chapter 12 relief. One of those requirements, the “aggregate debt test” is the subject of a bill, H.R. 2336, that passed the U.S. House on July 25. The legislation increases the maximum aggregate debt a debtor can have and remain eligible for Chapter 12. It’s an important bill because of the economic struggles of many farming operations in certain parts of the country. I have discussed those problems in other posts, such as this one: https://lawprofessors.typepad.com/agriculturallaw/2018/03/chapter-12-bankruptcy-feasibility-of-the-reorganization-plan.html
The proposed increase in the Chapter 12 bankruptcy aggregate debt test - it’s the topic of today’s post.
To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.” 11 U.S.C. §§101(19A) & (21). A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing, and whose aggregate debts do not exceed $4,411,400. 11 U.S.C. §18). In addition, more than 50 percent of the debt must be debt from a farming operation that the debtor owns or operates. Id. H.R. 2336 proposes to increase the $4,411,400 amount to$10 million.
Changed Nature of Agricultural Production
As noted above, Chapter 12 was added to the Bankruptcy Code in 1986. At that time, much of agriculture was faced with a debt crisis when crop prices declined sharply, interest rates rose sharply, and farmland values, particularly in the Midwest, plummeted. That toxic mix resulted in many farmers, some of whom were very good managers, finding themselves in a precarious economic position. It was this environment that led to Chapter 12’s enactment and, at the time, it was estimated that 86 percent of farmers could qualify for relief under Chapter 12 . At time of enactment, the aggregate debt limit for Chapter 12 was $1,500,000. That debt limit did not increase until 2005 when it was increased to $3.237,000 via an inflation adjustment. The current limit of $4,411,400 is the present inflation-adjusted limit.
According to U.S.D.A. data, total real farm sector debt has now reached the level it was at during the depth of the farm debt crisis in the early 1980s. However, the increase has been particularly accelerated since 2009, with lenders shoring up their collateral positions by increasing debt on real estate to allow them to continue making loans to farmers. But that is only a short-term solution to a deeper problem. Presently, U.S.D.A. data indicates that the current ratio for agriculture (a measure of the ability to pay bill from current assets – it is total current assets divided by total current liabilities) is 1.31. That number indicates that many farmers are facing a liquidity crisis, and it is generally the position of ag economists that the ratio should be between 1.5 and 3.0.
In addition, U.S.D.A. data also indicates that the working capital compared to the value of farm production is at .09, further supporting the notion that a liquidity crisis is looming for even more farmers. Working capital is the amount of liquid funds that a business has available to meet short-term financial obligations. It is calculated by subtracting current liabilities from current assets, and it provides the short-term financial reserves that are available. In other words, it measures the ability of a farming operation to withstand a financial/economic downturn. For healthy farm businesses, ag economists generally take the position that ratio should be in the 15% to 25% range. The current number of nine-percent means that ag operations are “burning” through working capital and are more vulnerable to financial stress.
“Right-Sizing” the Farming Operation
With land increasingly used as collateral, if economic conditions in agriculture remain difficult, the ability of many farmers to stay in business will be further decreased. Some will be forced to “right-size” their farms by selling assets. But doing so has the very real potential of triggering significant taxes – both capital gain and ordinary income caused by depreciation recapture. Historically, this was a very real problem for farmers filing Chapter 12. The sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors. Even though the priority tax claims could be paid in full in deferred payments, in many instances the debtor did not have sufficient funds to allow payment of the priority tax claims in full even in deferred payments.
Congress addressed this problem with the 2005 Bankruptcy Act overhaul. That law contained a provision allowing a Chapter 12 debtor to treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. The provision is now contained in 11 U.S.C. §1232, and it is immaterial whether the tax is triggered pre or post-petition.
Back to the Debt Limit
For the above-mentioned reasons, eligibility for Chapter 12 essential for a farmer to be able to deprioritize taxes associated with the sale of farm assets used in the farming operation and ultimately put together a reorganization plan that will allow the farmer to stay on the farm to continue production activities, make restructured loan payments and have some debt written off.
While the Chapter 12 debt limit has only adjusted for inflation since 1986, farms have increased in size and capital needs faster than the rate of inflation. This means that far less than 86 percent of farmers can satisfy the aggregate debt limit of Chapter 12 – the percentage estimated to qualify for Chapter 12 when it was enacted. While Chapter 11 is an alternative reorganization provision, it does not contain the favorable tax rule of a Chapter 12, is more costly to file, has different “timing” rules, and contains an “absolute priority” rule that can severely limit the ability of a farmer to reorganize debts and remain in farming. I discussed the absolute priority rule here: https://lawprofessors.typepad.com/agriculturallaw/2019/07/farmers-bankruptcy-and-the-absolute-priority-rule.html. In addition, for a farm debtor that has aggregate debt over the $4,411,400 limit, it’s not possible to file a Chapter 11, pay debt down beneath the threshold, and convert to Chapter 12.
H.R. 2336 (and the companion Senate bill S. 987) is important legislation designed to restore the availability of Chapter 12 to farmers (but not family fisherman) that were intended to benefit from it when it was enacted in 1986. If the original policy reasons justifying the enactment of Chapter 12 in 1986 remain, the debt ceiling should increase to reflect that rationale. Senate rules are different than those in the House and a Senator’s objection to a bill can cause a bill to stall much more easily than in the House. Presently, Senator Feinstein (D-CA) is objecting to the legislation on the basis that hearings have not been held. However, she is mistaken on that point. Hearings were held last year – on both the House and Senate bills. Senator Durbin (D-IL) is also objecting for other reasons, and Senator Warren (D-MA) is believed to follow whatever Sen. Durbin does.
At this point, interested farmers and others are encouraged to contact their Senators via email before Thursday of this week. After Wednesday, the Senate is recessed. This week will be a key week for many family farmers.
Thursday, July 25, 2019
Agriculture is a heavily regulated industry. Land ownership; production activities; marketing of ag products; and food products that are in the consumer (and livestock) food supply are subject to federal and state regulations. What are the major federal rules? How do they apply to producers of food products?
The regulation of food products – it’s the topic of today’s post.
The government agencies with primary responsibility for ensuring the safety of the U.S. food supply are the USDA (through the Food Safety and Inspection Service (FSIS)) and the Food and Drug Administration (FDA). While neither agency has the authority to mandate a recall of unsafe food, they have developed general oversight procedures and protocol for voluntary food recalls by private companies. The USDA is generally responsible for the regulation of meat, poultry and certain egg products, while the FDA has responsibility for the regulation of all other food products including seafood, milk, grain products, fruits and vegetables, and certain canned, frozen and otherwise packaged foods that contain meat, poultry and eggs that USDA does not otherwise regulate.
Food Adulteration and Misbranding
The regulations generally proscribe the adulteration and misbranding of food. In general, a food is considered adulterated if it contains a harmful substance that may pose a safety risk, contains an added harmful substance that is acquired during production or cannot be reasonably avoided, contains a unapproved substance that has been intentionally added to the food, or if it has been handled under unsanitary conditions that presents a risk of contamination that may pose a safety threat. Under the Federal Food, Drug, and Cosmetic Act (FFDCA) (21 U.S.C. §§ 301-399), the manufacture, delivery, receipt or introduction of adulterated food into interstate commerce is prohibited. However, the USDA regulations did not prevent the introduction into the human food chain of meat from downed livestock. In Baur v. Veneman, 352 F.3d 625 (2d Cir. 2003), a beef consumer argued that the USDA should label all downed livestock as “adulterated,” and that the consumption of meat from downed animals created a serious health risk of disease transmission and that elimination of downed cattle from the human food stream was necessary to protect the public health. In late 2003, the United States Court of Appeals for the Second Circuit held that the beef consumer had standing to challenge the USDA policy. Shortly thereafter, the presence of “Mad-Cow” disease was discovered in the U.S., and the USDA announced on December 30, 2003, that it was changing its regulations to ban the meat from downed animals from the human food chain. FSIS issued a series of three interim rules in early 2004. The final rule is effective October 1, 2007, and prohibits the slaughter of non-ambulatory cattle in the United States (except that veal calves that cannot stand due to fatigue or cold weather may be set apart and held for treatment and re-inspection). 72 Fed. Reg. 38699 (July 13, 2007). Also, the final rule specifies that spinal cord must be removed from cattle 30 months of age and older at the place of slaughter, and that records must be maintained when beef products containing specific risk materials are moved from one federally inspected establishment to another for further processing. Under the final rule, countries that have received the internationally recognized BSE status of “negligible risk” are not required to remove specific risk materials.
While neither the USDA nor the FDA can order a private company to recall unsafe food products, they can issue warning letters, create adverse publicity, seize unsafe food products, seek an injunction or begin prosecuting criminal proceedings.
For food products over which the FSIS has jurisdiction, upon learning that a misbranded or adulterated food item may have entered commerce, the FSIS will conduct a preliminary investigation to determine whether a voluntary recall is warranted. If a recall is deemed necessary, a determination is made as to the degree of the recall and the public is notified. For food products subject to the FDA’s jurisdiction, a similar procedure is utilized.
Organic foods are produced according to certain production standards. For crops, “organic” generally means they were grown without the use of conventional pesticides, artificial fertilizers, human waste, or sewage sludge, and that they were processed without ionizing radiation or food additives. For animals, “organic” generally means they were raised without the use of antibiotics and without the use of growth hormones. In most countries, organic produce must not be genetically modified.
Historically, organic farms have been relatively small family-run farms with organic food products only available in small stores or farmers' markets. More recently, organic foods have become much more widely available, and organic food sales within the United States have grown by 17 to 20 percent a year in recent years while sales of conventional food have grown at only about 2 to 3 percent annually. This large growth is predicted to continue, and many companies (including Wal-Mart) are beginning to sell organic food products.
An organic food producer must obtain certification in order to market food as organic. Under the Organic Food Production Act (OFPA) of 1990 (7 U.S.C. §§ 6501-23), the USDA is required to develop national standards for organic products. USDA regulations are enforced through the National Organic Program (NOP) governing the manufacturing and handling of organic food products. As enacted, the statute provides that an agricultural product must be produced and handled without the use of synthetic substances in order to be labeled or sold as “organic”. But, under USDA regulations, a “USDA Organic” seal can be placed on products with at least 95% organic ingredients. The 95 percent rule was challenged by a Maine organic blueberry farmer as being overly tolerant of non-organic substances and inconsistent with the statute, and the United States Court of Appeals for the First Circuit agreed, invalidated several of the regulations while scaling back the scope of other regulations. Harvey v. Veneman, 396 F.3d 28 (1st Cir. 2005). In response to the court’s opinion (and while the case was on appeal) the Congress amended OFPA. Upon further review, the court determined that OFPA, as amended, permitted the use of synthetics as both ingredients in and processing aids to organic food. Harvey v. Johanns, 494 F.3d 237 (1st Cir. 2007).
Produce Safety Rule
In early 2011, the President signed into law the Food Safety Modernization Act (FSMA) of 2010. 21 U.S.C. §301, et seq. The FMSA gives the FDA expansive power to regulate the food supply, including the ability to establish standards for the harvesting of produce and preventative control for food production businesses. Beginning in 2018, the new rules will significantly impact many growers and handlers of fresh produce.
The FMSA also gives the FDA greater authority to restrict imports and conduct inspections of domestic and foreign food facilities. To implement the requirements of the FMSA, the FDA had to prepare in excess of 50 rules, guidance documents, reports under a short time constraint. Indeed, the timeframe was so short FDA complained that they didn’t have enough time to do the job appropriately. That led to lawsuits being filed by activist groups to compel the FDA to issue several rules that were past-due. A federal court agreed with the activists in the spring of 2013 and, as a result, the FDA issued four proposed rules with comment periods that ended in November of 2013. Center for Food Safety v. Hamburg, 954 F. Supp. 2d 965 (N.D. Cal. 2013). One of the most contentious issues involved the rule FDA was supposed to develop involving intentional adulteration of food. FDA said it needed two more years to develop an appropriate rule, but the Court ordered them to develop it immediately. The hope, at that time, was that the Congress would step in and modify the deadlines imposed on the FDA so that reasonable rules could be developed rather than being simply rushed through the regulatory process for the sake of meeting an arbitrary deadline.
In late 2015, the FDA issued its Final Produce Safety Rule that has application to growers and fresh produce handlers (those that pack and store fresh produce). The rule is designed to reduce the instances of foodborne illnesses. Effective, January 16, 2016, the rule generally covers the use of manure or compost as fertilizer, allowing (at least for the present time) a 90 to120-day waiting period between the application of untreated manure on land and the time of harvest. That timeframe is in accordance with USDA National Organic Program Standards. Relatedly, the rule requires that raw manure and untreated biological soil amendments of animal origin must be applied without contacting produce and post-application contact must be minimized. Also, the rule addresses water quality and establishes testing for water that is used on the farm such as for irrigation or handwashing purposes. Under the rule, there must be no detectible generic E coli in water that has the potential to contact produce. The rule establishes a timeframe for noncompliant growers to come into compliance with the water requirements. The rule also addresses scenarios that could involve contamination of food products by animals, both domestic and wild, and establishes standards for equipment, tools and hygiene. As for potential contamination by wild animals, the rule requires farmers to monitor growing areas for potential contamination by animals and not harvest produce that has likely been contaminated. In addition, the rule establishes requirements for worker training, health and hygiene, and particular rules for farms that grow sprouts.
Under the rule, farms that sell an average of $25,000 or less of produce over the prior three years are exempt. Similarly, exempt are farms (of any size) whose production is limited exclusively to food products that are cooked or processed before human consumption. For producers whose overall food sales average less than $500,000 annually over the prior three years where the majority of the sales are directly to consumers or local restaurants or retail establishments, a limited exemption from the rule can apply. However, these producers must maintain certain required documentation (effective Jan. 16, 2016) and disclose on the product label at the time the product is purchased the name and location of the farm where the food product originated. In addition, the rule also allows commercial buyers to require that the farms from which they purchase produce follow the rule on their own accord.
Food products – yet another aspect of agriculture that is substantially regulated.
Tuesday, July 23, 2019
In last Friday’s post, I examined what an Employee Stock Ownership Plan (ESOP) is, the basic structure of an ESOP, and the benefits of using an ESOP. In Part Two today, I look at an ESOP’s potential pitfalls, how the U.S. Department of Labor might get involved (in not a good way), and the impact of the Tax Cuts and Jobs Act (TCJA) on ESOPs.
ESOPs and ag businesses – part two. It’s the topic of today’s post.
What the DOL Looks For
The U.S. Department of Labor (DOL) has a national enforcement project focused on ESOPS. The Employee Benefits Security Administration (EBSA) is an agency within the DOL that enforces the Employee Retirement Income Security Act of 1974 (ERISA) and is charged with protecting the interests of the plan participants. One of the primary concerns of the DOL is the belief that ESOPs suffer chronically from bad appraisals. As a result, the EBSA has increased its level of scrutiny of ESOP appraisals, and litigates cases it believes are egregious and could not be settled or otherwise resolved. In these situations, the basic allegation is that the fiduciaries of the ESOP didn’t exercise adequate diligence in obtaining and reviewing the appraisals as part of the transaction process.
Appraisals that are based on projections that are too optimistic can result in an overpayment by the ESOP in the transaction. This can be a particular problem when the appraisal is prepared by a party to the transaction – the same people that are selling the stock to the ESOP or who are subordinates of the sellers. I.R.C. §401(a)(28)(C) requires that all employer securities which are not readily tradeable on an established securities market must be valued by an “independent appraiser.” An “independent appraiser” is a “qualified appraiser” as defined by Treas. Reg. §1.170A-13(c)(5)(i). For example, in Churchill, LTD. Employee Stock Ownership Plan & Trust v. Comr., T.C. Memo. 2012-300, pet. for rev. den., No. 13-1295, 2013 U.S. App. LEXIS 11046 (8th Cir. May 29, 2013), the appraiser did not satisfy the requirements to be a qualified appraiser. The court also upheld the IRS determination to revoke the ESOP as a disqualified plan from 1995 forward (total of 15 years) for failure to meet certain statutory requirements (i.e., failure to timely amend plan documents necessitated by tax law changes and failure in addition to not having a qualified appraiser) to which ESOPs are subject.
If the ESOP fiduciaries simply accept the projections without determining whether the projections are realistic that will likely constitute a breach of their fiduciary duties. So, simply plugging management projections into the ESOP appraisal without a critical review by the fiduciaries is problematic. Clearly, an ESOP’s fiduciaries should be communicating with the appraisers about the projections and asking questions. Similarly, if the appraisal incorporates a control premium when the ESOP is not really buying control, that will bring scrutiny from the EBSA. The reason for the scrutiny is that the result will be an enhanced stock value over what it should be in reality. Relatedly, an issue can arise where the ESOP pays full value for the stock but does not get all of the upside potential because of dilution caused by warrants, options, or earn-outs that are not considered in determining adequate consideration. That results in overpayment for the stock. The EBSA is also concerned about the use of out-of-date financials on which the appraisals are based which don’t reflect current corporate reality.
Also, EBSA looks for situations where the plan effectively owns the company, but is not exercising any of its ownership rights in the company. In other words, in this situation the claim is that company management is effectively “looting” the company of its value and the ESOP fiduciaries are doing little or nothing to protect the value of the corporate stock.
The Cactus Feeders Case
Basic facts. The concerns of the DOL and the EBSA were illustrated recently in a matter involving Cactus Feeders, Inc. (CFI), a large cattle feeding business. In early March of 2016, the DOL filed a lawsuit in federal district court in Amarillo, TX, against CFI and various fiduciaries to the CFI ESOP for allegedly causing the ESOP to pay tens of millions of dollars more than the DOL claims it should have paid for company stock. The court filing points out ESOPs require care in their implementation and usage to avoid government scrutiny and the possible fines and penalties, and revocation that can accompany failing to meet all of the technical requirements.
The DOL alleged that Lubbock National Bank (the ESOP trustee) violated its fiduciary obligations under the (ERISA) when it caused the ESOP to overpay for company stock. The DOL also claimed that CFI, as the ESOP administrator and acting through its board of directors and designated ESOP committee members, knew of the trustee’s breaches of duty and didn’t stop them. The ESOP, which already owned 30 percent of corporate stock, bought the remaining 70 percent for $100 million which DOL claims was too high of a price to pay because it failed to account for warrants and stock options that would dilute the ESOP’s equity from 100 percent to 55 percent when exercised; a lack of marketability discount; and a price adjustment for an investors’ rights agreement that allowed the selling shareholders to retain control over CFI for a 15-year period.
Settlement. On May 4, 2018, the DOL and CFI settled. The settlement also involved CFI’s insurers, certain parties involved with the ESOP committee, and the ESOP trustee. The settlement involved the payment of an additional $5.4 million into the CFI ESOP. Acosta v. Cactus Feeders, Inc., et al., No. 2:16-cv-00049-J-BR (N.D. Tex. May 4, 2018). In addition, the settlement placed additional requirements on the ESOP trustee that are comparable to an agreement the DOL reached in 2014 with GreatBanc Trust Co. Basically, the agreement requires the CFI ESOP trustee to follow specified procedures when serving as a trustee or other fiduciary of an ESOP that is subject to ERISA when non-publicly traded employer securities are involved. But, it did not require the CFI ESOP trustee to do a number of things that the DOLwas seeking – such as reviewing financing options for ESOPs; obtaining “fairness” opinions; obtain sufficient insurance to provide liability coverage as a fiduciary; perform oversight of a valuation advisor; and maintain documentation of when control is given up via an ESOP transaction.
Impact of the TCJA
The TCJA retained the existing tax benefit when an ESOP owns an S corporation. In that situation, the portion of ESOP earnings that are attributable to the S corporation are exempt from federal (and most state) income tax. In other words, the flow-through tax status of the S corporation is recognized. However, when an ESOP owns a C corporation or less than 100 percent of an S corporation, the TCJA will have an impact. Under the TCJA, the C corporate tax rate was changed to a flat 21 percent, effective January 1, 2018. Depending on the prior applicable tax rate for the corporation, this could be a benefit. As for interest expense deductibility (which could be an issue for an ESOP where the company borrowed funds to finance the acquisition), the TCJA limits the deduction for business interest to the sum of business interest income; 30% of the taxpayer’s adjusted taxable income for the tax year; and the taxpayer’s floor plan financing interest for the tax year. Any disallowed business interest deduction can be carried forward indefinitely (with certain restrictions for partnerships). But, the limitation doesn’t apply to a taxpayer with gross receipts of $25 million or less. A “farming business” can elect out of the limitation (with some “pain” incurred on the depreciation side of things).
On the ESOP valuation issue, the reduction in the top C corporate tax rate (federal) from 35 percent to 21 percent may result in enhanced after-tax corporate earnings. If so, it will trigger higher valuations when the ESOP is valued using the discounted cash-flow method (which is a common ESOP valuation approach). This rate reduction could also result in higher ESOP repurchase obligations.
If an ESOP transaction is treated seriously, is minimally complex (e.g., the plan buys shares of common stock at fair market value), and the trustee considers how the structure of the transaction can either help or hurt plan participants, it is likely that the ESOP will avoid scrutiny. Clearly, the trustee should be communicating with the appraisers, analyzing company projections by comparing them with industry competitors and historical numbers, and determining whether the plan should be paying for control (it shouldn’t when the plan can’t control who manages the company or how it is managed). In addition, the use of an independent appraiser is required.
Certainly, ESOPS are useful primarily as a management succession vehicle for a closely held business. Also, they tend to work better for lower income, relatively younger employees compared to the typical company retirement plan. But, they are very complex and potentially dangerous. They do require meticulous compliance to avoid catastrophic results, and should never be used as a tax shelter for a closely-held business when the owner wants to maintain control. They require compliance with complex qualification rules on an annual basis, which requires significant legal and consulting bills. So, in the right situation, an ESOP can be useful and may even outperform a more traditional retirement plan. But, that’s to be expected given the greater inherent compliance costs and risks.
Is an ESOP a good tool for your farming or ranching operation? It depends.