Agricultural Law and Taxation Blog

Top Ag Law and Tax Developments of 2022 – Part 3

Overview

Today’s blog article continues the series that began earlier this week reviewing the top ag law and tax developments of 2022.  I am working my way through those developments that were significant, but not quite of national significance to make the “Top Ten” of 2022.

More ag law and tax developments of 2022 – it’s the topic of today’s post.

Tax Court has Equitable Jurisdiction to Review CDP Determination

Boechler, P.C. v. Commissioner, 142 S. Ct. 1493 (2022)

The petitioner, a two-person North Dakota law firm, was assessed an “intentional disregard” penalty. The IRS notified them of an intent to levy. They requested and received a CDP (Collection Due Process) hearing, in which appeals sustained the proposed levy. I.R.C. §6330(d)(1) requires a Tax Court petition to be filed within 30 days, but the firm filed one day late. The Tax Court dismissed the petition for lack of jurisdiction.  The Eighth Circuit affirmed on the ground that the statutory requirement for filing was jurisdictional and thus could not be waived. In a unanimous decision, the U.S. Supreme Court ruled that the 30-day period was not a jurisdictional requirement largely due to lack of clarity in I.R.C. §6330(d)(1).  Moreover, the Supreme Court reasoned that its decision preserved the possibility for a court to apply equitable tolling to benefit taxpayers in this context, who often acted without counsel. While the application of equitable tolling would depend on further proceedings, the law firm will get the chance to make its case.

Comment: Although the Supreme Court’s decision does not create greater clarity, it may avoid some injustice. Eighth Circuit Judge Kelly wrote a concurring opinion in which he stated that a jurisdictional approach is a “drastic” measure that may impose a disproportionate burden on low-income taxpayers. This concurring opinion may have been what convinced the U.S. Supreme Court to hear the case. 

Additional Note:  In late 2022, the Tax Court addressed the issue of the right to judicial review of an IRS deficiency proceeding in accordance with I.R.C. §6213(a).  In Hallmark Research Collective v. Comr., 159 T.C. No. 6 (2022), the petition was electronically filed one day late.  The Tax Court held that the statute was clear in specifying that the IRS must issue a deficiency notice and that the taxpayer must respond by filing a Tax Court petition within a 90-day time limit.  As such, the 90-day time limit is a prerequisite of jurisdiction.  The court concluded that deficiency proceedings are based in statute and cannot be equitably tolled. 

COE Improperly Declined Jurisdiction

Hoosier Environmental Council, et al. v. Natural Prairie Indiana Farmland Holdings, LLC, et al., 564 F. Supp. 3d 683 (N.D. Ind. 2021)

Note:  I’m reaching back into 2021 to grab this case.  I didn’t see it until early in 2022,  and it should have been on last year’s list.  But, nevertheless, I want to include it as a significant development for 2022 albeit it was a 2021 federal court decision from Indiana. 

This case involved the issue of the U.S. Army Corps of Engineers (COE) deciding not to regulate a wet area on a farm and whether the decision not to exercise jurisdiction was done properly.  The court’s decision is instructive on the procedure for determining the existence of a wetland, what “prior converted cropland is” and how the agency should properly decline to regulate

The defendant acquired farmland to build and operate a concentrated animal feeding operation (CAFO) with over 4,350 dairy cows.  The COE inspected the property and concluded that much of the land was not subject to the Clean Water Act (CWA). The plaintiffs, two environmental groups, sued alleging that the defendant violated the CWA and that the COE’s administrative jurisdictional determination violated the Administrative Procedures Act (APA).  The land at issue was drained in the early 1900's via the creation of several large ditches and drainage canals to move surface water into the Kankakee River 9.5 miles downstream.  The CAFO was constructed on what had been a lakebed over a century ago, and two of the drainage ditches are on the defendant’s land. 

Note:  The lake was totally drained in the early 1990s to make farmland.  Vested with that is the right to maintain the drain.  See, e.g., Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).  It is immaterial what the size of the lake was or whether it was where a marsh was at some time in the past.  The land at issue was completely transformed to farmland long before the defendant acquired the land at issue. 

The primary issue before the court was whether the COE’s determination that the land was prior converted wetland (and therefore not subject to COE regulation) was arbitrary and capricious.  The court examined the record to determine if the COE followed its own guidance for delineating wetlands.  The court noted that the administrative record lacked any description of the prior drainage system (the series of medial and lateral ditches transecting the property before defendant’s alterations), the defendant’s new drainage system, how these systems were designed to function, and whether they were effective in removing wetland hydrology from the area. 

Note:  While the plaintiffs made much ado about the COE’s lack of consideration of the hydrology of the land before the farm’s alterations, that is largely an irrelevant point.  Famers are entitled to maintain the “wetland and farming regime” on the land and may engage in whatever drainage activities necessary to keep that historic farming activity and production.  The land in question had been converted to farmland many decades earlier and had been constantly maintained in that status.

The court examined aerial photographs, noting that there was an absence of data identified in the COE’s “Midwest Supplement” to assess the relevant drainage factors, including how the existing and current drainage systems were designed to function, whether they were effective in removing wetland hydrology from the area, and when any conversion occurred.  The absence of these sources, coupled with an absence of any meaningful discussion of the hydrology of the site before the defendant’s alterations, led the court to believe that the COE failed to follow the procedures outlined in its own guidance in deciding the land was prior converted cropland.  The COE also reviewed 14 aerial photographs that spanned from 1938 to 2017.  Those photos showed the presence of row cropping and offered no evidence of potential wetlands.  Relying on aerial photographs, the COE expert’s determination, and a determination of the Natural Resources Conservation Service to conclude that wetlands did not exist, was certainly appropriate. 

Note:  In addition, the court’s analysis on this point seems suspect.  The COE did not need to find and document all three factors.  The hydrology had been materially altered to enable consistent row crop farming.  In that situation wetland hydrology is not present, and the area in question is not a wetland.  As a result, other levees, systems, or dams do not alter area hydrology because there is no wetland hydrology present to alter.  The court referred to the COE’s 1987 Manual for its conclusion that the COE didn’t follow its own procedures.  However, the 1987 Manual was established to evaluate recent alterations to undisturbed wetland.  The court incorrectly applied this standard to materially hydrologically altered wetland where the alteration had occurred a century earlier.  As such, the land in issue was prior converted wetland.  The court incorrectly applied the standards of the 1987 Manual to the facts before it involving alterations that occurred over 100 years ago.   

The court also determined that there was no indication in the record that the aerial photographs were used to assess hydrology characteristics of the defendant’s land before alterations were made, how the drainage systems were designed to function, and how effectively and efficiently they could convert land from wetland to upland.  Further, the court noted there was also no explanation why the COE skipped these steps.  The COE took the position that its review of aerial photographs was sufficient to determine the land’s normal circumstances. The court disagreed, determining that the evidence did not support the COE’s claim that its decision was based on identified relevant factors.  Instead, the court concluded that the COE made impermissible post hoc justifications.  If reliance on its own manuals was not warranted in this situation, the court stated, the COE needed to provide a rationale.  As such, the court determined that the evidence did not support the COE’s argument that its decision was rationally based on the relevant wetland hydrological factors before concluding the land was prior converted cropland.  Absent that rationale, the COE’s determination of wetland status of the defendant’s farmland was arbitrary and capricious. 

Note:  The COE followed its correct procedure in this case contained in the Midwest Supplement and also accepted a prior USDA determination as to the land’s status for federal farm program purposes. The ditches and drains that were legally installed successfully removed wetland hydrology.  The COE did not deviate from its own regulatory guidance and procedures, but the court assumed that it did.  There was no need for the COE to find and document all three wetland characteristic factors. The elimination of wetland hydrology eliminates the possibility that the land was a wetland. 

Concerning the lateral ditch, the plaintiffs claimed that the record did not support the COE’s conclusion that the lateral ditches were irrigation canals that drained uplands and lacked relatively permanent flow.  The plaintiffs pointed to a lack of administrative record and the claimed failure of the COE to follow the relevant factors that it lists in its Approved Jurisdictional Determination Form. The court also held that the COE’s finding of non-jurisdiction over the lateral ditches was arbitrary and capricious. 

The court remanded the case to the COE to conduct a more thorough investigation of the defendant’s tract.

Note:  For farmers, the case is a frustrating one.  At issue was land that had been farmed for over 80 years and the right to continue to farm consistent with the historic drainage of the property was caught up in bureaucratic red tape. The court’s expansive view of standing and lack of understanding of the actual science behind the hydrology and geographic facts of the case created a problem for a dairy operation that should have never happened.  What was involved in the case were shallow ditches dug into prior converted wetland.  That is an activity that the Clean Water Act does not regulate. 

Conclusion

I will continue my journey through the top developments in ag law and tax in a subsequent post.

Top Ag Law and Developments of 2022 – Part 2

Overview

Today’s blog article continues the series that began earlier this week reviewing the top ag law and tax developments of 2022.  I am working my way through those developments that were significant, but not quite of national significance to make the “Top Ten” of 2022.

More ag law and tax developments of 2022 – it’s the topic of today’s post.

Regulation of Agricultural Activities on Wildlife Refuges

Tulelake Irrigation Dist. v. United States Fish & Wildlife Serv., 40 F.4th 930 (9th Cir. 2022)

This case involves the management of six national wildlife refuges in the Klamath Basin encompassing over 200,000 acres.  The court faced the specific question of whether the federal government can regulate agricultural activities on leased land within the refuges.  The plaintiffs, an irrigation district and associated agricultural groups, sued the defendant, U.S. Fish and Wildlife Service, claiming the defendant violated environmental laws by regulating leased farmland in the Tule Lake and Klamath Refuge. The trial court granted summary judgment in favor of the defendant.  The plaintiffs appealed.  The appellate court noted that the Kuchel Act and the Refuge Act allow the defendant to determine the proper land management practices to protect the waterfowl management of the area.  Under the Refuge Act, the defendant was required to issue an Environmental Impact Statement (EIS) and Comprehensive Conservation Plan (CCP). The defendant did issue an EIS and CCP for the Tule Lake and Klamath Refuge area, which included modifications to the agricultural use on the leased land within the region. The EIS/CCP required the leased lands to be flooded post-harvest, restricted some harvesting methods, and prohibited post-harvest field work, which the plaintiffs claimed violated their right to use the leased land. The plaintiffs argued that the language, “consistent with proper waterfowl management,” within the Kuchel Act was “nonrestrictive” and was not essential to the meaning of the Act. The appellate court held it was improper to read just that portion of the Act without considering the rest of the Act to understand the intent. The appellate court found the Kuchel Act was unambiguous and required the defendant to regulate the leased land to ensure proper waterfowl management. The Refuge Act allows the defendant to regulate the uses of the leased land, but the plaintiffs argued the agricultural practices were a “purpose” rather than a “use” so the defendant could not regulate it under the Refuge Act. The appellate court found the agricultural activity on the leased land was not a “purpose” equal to waterfowl management. The appellate court also held the language of the Act was unambiguous and determined that agricultural activities on the land were to be considered a use that the defendant could regulate.  As such, the conditions needed to benefit waterfowl trumped ag considerations under both the Refuge Act and the Kuchel Act and, as the court stated, if the defendant determined that “an ag use is not consistent with proper waterfowl management, the Service must be allowed to restrict agricultural use.  Accordingly, the appellate court affirmed the trial court’s award of summary judgment for the defendant.

Minnesota Farmer Protection Law Upheld

Pitman Farms v. Kuehl Poultry, LLC, et al., 48 F.4th 866 (8th Cir. 2022)

In early 1988, the Minnesota Legislature directed the Minnesota Department of Agriculture (MDA) to put together a task force to study the issue of agricultural contract production and recommend to the legislature how it might provide additional legal and economic protection to contract growers.  The MDA’s Final Report was issued in February of 1990.  During the 1990 legislative session, the Minnesota legislature approved various economic protections for farmers based on the task force recommendations focusing particularly on parent liability.  As signed into law, MN Stat. §17.93 provides as follows:

“Parent company liability.  If an agricultural contractor is the subsidiary of another corporation, partnership, or association, the parent corporation, partnership or association is liable to a seller for the amount of any unpaid claim or contract performance claim if the contractor fails to pay or perform according to the terms of the contract.” 

In addition, MN Stat. §17.90 specified as follows:

“’Producer” means a person who produces or causes to be produced an agricultural commodity in a quantity beyond the person’s own family use and: (1) is able to transfer title to another; or (2) provides management input for the production of an agricultural commodity.”

The MDA then prepared at “statement of need and reasonableness” (SONAR) to implement the new statutory provision.  The SONAR referred to the legislation as the “Producer Protection Act” (PPA) and the MDA’s implementing rule (MN Rule 1572.0040) for MN Stat §17.93 which went into effect on March 4, 1991, read as follows:

“A corporation, partnership, sole proprietorship, or association that through ownership of capital stock, cumulative voting rights, voting trust agreements, or any other plan, agreement, or device, owns more than 50 percent of the common or preferred stock entitled to vote for directors of a subsidiary corporation or provides more than 50 percent of the management or control of a subsidiary is liable to a seller of agricultural commodities for any unpaid claim or contract performance claim of that subsidiary.”

 During the same 1990 legislative session the Minnesota legislature approved, and the governor signed into law MN Stat. §27.133.  This new law stated as follows:

“Parent company liability.  If a wholesale produce dealer is a subsidiary of another corporation, partnership, or association, the parent corporation, partnership, or association is liable to a seller for the amount of any unpaid claim or contract performance claim if the wholesale produce dealer fails to pay or perform in according to the terms of the contract and this chapter.”

Concerning this provision, the legislature stated, “It is therefore declared to be the policy of the legislature that certain financial protection be afforded those who are producers on the farm….”

Also, under both MN Stat. §17.93 and MN Stat. §27.133, “contractor” and “wholesale produce dealer” were defined as “persons” and “person” was to be applied to corporations, partnerships and other unincorporated associations.”  MN Stat. §665.44, sub. 7. 

In 2017, the defendants entered into chicken production contracts with Prairie’s Best Farm, Inc. to grow chickens in exchange for monthly payments and bi-monthly bonus payments.  In late 2017, Simply Essentials bought the assets of Prairie’s Best and assumed the grower contracts.  Simply Essentials, incorporated in Delaware and headquartered in California, was the subsidiary of the plaintiff, Pitman Farms, which owned more than 50 percent of Simply Essentials.  Shortly thereafter, the plaintiff bought Simply Essentials’ membership interests and became its sole owner.  In 2019, Simply Essentials encountered financial trouble, ceased processing activities and notified the defendants that it was terminating the contracts effective three months later.  The defendants’ demands for payment in excess of $6 million from the plaintiff for breach of contract failed. Both parties sought a declaratory judgment concerning the application of the PPA to the contracts. 

The plaintiff claimed that the PPA did not apply because the defendants were not “sellers” and, even if they were, the PPA didn’t apply because Simply Essentials was an LLC rather than a “corporation, partnership, or association.  The plaintiff also asserted that the PPA’s parent company liability provisions didn’t apply to it because Delaware law applied, and that applying Minnesota law would violate the Dormant Commerce Clause.  The defendant’s counterclaim made the opposite arguments.

The trial court ruled for the plaintiff, finding that the PPA did not apply by its terms because the defendants were not “sellers” and because Simply Essentials was an LLC rather than a “corporation, partnership, or association.”

On appeal, the appellate court unanimously reversed.  The appellate court read the various statutes together to determine the legislature’s purpose and intent.  The appellate court noted that the parent company liability statute of MN Stat. §27.133, the PPA of §§17.90-17.98 and the MDA’s implementing rule all arose from the same legislative session, addressed the same issue, and contained nearly identical language.  Accordingly, the appellate court determined that the trial court should have looked to MN Stat. §27.133 when construing the meaning of “seller” contained in MN Stat. §17.93 and in MDA Rule 1572.0040.  When the various provisions were taken together, the appellate court determined that “seller” can include “producer” under the PPA and the MDA’s implementing regulation. 

The appellate court also concluded that the trial court erred in finding that “seller” was limited to transferors of title.  Because the defendants did not have title to the chickens and could not therefore transfer title, the trial court held that the PPA did not apply.  The appellate court held that such a construction was plainly contrary to the legislature’s intent in creating the PPA which was to provide financial protections to agricultural producers in general and not merely agricultural commodity sellers.  Further, because the appellate court determined that “seller” included “producer,” the defendants were covered by the PPA as providing management services in accordance with MN Stat. §17.90 (2) for the growing of the chickens under contract.  In addition, the appellate court held that the growers were also “sellers” for purposes of the parent company liability provision of MN Stat. §27.133.

The plaintiff also asserted that “subsidiary of another corporation, partnership or association” contained in MN Stat. §17.93 and §27.133 meant that both the parent and the subsidiary had to be either a corporation, partnership or an association.  The trial court agreed with this interpretation.  The appellate court also agreed but pointed out that LLCs (which Simply Essentials was) did not exist in Minnesota when the PPA was enacted and, as such, the legislature had not purposefully excluded them from the statute. The appellate court also noted that an LLC had been found to be a “person” for purposes of the Minnesota Human Rights Act.  That law defined “person” to include a partnership, association, or corporation.  In addition, an unpublished decision of the Minnesota Court of Appeals had previously held that an LLC was an “association” for purposes of a Minnesota oil transportation statute. Thus, there was no apparent reason why the legislature would have singled out LLCs to not be covered under the parent company liability provisions of the PPA. 

The appellate court also noted the strong public policy statement of the Minnesota legislature in enacting the PPA – to protect producers of agricultural commodities from economic harm due to parent business entities using their organizational form to avoid liability for their subsidiaries’ actions. 

Conclusion

I will continue my journey through the top developments in ag law and tax in a subsequent post.

Here Come the Feds: EPA Final Rule Defining Waters of the United States – Again

Overview

On December 30, 2022, the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COA).  On December 30, 2022, the agencies announced the final "Revised Definition of 'Waters of the United States'" rule which will be effective 60 days after it is published in the Federal Register.  It represents a “change of mind” of the agencies from the positions that they held concerning a water of the United States (WOTUS) and wetlands from just over three years ago.  The bottom line is that the new interpretation is extremely unfriendly to agriculture, particularly to farmland owners in the prairie pothole region of the upper Midwest.    

Background

The scope of the federal government’s Clean Water Act (CWA) regulatory authority over wet areas on private land, streams and rivers has been controversial for more than 40 years.  The CWA bars the discharge of a “pollutant” into the “navigable waters of the United States without a federal discharge permit.  A “pollutant” is defined as “dredged spoil, solid waste, incinerator residue, sewage, garbage, sewage sludge, munitions, chemical wastes, biological materials, radioactive materials, heat, wrecked or discarded equipment, rock, sand, cellar dirt and industrial, municipal, and agricultural waste.”

Note:  The legislative history of the CWA reveals that the Congress was not thinking about preserving wetlands when the definition of a “pollutant” was written.  Instead, it blended together (under the umbrella of “pollution”) the COE’s responsibility to protect navigation with the EPA’s responsibility to prevent contamination.  This is the genesis of upstream regulation that environmental groups and numerous courts latched onto.  Routine farming activities were exempted from the discharge permit requirement.       

Many court opinions have been filed attempting to define the scope of the government’s jurisdiction.  On two occasions, the U.S. Supreme Court attempted to clarify matters, but in the process of rejecting the regulatory definitions of a WOTUS proffered by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE) didn’t provide clear direction for the lower courts.  See Solid Waste Agency of Northern Cook County v. United States Army Corps of Engineers, 531 U.S. 159 (2001); Rapanos v. United States, 547 U.S. 175 (2006). 

Particularly with its Rapanos decision, the Court failed to clarify the meaning of the CWA phrase “waters of the United States” and the scope of federal regulation of isolated wetlands. The Court did not render a majority opinion in Rapanos, instead issuing a total of five separate opinions. The plurality opinion, written by Justice Scalia and joined by Justices Thomas, Alito and Chief Justice Roberts, would have construed the phrase “waters of the United States” to include only those relatively permanent, standing or continuously flowing bodies of water that are ordinarily described as “streams,” “oceans,” and “lakes.”  In addition, the plurality opinion also held that a wetland may not be considered “adjacent to” remote “waters of the United States” based merely on a hydrological connection. Thus, in the plurality’s view, only those wetlands with a continuous surface connection to bodies that are “waters of the United States” in their own right, so that there is no clear demarcation between the two, are “adjacent” to such waters and covered by permit requirement of Section 404 of the CWA.

Justice Kennedy authored a concurring opinion, but on much narrower grounds.  In Justice Kennedy’s view, the lower court correctly recognized that a water or wetland constitutes “navigable waters” under the CWA if it possesses a significant nexus to waters that are navigable in fact or that could reasonably be so made. But, in Justice Kennedy’s view, the lower court failed to consider all of the factors necessary to determine that the lands in question had, or did not have, the requisite nexus. Without more specific regulations comporting with the Court’s 2001 SWANCC opinion, Justice Kennedy stated that the COE needed to establish a significant nexus on a case-by-case basis when seeking to regulate wetlands based on adjacency to non-navigable tributaries, in order to avoid unreasonable application of the CWA. In Justice Kennedy’s view, the record in the cases contained evidence pointing to a possible significant nexus, but neither the COE nor the lower court established a significant nexus. As a result, Justice Kennedy concurred that the lower court opinions should be vacated, and the cases remanded for further proceedings.

Justice Kennedy’s opinion was neither a clear victory for the landowners in the cases or the COE. While he rejected the plurality’s narrow reading of the phrase “waters of the United States,” he also rejected the government’s broad interpretation of the phrase. While the “significant nexus” test of the Court’s 2001 SWANCC opinion required regulated parcels to be “inseparably bound up with the ‘waters’ of the United States,” Justice Kennedy would require the nexus to “be assessed in terms of the statute’s goals and purposes” in accordance with the Court’s 1985 opinion in United States v. Riverside Bayview Homes. 474 U.S. 121 (1985). 

The “WOTUS Rule”.  The Obama Administration attempted take advantage of the lack of clear guidance on the scope of federally jurisdictional wetland by dramatically expanding the federal government’s reach by issuing an expansive WOTUS rule.  The EPA/COE regulation was deeply opposed by the farming/ranching and rural landowning communities and triggered many legal challenges.   The rule was challenged by over 30 states and the courts were, in general, highly critical of the regulation and it became a primary target of the Trump Administration.

The “NWPR Rule”.  The Trump Administration essentially rescinded the Obama-era rule with its own rule – the “Navigable Waters Protection Rule” (NWPR). 85 Fed. Reg. 22, 250 (Apr. 21, 2020).  The NWPR redefined the Obama-era WOTUS rule to include only: “traditional navigable waters; perennial and intermittent tributaries that contribute surface water flow to such waters; certain lakes, ponds, and impoundments of jurisdictional waters; and wetlands adjacent to other jurisdictional waters.  In short, the NWPR narrowed the definition of the statutory phrase “waters of the United States” to comport with Justice Scalia’s approach in Rapanos.  Thus, the NWPR excludes from CWA jurisdiction wetlands that have no “continuous surface connection” to jurisdictional waters.  The rule much more closely followed the Supreme Court’s guidance issued in 2001 and 2006 that did the Obama-era rule, but it was challenged by environmental groups.  Indeed, the NWPR has been challenged in 15 cases filed in 11 federal district courts.   

In early 2020, the U.S. Court of Appeals for the Tenth Circuit reversed a Colorado trial court that had entered a preliminary injunction barring the NWPR from taking effect in Colorado as applied to the discharge permit requirement of Section 404 of the CWA.  The result of the appellate court’s decision was that the NWPR became effective in every state.  Colorado v. United States Environmental Protection Agency, 989 F.3d 874 (10th Cir. 2021). 

Later, a federal district court in South Carolina remanded the NWPR to the EPA. South Carolina Coastal Conservation League, et al. v. Regan, No. 2:20-cv-016787-BHH (D. S.C. Jul. 15, 2021).  The NWPR was being challenged on the scope issue.  Even though the NWPR was remanded, the court left the rule intact.  That fit with the strategy of present Administration.  If the court had invalidated the NWPR, then the Administration would have had to defend the indefensible Obama-era rule in court.  That wouldn’t have turned out well for the Administration.  In addition, the opinion not vacating the NWPR allowed the Administration to proceed in trying to write a new rule without bothering to defend the Obama-era rule in court.

Another definition.  On December 7, 2021, the EPA and the COE published a proposed rule redefining a “water of the United States” (WOTUS) in accordance with the pre-2015 definition of the term. 86 FR 69372 (Dec. 7, 2021).   Under the proposed rule, EPA stated its intention to define a WOTUS in accordance with the 1986 regulations as further defined by the courts since that time.  In addition, the agencies said that the proposed rule would base the existence of a WOTUS on the “significant nexus” standard set forth in prior Supreme Court decisions.  As such, a WOTUS would include traditional navigable waters; territorial seas and adjacent wetlands; most impoundments of a WOTUS and wetlands adjacent to impoundments or tributaries that meet either the relatively permanent standard or the significant nexus standard; all waters that are currently used or were used in the past or may be susceptible to use in interstate or foreign commerce, including all waters that are subject to the ebb and flow of the tide. 

The proposed rule defines “interstate waters” as “all rivers, lakes, and other waters that flow across, or form a part of State boundaries” regardless of whether those waters are also traditionally navigable. A “tributary” is also defined as being a WOTUS if it fits in the “other waters” category via a significant nexus with covered waters or if it is relatively permanent. The EPA and COE further define the “relatively permanent standard” as “waters that are relatively permanent, standing or continuously flowing and waters with a continuous surface connection to such waters.” The “significant nexus standard” is defined as “waters that either alone or in combination with similarly situated waters in the region, significantly affect the chemical, physical, or biological integrity of traditional navigable waters, interstate waters, or the territorial seas (the "foundational waters").”

Final Rule

The agencies announced their Final Rule on December 30, 2022.  It will become effective 60 days after it is published in the Federal Register.  As promised, the Final Rule uses a definition that was in place before 2015 (for purposes of the Clean Water Act) for traditional navigable waters, territorial seas, interstate waters, and upstream water resources that “significantly” affect those waters.

Note:  Going back to before 2015 is interesting.  It was in 2015 that the Obama Administration was going to “clarify” everything, and the result was to greatly expand control over private property.  As noted above, this “clarification” resulted in more than 30 states suing the federal government and an injunction was imposed.  Also as noted above, the EPA and the COE under the Trump administration then pursued a long, careful rulemaking procedure which brought actual clarity to the definition.  It’s that clarity that has now been completely overturned, supposedly for “clarity’s” sake.

Two joint memos were published with the final rule to set forth the delineation of the implementation of roles and responsibilities between the agencies.  One is a joint coordination memo to “ensure accuracy and consistency of jurisdictional determinations under the final rule.”  The other is a memo with the USDA to provide “clarity on the agencies’ programs under the Clean Water act and the Food Security Act (Swampbuster).”

Adjacency.  The EPA wants to restore the “significant nexus” via “adjacency.”  This is a big change in the definition of “adjacency.”  It doesn’t mean simply “abutting.”  Instead, “adjacent” includes a “significant nexus” and a “significant nexus” can be established by “shallow hydrologic subsurface connections” to the “waters of the United States.  A “shallow subsurface connection,” the Final Rule states, may be found below the ordinary root zone (below 12 inches), where other wetland delineation factors may not be present.  Frankly, that means farm field drain tile.      

Note:  Farmers needs to pay attention to this, despite what USDA will undoubtedly say about it – the USDA’s Natural Resource Conservation Service (NRCS) is now completely under the thumb of the EPA and the COE (particularly because the practice of mitigation banking under the CWA will cease).  Practically every tile for every tile-drained farmed wetland connects to an open ditch which is a WOTUS.  This effectively disqualifies farmed wetland from being an isolated wetland –[these terms means specific things under the regulations].  The only wetland that will qualify as an isolated wetland (no hydrological connection to a WOTUS) will be those that don’t overflow and don’t have drain tile. 

Specifically, the Final Rule sets forth two kinds of adjacency: 1) the traditional “relatively permanent” standard; and 2) the “significant nexus” standard.  The EPA and the COE say the agencies will not assume that all wetlands in a specific geographic area are similarly situated and can be assessed together on a watershed basis in a significant nexus analysis.  But it is clear from the Final Rule that the agencies intend to expand jurisdiction over isolated prairie pothole wetlands using the “significant nexus” standard. 

Note:  The “significant nexus” can be established via a connection to downstream waters by surface water, shallow subsurface water, and groundwater flows and through biological and chemical connections.  The Final Rule states that adjacency can be supported by a “pipe, non-jurisdictional ditch,… or some other factors that connects the wetland directly to the jurisdictional water.”  This appears to be the basis for overturning the NWPR.  Consequently, the prairie pothole region is directly in the “bullseye” of the Final Rule.

Prior Converted Cropland.  The agencies say the final rule increases “clarity” on which waters are not jurisdictional – including prior converted cropland.  This doesn’t make much sense.  Supposedly, the agencies are “clarifying” that prior converted cropland, (which is not a water), is not a water, but it somehow could be a water if the agencies had not clarified it?  In addition, the burden is placed on the landowner to prove that prior converted cropland is actually prior converted cropland and therefore not a water.

Ditches and drainage devices.  The Final Rule is vague enough to give the government regulatory authority over non-navigable ponds, ditches, and potholes.  On the ditch/drainage device maintenance issue, there is also no recognition that the agencies will follow the opinion of the U.S. Circuit Court of Appeals for the Eighth Circuit in Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).  In Barthel, the court ruled that a landowner can do whatever is necessary with respect to an existing drainage device to maintain the “historic wetland and farming regime” for the farm.  While Barthel is a Swampbuster case, it is relevant with respect to the Final Rule given that the USDA is now basically subservient to the EPA and the COE.  

The U.S. Supreme Court

It is rather presumptuous of the CWA and the COE to develop a Final Rule before the U.S. Supreme Court issues its opinion in a case presently pending involving the definition of a WOTUS.  In Sackett v. Environmental Protection Agency, 8 F.4th 1075 (9th Cir. 2021), cert, granted, 142 S. Ct. 896 (2022).  The issue in the case is whether the U.S. Circuit Court of Appeals for the Ninth Circuit used the proper test for determining whether wetlands are “waters of the United States” under the CWA.  The plaintiffs bought a .63-acre lot in 2004 on which they intended to build a home.  The lot is near numerous wetlands the water from which flows from a tributary to a creek, and eventually runs into a lake approximately 100 yards from the lot.  The lake is 19 miles long and is a navigable water subject to the CWA.  The plaintiffs began construction of their home, and the Environmental Protection Agency (EPA) issued a compliance order notifying the plaintiffs that their lot contained wetlands due to adjacency to the lake and that continuing to backfill sand and gravel on the lot would trigger penalties of $40,000 per day.  The plaintiffs sued and the EPA claimed that its administrative orders weren’t subject to judicial review. 

Ultimately the U.S. Supreme Court unanimously rejected the EPA’s argument and remanded the case to the trial court for further proceedings.  The EPA withdrew the initial compliance order and issued an amended compliance order which the trial court held was not arbitrary or capricious.  The plaintiffs appealed and the EPA declined to enforce the order, withdrew it and moved to dismiss the case.  However, the EPA still maintained the lot was a jurisdictional wetland subject to the CWA and reserved the right to bring enforcement actions in the future.  In 2019, the plaintiffs resisted the EPA’s motion and sought a ruling on the motion to bring finality to the matter.  The EPA claimed that the case was moot, but the appellate court disagreed, noting that the withdrawal of the compliance order did not give the plaintiffs final and full relief.  On the merits, the appellate court noted that the lot contained wetlands 30 feet from the tributary, and that under the “significant nexus” test of Rapanos v. United States, 547 U.S. 715 (2006), the lot was a regulable wetland under the CWA as being adjacent to a navigable water of the United States (the lake). 

The U.S. Supreme Court agreed to hear the case and oral argument occurred in early October of 2022.  The Court’s opinion is anticipated sometime before mid-March of 2023, but the issuance of the Final Rule may cause that to be delayed.  In any event, the Supreme Court will have the final say on what a WOTUS rather than the COE or the EPA.

Note:  EPA says the Final Rule reflects prior Supreme Court decisions and will provide “clarity” on which waters are jurisdictional and which ones are not.  How can EPA provide “clarity” when the Supreme Court hasn’t yet said what a WOTUS is?  The role of an administrative agency is to take a statute, or a court decision construing a statute and then write a rule defining the boundaries of the definition - in this instance, that of a WOTUS. 

Conclusion

The definition of a WOTUS has become a political football.  This constant flip-flopping of definitions lends a lack of credibility to the COE and the EPA on the issue.  Didn’t these same agencies believe the 2019 NWPR was good?  The Final Rule represents the agencies’ stealth techniques to extend the government’s reach over wetlands on private property.  There is absolutely no chance that the Final Rule is fair to farmers. 

Top Ag Law and Tax Developments of 2022 – Part 1

Overview

At the beginning of each year for about the past 25 years, I have made a point to catalogue the immediately prior year’s top developments in agricultural law and taxation.  It’s important to look back at what the major issues were because they can also provide insight into what might be the big issues in the coming year.  Insight into trends in the law and taxation impacting farmers, ranchers, rural landowners and agribusiness is important because it can aid planning to avoid legal issues in the future.  The law and taxation can have a significant economic impact on a farming operation, or on a family legacy.  While it is very true that issues involving agronomy or animal science or horticulture or other similar disciplines are important and each have their role in the success of a farming business, where “the rubber meets the road” is in the law and taxation.  The law and tax rules set the framework within which all other disciplines must operate.  A deviation outside those boundaries can result in costly litigation, family disputes and an inefficiently run operation that might not survive into the next generation.

With that in mind, today’s article is the beginning of several that highlight the major legal and tax issues of 2022 that were significant for agriculture.  Some are important developments at that state level that could spill over to other states, but the major developments, of course, are those at the federal level – in the federal courts all the way up to the U.S. Supreme Court and with the IRS.

The major developments in ag law and tax from 2022 – the “Almost Top Ten.”  It’s the first in a multi-part series.

Nuisance Law

The first development that was significant in 2022, but not important enough nationally to make the Top Ten, involves a nuisance lawsuit in Iowa that resulted in a significant Iowa Supreme Court decision.  But, first a bit of background on the issue of ag nuisance 

In general.  An issue that is of significance to agriculture is that of nuisance.  Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property.  It’s based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.  Because each claim of nuisance depends on the fact of the case, there are no easy rules to determine when an activity will be considered a nuisance. 

Defenses.  There are no common law defenses that an agricultural operation may use to shield itself from liability arising from a nuisance action.  However, courts do consider a variety of factors.  Of primary importance are priority of location and reasonableness of the operation.  Together, these two factors have led courts to develop a “coming to the nuisance” defense.  This means that if people move to an area they know is not suited for their intended use, they should be prohibited from claiming that the existing uses are nuisances. 

While there are no common law defenses to a nuisance suit, every state has enacted a right-to-farm law that is designed to protect existing agricultural operations by giving farmers and ranchers who meet the legal requirements a defense in nuisance suits.  The basic thrust of a particular state's right-to-farm law is that it is unfair for a person to move to an agricultural area knowing the conditions which might be present and then ask a court to declare a neighboring farm a nuisance.  Thus, the basic purpose of a right-to-farm law is to create a legal and economic climate in which farm operations can be continued. 

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

“An animal feeding operation…shall not be found to be a…nuisance under this chapter or under principles of common law, and the animal feeding operation shall not be found to interfere with another person’s comfortable use and enjoyment of the person’s life or property under any other cause of action.”  Iowa Code §657.11.

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

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

On appeal, the Iowa Supreme Court held the right-to-farm law unconstitutional, but only to the extent that it denied the plaintiffs compensation for the decreased value of their property.  In essence, the Court held that the statute gave the defendant an easement to produce odors over the plaintiffs’ property, for which compensation had to be paid.  Importantly, the Court did not opine that right-to-farm laws are not a legitimate purpose of state government. To the contrary, the Court noted the Iowa legislature’s objective of promoting animal agriculture in the state and that the right-to-farm law bore a reasonable relationship to that legitimate objective.  The Court also seemed to indicate that the statute would not be constitutionally defective had the plaintiffs “come to the nuisance” (i.e., moved next door to the defendant’s existing hog operation).

Note:  Post Gacke, the Iowa right-to-farm law could be found to be unconstitutional on a case-by-case basis as determined by a three-part test with the burden on the plaintiff of establishing each element: 1) that the plaintiff personally had not benefitted from the right-to-farm law beyond what the general public enjoyed; 2) that the plaintiff suffered significant hardship; and 3) that the plaintiff lived on their property before the defendant’s operation began and that both the plaintiff and the defendant spent considerable funds in property improvements.

2022 development. In 2022, the Iowa Supreme Court again issued an opinion involving a nuisance suit against a confined animal feeding operation (CAFO).  In Garrison v. New Fashion Pork LLP, 977 N.W.2d 67 (Iowa Sup. Ct. 2022), the plaintiff claimed that the defendant’s neighboring confined animal feeding operation (CAFO) violated both the Clean Water Act and the Resource Conservation Recovery Act due to manure runoff that caused excessive nitrate levels in the plaintiff’s water sources.  The federal court dismissed the suit on summary judgment for lack of expert testimony to establish the plaintiff’s claim, finding that the alleged violations where wholly past violations, and that water test results showed no ongoing violation of either statute, but rather a slight decrease in nitrate levels since the start of the defendant’s confined animal feeding operation (CAFO).  The federal court also declined supplemental jurisdiction over the plaintiff’s state law claims.  The plaintiff then sued the defendant in state court for nuisance, trespass and violation of state drainage law.  The defendant moved for summary judgment based on statutory immunity of Iowa Code § 657.11 and the plaintiff’s lack of evidence or expert testimony. 

The plaintiff, relying on Gacke, claimed that Iowa Code §657.11 as applied to him was unconstitutional under Iowa’s inalienable rights clause.  The trial court, noting that the plaintiff’s own CAFO (raising of 500 ewes, and at times over 1,000 ewes and lambs, on his property for over 40 years, along with a six-foot tall manure pile) had benefited from immunity, rejected the plaintiff’s constitutional challenge for failure to satisfy Gacke’s three-part test.  The trial court then granted the defendant’s summary judgment motion based on the plaintiff’s failure to provide any expert testimony or other evidence to support any exception to the statutory immunity defense or to prove causation or damages. 

On further review, the Iowa Supreme Court affirmed, overruled the three-part test of Gacke and applied rational basis review to reject the plaintiff’s constitutional challenge to Iowa Code §657.11.  The court noted that the statue did not eliminate nuisance claims against CAFOs, but rather established reasonable limitations on recovery rights.  The Iowa Supreme Court concluded that the plaintiff failed to preserve error on his takings claim under article I, section 18 of the Iowa Constitution and failed to generate a question of fact precluding summary judgment on statutory nuisance immunity or causation for his trespass and drainage claims. Specifically, the Iowa Supreme Court noted that without accompanying expert testimony, the plaintiff’s water tests showed neither an increase in nitrate levels nor a spike in nitrate levels that would correlate with manure spreading. The Supreme Court further noted that even assuming an increase in nitrate levels, the plaintiff lacked expert testimony to attribute or correlate any increase in nitrate levels in the stream to the defendants’ actions. Thus, without expert witness testimony that tied the defendant’s alleged misapplication or over-application of manure to the nitrate levels in the plaintiff’s stream, the plaintiff could not, as a matter of law, satisfy his burden of proving that any trespass or drainage violation proximately caused his damages.  Ultimately, the Supreme Court concluded, “balancing the competing interests of CAFO operators and their neighbors is a quintessentially legislative function involving policy choices…[belonging] with the elected branches.” 

Note:   The Iowa Supreme Court’s opinion didn’t explain how the attorneys for the plaintiff failed to preserve error on the plaintiff’s takings claim and failed to provide expert witness testimony on the tort claims for trespass and drainage issues.  However, the Iowa Supreme Court clearly focused on those deficiencies in its opinion. 

Going forward, if a jury finds that a nuisance exists the ag operation can use the nuisance defense if the operation is in full compliance with state and federal regulations, exercises generally accepted management practices, and has for substantial periods of time not interfered with the use and enjoyment of the complaining party’s property. The nuisance defense will apply regardless of the established date or expansion of the operation.  In other words, there is no “first-in-time” requirement. 

Conclusion

There have been several significant developments over the past couple of years either legislatively or in the courts involving ag nuisances in several states.  Expect that to continue and also expect that the 2022 development in Iowa to have an impact on other state legislatures and courts grappling with the ag nuisance issue.   

Medicaid Estate Recovery and Trusts

Overview

When a Medicaid beneficiary dies, a state might seek recovery of the Medicaid benefits paid during the beneficiary’s life from the deceased beneficiary’s estate.  Part of estate planning to protect assets from being depleted during life and limit or eliminate a state’s right to recover benefits post-death involves transferring property to a trust with the appropriate terms.  Known as a Medicaid Asset Protection Trust (MAPT), it’s a part of estate planning that is very important to many farm and ranch families that desire to keep the farm in the family for multiple generations.  It’s also a topic that I started lecturing on nationally over 30 years ago after I wrote one of the very first law review articles ever published on the topic.  Roger A. McEowen, et al., “Estate Planning for the Elderly and Disabled: Organizing the Estate to Qualify for Federal Medical Extended Care Assistance,” 24 Ind. L. Rev. 1379 (1991).  I then followed that up with another article three years later.  Roger A. McEowen, “Estate Planning for Farm and Ranch Families Facing Long-Term Health Care,” 73 Neb. L. Rev. 104 (1994).

An MAPT was involved in a recent Iowa case.  Unfortunately for the estate, the court’s suspect reasoning resulted in the trust not operating to protect the decedent’s assets from the state seeking reimbursement.  A dissenting opinion, however, pointed out the majority’s flawed rationale.

Medicaid asset protection trusts – it’s the topic of today’s post.

Medicaid Basics

For many persons, estate planning also includes planning for the possibility of long-term health care.  Nursing home care is expensive and can require the liquidation of assets to generate the funds necessary to pay the nursing home bill unless appropriate planning has been taken.  Medicaid is a joint federal/state program that pays for long-term health care in a nursing home.  To be able to receive Medicaid benefits, an individual must meet numerous eligibility requirements but, in short, must have a very minimal level of income and assets.  States set their own asset limits and determine what assets count toward the limit.  Assets exceeding the limit must be spent on the applicant’s nursing home care before Medicaid eligibility can be established. 

There are also rules that can apply to help protect certain assets from being depleted to pay for a long-term care bill, and different rules apply when the Medicaid applicant/beneficiary is married, and the spouse is not applying for or receiving Medicaid.   However, the overriding public policy concern is that private assets are primarily used to pay for care before taxpayer dollars are utilized. 

While some states set different timeframe for the “look-back” period, the general rule is that the value of any non-exempt asset owned by a Medicaid applicant or applicant’s spouse that is disposed of for less than fair market value within five years of an application for Medicaid is treated as an available asset for purposes of Medicaid eligibility. That is the rule for outright transfers as well as transfers to or from a trust.  If such a transfer occurs, a penalty period is triggered that could further delay Medicaid eligibility.  The penalty period is determined by dividing the uncompensated value of the transfer by the average monthly cost of nursing home care in the individual’s state.  The resulting figure is the number of months the individual’s penalty period will last.  The penalty period begins on the date on which the individual has applied and is otherwise eligible for Medicaid. 

Asset Sheltering Trusts

An asset sheltering trust (also known as an MAPT) is a trust designed to enable the grantor to be eligible for public assistance benefits (Medicaid) for long-term health care costs that would be incurred if the grantor entered a nursing facility.  The rules surrounding these types of trusts are quite complex and are constantly changing given the public policy concerns that surround the creation of these types of trusts.

In general, these trusts contain language explicitly evidencing the grantor’s intent to give the trustee complete discretion (a “fully discretionary” trust) to distribute trust income and principal.  Similar language might also be used to assure that the grantor’s intent was to supplement rather than supplant public benefits that might be otherwise available.  The purpose of these types of provisions is that if the beneficiary ever is in need of long-term medical assistance in a nursing facility, then the trustee has the discretion to withhold the payment of funds from the grantor’s property contained in the trust to permit the beneficiary to receive public assistance (Medicaid) benefits at taxpayer expense and preserve the grantor’s assets for the heirs. They also operate to not create any interest in the trust corpus that the state can attach to seek reimbursement from after the beneficiary dies. 

Recent Iowa case.  In In re Trust Under the Will of Riessen, No. 22-0048, 2022 Iowa App. LEXIS 925 (Iowa Ct. App. Dec. 7, 2022), the court faced the issue of whether a trust effectively barred the state from seeking post-death reimbursement for Medicaid benefits paid to a trust beneficiary during life.  The trust grantor died in 1972 with a will that established a trust to hold an equal share of his farm for a daughter, with his son serving as trustee.  The trust authorized the son to pay the net income and principal of the trust to the daughter at his complete discretion – he was not obligated in any way to provide trust funds to his sister as the beneficiary.  The trust also stated that the grantor’s reason for giving the complete discretionary power to the trustee was because it was the grantor’s “hope and desire to keep the entire property in the family.”  The trust specified that the son had the right to rent the land in the trust and farm it as the tenant. The trust also stated that it was the grantor’s intent that the son, as trustee, buy certain adjacent tracts of land to help maintain the family farming operation.

The daughter died in 2020 and during her lifetime the trust didn’t provide any funds for her medical care, but the state did provide Medicaid benefits for her.  After she died, the state sought reimbursement from the trust for the Medicaid benefits provided to the daughter during her life.  The probate court ordered the trust to reimburse the state and the trustee appealed.  The state based its reimbursement claim on Iowa Code §249A.53(2), which provides that when Medicaid funds care for an individual 55 or older that is a resident of a care facility, the debt can be collected from any trust in which the individual had an interest.  However, the trustee asserted that the trust was a fully discretionary trust and that he had the complete discretion to ignore the beneficiary’s medical needs if he so desired – there was no standard set in the trust that he had to follow in providing trust funds for his sister’s care.  As such, the trustee asserted that the beneficiary had no interest in the trust to which the state’s claim could attach. 

The state claimed that the trust language meant that the trust gave the trustee the discretion to use trust funds for his sister’s care for that he deemed “advisable and beneficial” and that discretion meant that the trustee couldn’t completely ignore the beneficiary’s medical needs.  But the trustee pointed out that Iowa Code § 633A.4702 stated that, “in the absence of clear and convincing evidence to the contrary, language in a governing instrument granting a trustee discretion to make or withhold a distribution shall prevail over any language governing instrument indicating that the beneficiary may have a legally enforceable right to distributions or indicating a standard of payments or distributions.”  The appellate court, however, noted that the statute was inapplicable to trusts effective before 2004.  The appellate court also determined (with not much analysis (the entire majority opinion, including a recitation of the facts) is only eight pages (double-spaced)) that the grantor’s intent to maintain the farm in the family did not negate or outweigh the grantor’s desire that his daughter medical needs be met from the trust. 

The appellate court also reasoned that the trust language meant that the trustee could invade the corpus of the trust for the benefit of the sister when necessary and that the grantor preferred for the trust to be used to provide for the sister instead of protect family land.  Consequently, the appellate court determined that the beneficiary had an interest - portions of the trust were to be used for her care and the trustee was instructed to invade the corpus of the trust to make distributions in the sister’s support. This meant that the state had a right to the sister’s interest in the trust for reimbursement of past Medicaid benefits that were paid on her behalf and affirmed the probate court’s determination.

The dissenting judge, a senior judge sitting by designation and who had written a prominent court opinion on the issue in the past, disagreed that the trust language could be interpreted to identify any type of ascertainable or measurable standard that could give the daughter any interest in the trust that would allow the state to have a legitimate reimbursement claim.  Indeed, the trust granted the trustee the “sole and absolute discretion” to invade the trust corpus when the trustee deemed it “necessary for the benefit” of the grantor’s daughter.  That language did not reference any particular standard that could measure the daughter’s interest in the trust.  He noted that the term “benefit,” as used in the trust, is simply not a distributional, ascertainable standard. To read it as one as the majority did, meant that the majority was judicially rewriting the terms of the trust.

Conclusion

Medicaid asset and trust planning can be a complex part of estate planning.  But it can be a very important aspect of protecting farm assets from being depleted paying a long-term health-care bill.  The facts of the Riessen case as stated in the opinion were insufficient to be able to determine whether the trust was drafted with the intent of protecting assets from being depleted to pay for the beneficiary’s long-term health care.  However, as the dissent points out, and as I have written and lectured on this topic for years concerning MAPT language, the trust language at issue comported with that of a properly drafted as a fully discretionary MAPT to accomplish that goal.  The dissent properly pointed out that the majority’s opinion essentially rewrote the trust to give the state a reimbursement claim.   

If the case is appealed, it is likely that the Iowa Supreme Court, based on past precedent, will overturn the appellate court’s judgment.  It’s simply inappropriate for a court to essentially rewrite the terms of a trust to accomplish an outcome it desires.  If the decision is not appealed or is not overturned on appeal, the Iowa legislature will need to determine what it desires from a public policy standpoint concerning the breadth of the state’s ability to be reimbursed from a decedent’s estate for past Medicaid benefits paid. 

Recent Cases Involving Decedents' Estates

Overview

Unfortunately, litigation sometimes occurs after death and can involve family members.  The issues can be unique and may also be the result of misunderstandings, the lack memorializing understandings, or simply family members not getting along. 

In today’s post, I highlight three recent cases involving the estate of a decedent.  Hopefully, a review of these cases will provide some insight as to the issues that can arise at deaths in hopes of avoiding them in the future.

A look at recent cases involving estates – it’s the topic of today’s post.

Government Agency’s Interest in Estate Attaches Before Nursing Home’s Judgment Lien. A nursing home sought to recover fees from a decedent’s estate that the decedent incurred while a resident.  The Iowa Department of Health and Human Services (Department) had paid the deceased’s medical fees to the nursing home and filed a claim in probate seeking to recover $395,612.12. The estate executor filed a report and inventory showing the gross value of probate assets as $51,016.20, with $45,000.00 of the value attributed to the decedent’s home. The nursing home claimed it had a right to the value of the home to pay for the debt owed to it via a judicial secured lien, but the Department claimed it had a priority position.  The trial court agreed with the Department.  The nursing home argued on appeal that its secured lien was not subject to the probate code’s classification of debts and charges statutory provision, claiming instead that its judicial lien was on the real estate the decedent owned.  However, the appellate court pointed out that the real estate was a homestead to which the judgment lien did not attach and would not attach upon the decedent’s death merely because the decedent had no heirs.  The appellate court determined that the Department could recover from the decedent’s estate as it existed immediately before death, including her home with the homestead exception still in effect because the nursing’s home judgment would not attach until after the death. The appellate court affirmed the trial court’s grant of summary judgment for the Department.  In re Estate of Rice, No. 21-1868, 2022 Iowa App. LEXIS 936 (Iowa Ct. App. Dec. 7, 2022).

Economic Benefit Not Required for Trust Funds to Pay Attorney’s Fees. The grantor created a trust naming his three daughters as beneficiary.  However, before death, the grantor agreed to give one of his daughters the homestead in return for helping him on the homeplace during his life.  However, this agreement was not memorialized in the trust due to a drafting error.  One of the daughters objected to the alleged pre-death agreement and also objected to part of the trust being used to pay off debts immediately.  The trial court determined that the evidence was sufficient as to the grantor’s intent to respect the pre-death agreement, but did not allow that daughter use funds from the trust to pay attorney fees on the basis that the litigation did not benefit the trust.  On appeal, the appellate court reversed in part.  The appellate court noted that state law allows a court to award “attorney’s fees from trusts administered through the court as well as in probate and guardianship proceedings” when the litigation benefits the decedent’s estate and when the litigation resulted from the executor’s negligence, fraud, or inactivity.  The appellate court determined that an economic benefit was not necessary to award fees, but that other non-economic benefits were sufficient.  Consequently, the appellate court determined that the litigation involving the trust resulted in the trust being administered in the way intended the grantor intended and that this was sufficient to be considered beneficial. In addition, the court found that the fact that the daughter to receive the homestead was a beneficiary of the trust had no bearing on the attorney fee issue.  The appellate court reasoned that to not allow beneficiaries to use trust funds to litigate issues would discourage strong claims from being brought. Ultimately, the appellate court held that the trial court abused its discretion by denying the motion for attorney fees based on its erroneous view that an attorney fees award "required" an economic benefit to the trust and that fulfilling the intent of the settlor was not a basis for awarding attorney fees.  The appellate court held that the trial court should not have discounted the efforts to reform the trust to align with the settlor's undisputed intent simply because the daughter benefitted from the successful outcome of the litigation.  The appellate court, however, determined that the trial court did not err when it determined that the litigation on the issue of mortgage payments did not provide the trust with an economic benefit because the successful litigation did not provide the estate with income it could not have otherwise obtained from a different renter.  In re Petersen Land Trust, No. 29745, 2022 S.D. LEXIS 139 (S.D. Sup. Ct. Nov. 23, 2022).

Surviving Spouse Removed as Co-Trustee. The decedent established a revocable living trust in 2000 to continue his farming operation and benefit his wife as the primary beneficiary and his two sons as the other beneficiaries.  Effective upon the grantor’s death, the trust named the surviving wife as a co-trustee and the decedent’s cousin as an independent co-trustee.  The trust specified that the independent trustee could distribute income and principal to any of the beneficiaries at the independent trustee’s discretion.  Upon the wife’s subsequent death, the trust was to be divided into two separate shares, one for each son, and funded with the remaining trust undistributed income and principal.  Upon the decedent’s death in 2014 the trust contained about $2,385,000 in assets, most of which were nonliquid. Most of the assets had to be liquidated to pay debts that the decedent incurred during life, including part of the decedent’s farm that was sold in 2018.  After payment of debts $112,048.34 remained in the trust. The trust was divided into a marital and a nonmarital share and at the time of the decedent’s death only the nonmarital half was funded.  Without the cousin’s knowledge, the wife withdrew $104,161.34 of the $112,048.34 for her own personal expenses. This amount was more than the wife had a right to receive that year from the trust. In addition, the Farm Service Agency (FSA) deposited farm-related funds directly into the wife’s account instead of the trust account. The cousin requested that the FSA deposit the funds into the trust instead of the wife’s account, but the FSA refused citing the wife’s name as the first named trustee and the only one with the right to change where the funds should be sent. Soon after this, the cousin filed an action to remove the wife as a trustee for mishandling the funds.  The trial court removed the wife as a co-trustee. The wife appealed. The Kansas Uniform Trust Code (KUTC) specifies that a court may remove a trustee if “the trustee has committed breach of trust.” A breach of trust is a violation of the trustee’s duty to the beneficiaries. To determine if the wife committed a breach, the appellate court looked to the decedent's intent for management of the trust. The language of the trust gave the exclusive discretion over distribution of the trust’s income and principal to the cousin as the independent trustee.  The trust stated that, “whenever a power of discretion is granted exclusively to my Independent Trustee, then any Interested Trustee who is then serving as my Trustee is prohibited from participating in the exercise of the power of discretion.” The appellate court found the wife was an interested trustee because she was both a trustee and beneficiary, so she should not have exercised any discretion over the distribution of the funds of the trust. The appellate court agreed with the trial court that the wife repeatedly disregarded the terms of the trust and tried to take advantage of being a co-trustee. The language of the trust agreement was clear that the wife’s discretion should have been restricted and her acts prohibited. The wife failed to show the trial court abused its discretion by removing her as a co-trustee and affirmed the trial court’s decision. In re Link Zweygardt Trust No. 1., No. 124,760, 2022 Kan. App. Unpub. LEXIS 616 (Kan. Ct. App. Dec. 2, 2022).   

Conclusion

The issues that can arise post-death are numerous.  These cases are merely a sample of what can happen. 

January Tax Update Webinar and 2023 Summer National Seminars

Overview

Next month, on January 20, I will be doing a two-hour tax update webinar on key tax changes and updates for the 2023 filing season.  As I write this, the Congress is considering yet another massive spending bill that contains important tax provisions.  Indeed the Senate has passed the bill and sent it to the House.  It seems that long gone are the days where the Congress could pass legislation addressing specific tax issues and not have to include technical tax matters in a massive spending bill with all kinds of miscellaneous (i.e., garbage) provisions.  This makes the January 20 webinar important.  This will be (as of now) right before the start of the tax filing season.   Be watching for a link to register.  

Omnibus Legislation – Retirement Provisions

One of the topics that I will address in the 2-hour webinar on January 20 are the tax provisions in the Omnibus legislation (assuming the Congress passes the bill) will be the retirement-related provisions.  As the bill stands as of now, here are just a few of the retirement-related provisions:

• Increased required minimum distribution (RMD) age. The provision increases the current beginning RMD age from 72 to 73 effective January 1, 2023, and then to age 75 effective January 1, 2033. Act, Sec. 107
• Excise tax. This provision reduces to 25 percent and, under certain circumstances, practically eliminates the excise tax imposed on failure to take the RMD.  This provision is effective for tax years beginning after the date of enactment.  Act, Sec. 302.
• Catch-up contributions. While the dollar amount that can be elected to be deferred annually is capped, those who are age 50 and older can defer an additional (“catch-up) amount.  Starting in 2025, this provision increases the current catch-up limit to the greater of $10,000 ($5,000 for SIMPLE plans) or 50 percent more than the regular catch-up amount in 2024 (2025 for SIMPLE plans).  Act, Sec. 109
• Penalty-free withdrawals. This provision would allow penalty-free withdrawals for “unforeseeable or immediate financial needs relating to necessary personal or family expenses, capped at $1,000 and limited to once every three years (or once annually if the distribution is repaid within three years).  Act, Sec. 115. 

There are numerous other provisions.  In fact, there are over 100 provisions designed to expand coverage, increase retirement savings, and otherwise make the retirement plan rules more streamlined.  I will address the full run-down of what passes at the January 20 webinar. 

Summer 2023 Events

Mark your calendars for the law school’s summer 2023 national ag tax seminars, those will be on June 15-16 in Petosky, Michigan and August 7 and 8 in Coeur ‘d Alene, Idaho.  More information will be coming on those in the next few weeks as the programs get built out.  The Michigan event will be the standard farm income tax, farm estate and business planning seminar.  The August event in Idaho will have the standard farm income tax, farm estate and business planning topical coverage, but there will be a separate concurrent track each day on various agricultural law topics.  Those topics will cover real estate issues, environmental issues, water law, ag torts, leasing arrangements, and other issues facing rural practitioners.  You will be able to pick and choose the sessions that you would like to attend.  Both the Michigan conference and the Idaho conference will be live broadcast online. 

Conclusion

I hope that you will be able to join the online webinar on January 20 as well as one of the summer events.  There are always many legal issues to discuss involving farm and ranch clients.

Does Using Old Tractors Mean You Aren’t a Farmer? And the Wind Energy Production Tax Credit – Is it Subject to State Property Tax?

Overview

Two recent court opinions highlight how unique tax law can be.  In a recent U.S. Tax Court decision, the court was faced with an IRS challenge of deductions largely because of the manner in which the farming operation was conducted.  In a decision of the Oklahoma Supreme Court, the Court determined that the Federal Production Tax Credit, was not subject to state property tax.

Recent tax cases – it’s the topic of today’s post.

IRS Questions Farming Practices, But Tax Court Allows Most Deductions

Hoakison v. Comr., T.C. Memo. 2022-117

The petitioners, a married couple, farm in southwest Iowa.  The wife worked off-farm at a veterinary clinic, and the husband was a full-time delivery driver for United Parcel Service (UPS).  He purchased his first farm in 1975 four years after graduating high-school and started a cow-calf operation.  The petitioners lived frugally and always avoided incurring debt when possible by purchasing used equipment with cash with the husband doing his own repairs and maintenance.  The petitioners were able to weather the farm crises of the early-mid 1980s by farming in this manner.  Ultimately, the petitioners owned five tracts totaling 482 acres.  The tracts are noncontiguous and range anywhere from six to 14 miles apart.  On the tracts, the petitioners conduct a row-crop and cow-calf operation.  He worked on the farms early in the mornings before his UPS shift and after his shift ended until late into the night. 

Over the years, the petitioners acquired approximately 40 tractors with 17 in use during the years in issue (2013-2015).  The tractors had specific features or used a variety of mounted implements to perform the various tasks needed to operate the various farms.  Certain tractors were dedicated to a particular tract and attached to implements to save time and effort in taking the implements off and reattaching them.  The petitioners also have several used pickup trucks and a machine shed that was used to store farm equipment.  The petitioners’ tax returns for 2013-2015 showed farm losses each year primarily due to depreciation and other farm expenses. 

The IRS disallowed significant amounts of depreciation and other farm expense deductions largely on its claim that the petitioners were not engaged in a farming business, but rather were engaged in a “nostalgic” activity with an excessive and unnecessary amount of old tractors.  The IRS also took the position that the petitioners’ pickups and other vehicles were subject to the strict substantiation requirements of I.R.C. §274(d).  The Tax Court disagreed as to the trucks that had been modified for use on the farm and were only driven a de minimis amount for personal purposes but agreed as to one pickup that was used to travel from farm to farm and to the UPS office.  The Tax Court also pointed out that farm tractors are not listed property. 

Note:  I.R.C. §274(d) excludes from the strict substantiation requirements any "qualified nonpersonal use vehicle." A "qualified nonpersonal use vehicle" is "any vehicle which, by reason of its nature, is not likely to be used more than a de minimis amount for personal purposes." I.R.C. §274(i). The strict substantiation requirements of I.R.C. §274(d) generally apply to any pickup truck or van "unless the truck or van has been specially modified with the result that it is not likely to be used more than a de minimis amount for personal purposes." Treas. Reg. § 1.274-5(k)(7). Other qualified nonpersonal use vehicles not subject to the strict substantiation requirements of I.R.C. §274(d) include any vehicle designed to carry cargo with a loaded gross vehicle weight over 14,000 pounds, combines, flatbed trucks, and tractors and other special purpose farm vehicles. Treas. Reg. §1.274-5(k)(2)(ii)(C), (F), (J) and (Q).

As to the disallowed depreciation on certain tractors, the IRS asserted that the tractors were not used in the petitioners’ farming business because, according to the IRS, the husband was a collector of antique tractors and that the acquisition and maintenance of 40 tractors, most of them more than 40 years old served no business purpose and involved an element of “nostalgia.”  The Tax Court disagreed, noting that the husband had sufficiently detailed his farming practices – avoidance of debt and personally repairing and maintaining the tractors and other farm equipment so as to avoid hiring mechanic work – and that this was an approach that worked well for them.

The Tax Court also noted that the IRS failed to account for petitioners’ noncontiguous tracts which meant that it was necessary to have various tractors and implements located at each farm to save time moving tractors from farm to farm and assembling and disassembling various attachments.   As such, the Tax Court concluded that the items of farm machinery and tractors were used in the petitioners’ farming business and, as such, it was immaterial whether the purchase of the various farm tractors and implements constituted ordinary and necessary expenses.  The Tax Court also determined that the machine shed was a depreciable farm building.  As to various other farming expenses, the Tax Court allowed the petitioners’ claimed deductions for utilities, insurance, gasoline, fuel, oil and repair/maintenance expenses. 

Note:  The Tax Court upheld the accuracy-related penalty with respect to the underpayment related to depreciation on assets that had previously depreciated, but otherwise denied it because the petitioners had reasonably relied on a an experienced professional tax preparer

Federal Production Tax Credits Not Subject to Property Tax  

Kingfisher Wind, LLC v. Wehmuller, No. 119837, 2022 Okla. LEXIS 84 (Okla. Sup. Ct. Oct. 18, 2022)

The plaintiff developed and built two commercial wind energy projects in Oklahoma that included over 100 aerogenerators, electrical equipment, maintenance facility, substation and transmission lines.  The defendant, county assessors, valued the projects at $458 million for property tax purposes.  The plaintiff asserted that the projects were worth only $169 million on the basis that value of the federal Production Tax Credits (PTCs) should be excluded for property tax purposes.  The assessors claimed that the PTCs were tangible personal property subject to tax because they “are of such an economic benefit to owning, operating, and determining the full fair cash value of the wind farm and its real property, they must be included to determine a fair and accurate taxable ad valorem valuation of the wind farm.”  The plaintiff claimed that the PTCs (which have existed since 1992) were intangible personal property that were expressly precluded from property taxation by state law.  The PTC is a federal tax credit that is based on the kilowatt hours of electricity produced by certain types of energy generation, such as that generated by the plaintiff’s projects at issue.  If a taxpayer has insufficient tax liability to use the PTCs that it is entitled to, it may structure a project such that a tax equity investor will contribute cash in exchange for receiving the excess PTCs.  Thus, PTCs are a material economic component of a commercial wind development project and how their value is treated for property tax purposes significantly impacts a project’s return on investment.  Oklahoma law taxes all real and personal property that is not otherwise expressly excluded and classifies intangible property as personal property.  Thus, the question was whether intangible property (such as PTCs) was expressly excluded.  The trial court held that the PTCs were not subject to property tax under Oklahoma law.  On further review, the state Supreme Court noted that it had previously deemed computer software, lease agreements, trademarks, databases, and customer lists to be subject to ad valorem taxation.  After that decision, Oklahoma law was changed to specify that intangible property shall not be subject to ad valorem tax. The Supreme Court determined that PTCs have limited intrinsic value and can only be claimed or enforced by legal action. The court found that even if PTCs had qualities of both tangible and intangible property, the Oklahoma legislature intended for those “in-between” items to be considered intangible and not subject to ad valorem taxation. 

Note:  The Court’s decision only construed Oklahoma law.  Other states have different statutory and constitutional provisions defining items subject to property tax in those respective states.  For instance, the value of the PTC has been held to be subject to property tax in IL, MI, PA, SD and TN.  The opposite result has been reached in AZ, GA, MO, OH, OR and WA. 

Conclusion

From the IRS claiming that a farmer can’t truly be in the farming business by using old tractors to a case illustrating the economic inefficiency of wind energy without a massive taxpayer subsidy, there’s never a dull moment in tax.

How NOT to Use a Charitable Remainder Trust

Overview

A charitable remainder trust can be a useful estate planning tool for a farmer or rancher, particularly one that is ready to retire from farming or ranching.  Instead of selling the last crop and reporting the income along with the income from the previous year’s crop that has been deferred to the current year, the crop can be transferred to a charitable remainder trust.  Doing so avoids having to report the sale of the crop and the associated self-employment tax that would be triggered.  But, a charitable remainder trust is a complex estate planning device that should only be utilized by professionals the understand the rules.  A recent Tax Court case involving an Indiana farm couple illustrates how badly things can turn out with a charitable remainder trust if the rules aren’t closely followed.

Charitable remainder trusts – it’s the topic of today’s post.

Background

A charitable remainder trust is an irrevocable trust to which you can donate property, cash or other property.  The trust takes a carryover income tax basis in the transferred asset(s).  The trust then sells the transferred assets (the sale is not taxable because the seller is a charity) and uses the income from the sale to pay the donor (or other designated person(s)).  The payments continue for a specific term of up to 20 years of the life of one or more beneficiaries (typically the transferor).  At the end of the term, the remainder of the trust passes to at least one designated charity.  The remainder donated to the charity must be at least 10 percent of the initial net fair market value of all of the property placed in the trust. 

Types.  There are two types of charitable remainder trusts.  The type of trust is tied to how payment from the trust is made.  A charitable remainder unitrust (CRUT) pays a percentage of the trust value annually to noncharitable beneficiaries.  The payments must be at least five percent and not exceed 50 percent of the fair market value of the trust’s assets, valued annually.  A charitable remainder annuity trust (CRAT) pays a specific dollar amount each year.  The amount is at least 5 percent and no more than 50 percent of the value of the trust’s property, valued as of the date the trust was established. 

Tax on payments.  Payments from a charitable remainder trust are taxed to the non-charitable beneficiaries.  The non-charitable beneficiaries report the income on Schedule K-1 (Form 1041) as distributions of the trust’s income and gains. 

The distributions are reported in a particular order. 

• Payments are considered to be ordinary income first to the extent the trust had ordinary income for the year and undistributed ordinary income from prior years. This means that if the trust had enough ordinary income to cover all of the payments, all of the payments are taxed as ordinary income.  As a result, it is not advisable to transfer ordinary income property to the trust – particularly not ordinary income property with low or no income tax basis. 
• Once the trust’s ordinary income is exhausted, payments are taxed as capital gains based on the sale or disposition of the trust’s capital assets. The payments are taxed as capital gain to the extent of the trust’s capital gain for the current year and any undistributed capital gain income from prior years.
• After all of the trust’s ordinary income and capital gain have been distributed, any additional payments are then characterized as other income to the extent of the trust’s current year and accumulated other income.
• Finally, after the first three-tiers of distributions have been made, any further payments are considered to be from the “principal” of the trust and are not taxable.

Charitable deduction.  The contribution to a charitable remainder trust will qualify for a partial charitable deduction.  The deduction is partial because it is limited to the present value of the charitable organization’s remainder interest calculated as the value of the donated property minus the present value of the annuity that the trust pays to the non-charitable beneficiary (or beneficiaries).  Treas. Reg. §1.664-2(c).  The deduction is also subject to adjusted gross income and other limits set forth in I.R.C. §170(e). 

Tax filing requirements.  A charitable remainder trust must file Form 5227 every year.  A beneficiary must report any payments received from the trust on Schedule K-1 of Form 1041. 

IRS concerns.  The IRS closely monitors the use of charitable trusts.  It is critical to not inflate the basis of assets transferred to the trust as well as failing to account for the transfer of any assets to the trust.  It’s also important to not mischaracterize the distributions of ordinary or capital gain income as distributions of corpus.  The ordering rules must be closely followed.  There can also be no self-dealing, making an upfront cash payment to a charitable beneficiary in lieu of the remainder interest, or a transfer of the trust’s remainder interest to a non-qualified organization.  Also, personal expenses can’t be paid with trust funds, and funds can’t be borrowed from the trust.  It’s also prohibited to use loans or forward sales of assets or other financial schemes to hid capital gains or income in the trust. 

The Furrer Case

If there ever was a case that provides a roadmap for farmers as to how not to use a charitable remainder, Furrer v. Comr., T.C. Memo. 2022-100 is that case.  Indeed, it is almost inconceivable that the farmer couple involved in the case were represented by legal counsel.  The arguments made on behalf of the Furrers were that bad.    

The Tax Court began its opinion by noted that the Furrers, “after seeing an advertisement in a farm magazine” formed a CRAT.  The opinion goes downhill quickly from there for the Furrers.  The Furrers raised corn and soybeans on their Indiana farm. In July of 2015, they formed the first of two CRATs, naming their son as trustee. The Furrers were the life beneficiaries, and three qualified charities were designated as remaindermen. They transferred 100,000 bushels of corn and 10,000 bushels of soybeans from their farm to the first CRAT, which then sold the grain for $469,003. The CRAT distributed $47,000 to the charities and used the balance to purchase a Single Premium Immediate Annuity (SPIA), which made annual payments to the Furrers of $84,369 in 2015, 2016 and 2017.  The SPIA issued a Form 1099-R to the trustee listing the annuity payments as “gross distributions” and showed a small amount of interest as the “taxable amount.”  The Furrers claimed a $47,000 charitable deduction.

The Furrers created a second CRAT in 2016 naming themselves as the lie beneficiaries and seven qualified charities as the remainder beneficiaries. and also funded that trust with grain that they raised.  The CRAT sold the grain for $691,827 and distributed $69,294 to the charities.  The annuity from this trust was payable over 2016 and 2017 in the amount of $124,921 each year.  The SPIA also issued Form 1099-R to the trustee listing the annuity payments as “gross distributions” and showing a small amount of interest as the “taxable amount.”  They claimed a charitable deduction of $69,294.

On their 2015 and 2016 returns, they did not claim charitable deductions for their transfers to the CRATs, but reported only the interest income from the SPIA, which was reported to them by the life insurance company providing the annuity.  They treated the balance of the annuity distributions that they received as a nontaxable return of corpus under I.R.C. §664(b)(4). They also reported their transfers of crops to the CRATS on Forms 709 for 2015 and 2016, which reflected the fair market value of the crops with a cost basis of zero. The CRATs reported the sales of crops as sales of business property on Form 4797, inexplicably treating the crops as having substantial basis (derived from the purported purchase of the grain at fair market value) that generated a small loss for 2015 and a small gain for 2016. Their son (as trustee) prepared the CRATs’ returns.  

On audit, the Furrers claimed they should be entitled to charitable deductions for the in-kind transfers of the crops that were ultimately destined for the charitable remaindermen, which were not claimed on their return. They made this claim even though they had no income tax basis in the grain that was transferred to the CRATs.  Incredibly, and despite not including the proper documentation, the IRS Revenue Agent allowed the charitable deductions. But the IRS still issued a notice of deficiency for each year because of the omitted income from the annuity and increased their Schedule F income by $83,440 in 2015, and by $206,967 in 2016 and also in 2017.  This resulted in tax deficiencies of $55,040 for 2015, $56,904 for 2016 and $95,907 for 2017.  The IRS also tacked on an accuracy-related penalty for each year.

Note:  For gifts of property (other than publicly traded securities) valued in excess of $5,000, the taxpayer generally must (1) obtain a qualified appraisal of the property and (2) attach to the return on which the deduction is claimed a fully completed appraisal summary on Form 8283.  I.R.C. §170(f)(11)(C). A “qualified appraisal” must be prepared by a “qualified appraiser” no later than the due date of the return, including extensions.  I.R.C. §170(f)(11)(E); Treas. Reg. §1.170A-13(c)(3). The taxpayer must also maintain records substantiating the deduction. Treas. Reg. § 1.170A-13(b)(2)(ii)(D).   At no time did the Furrers secure an appraisal (“qualified” or otherwise) of the crops they transferred to the CRATs. They also did not attach to their 2015 or 2016 return a completed Form 8283 substantiating the gifts, and they did not maintain the written records that the regulations required. But, even had they done so, they would not have been entitled to any charitable deduction because of the lack of an income tax basis in the grain transferred to the trusts.

After the Furrers filed the Tax Court petition, the IRS conceded the accuracy-related penalties for lack of the immediate supervisor’s approval.    But, the IRS attorneys also requested leave to amend its answer to disallow the charitable deductions that the Revenue Agent allowed.  The Tax Court held that the IRS carried its burden of proof on the charitable deduction disallowance issue – the Furrers did not substantiate the in-kind donations and they had no income tax basis in the crops.  Thus, any charitable deduction was limited to zero regardless of whether they would have satisfied the substantiation requirements.  The IRS also maintained that the annuity distributions were fully taxable as ordinary income on the basis that the grain was inventory that the Furrers held for sale to customers in the ordinary course of their farming business.  The Tax Court agreed and noted that the Furrers violated the ordering rules for income tax treatment of distributions from the CRATs.  The Trusts’ sale of the grain involved a sale of ordinary income property (raised grain).  As a result, the annuity was purchased with the proceeds of ordinary income property and any distributions from the trust to the Furrers retained that same ordinary income character.  While the Furrers tried to apply the rules of I.R.C. §72 to the annuity distributions, the Tax Court noted that I.R.C. §664 provides a special rule for annuity distributions from CRATS that was not in their favor. In addition, even if I.R.C. §72 applied, the Tax Court noted that the Furrers would not have been able to use the exclusion rule because they had no “investment in the contract” – the funds used to purchase the contract had never been taxable.

Comment:  I have no answer as to why this case ended up in the Tax Court.  The Furrers were represented by counsel, but there appears to have been some very poor choices made on their behalf.  The counsel of record is from California and the Furreres, as mentioned, farm in Indiana.  I have no explanation as to how that happened. Many aspects of the set-up of the CRATs was wrong, and by not accepting the adjustment made by the IRS Revenue Agent and filing a Tax Court petition, the Furrers ended up losing the charitable deductions that the Revenue Agent had (mistakenly) allowed!  Granted, the Furrers got the accuracy-related penalty to go away, but that was achieved at the price of losing substantial charitable deductions.  I also wonder whether the IRS should have conceded on the penalty issue. The Tax Court’s approach to IRS supervisory approval as a prerequisite to applying penalties has been disregarded by two Circuit Courts of Appeal.  According to the 11th and 9th Circuits, supervisor approval at any time before assessment is enough to satisfy the statute.  See, e.g., Kroner v. Comr., 48 F.4th 1272 (11th Cir. 2022) and Laidlaw’s Harley Davidson Sales, Inc. v. Comr., 29 F.4th 1066 (9th Cir. 2022).  Hopefully the Tax Court’s decision will not be appealed to the Seventh Circuit.  If it is, the prospect for a favorable outcome for the Furrers is slim to none. 

Conclusion

The Furrer case illustrates that the rules surrounding the use of charitable remainder trusts are very complex.  Only competent professionals that are experienced in the rules and use of such trusts should be engaged in utilizing them on behalf of clients.  While the Tax Court said that the Furrers created the trusts after reading an ad in a farm magazine, I do not know the nature and extent of legal and tax advice they received (if any) in advance. If they were guided by tax counsel in setting up the trusts, the counsel was woefully inadequate.  To add insult to injury, as noted, the decision to petition the Tax Court rather than accepting the Revenue Agent’s adjustments put the Furrers in a worse position. 

The Tax Court has not yet officially entered its decision in the Furrer case.  The 90-day timeframe for appeal does not start until the decision document (which is separate from the court’s opinion) has been entered.  Presently, the parties must submit their Tax Court Rule 155 calculations by December 21, 2022.  Those calculations will form the basis of the decision document. 

Ag Law Developments in the Courts

Overview

It’s been a while since I did a blog article on recent court developments involving farmers, ranchers rural landowners and agribusinesses.  I have been on the road just about continuously for the last couple of months and nine more events remain between now and Christmas.  But, let me take a moment today (and later this week) to provide a summary of some recent court cases involving agriculture.

Recent court opinions involving agriculture – it’s the topic of today’s post.

Jumping Mouse Habitat Designation Upheld

Northern New Mexico Stockman’s Association, et al. v. United States Fish and Wildlife Service, 494 F.Supp.3d 850 (D. N.M. 2020), aff’d., 30 F.4th 1210 (10th Cir. 2022)

In 2014, the U.S. Fish and Wildlife Service (USFWS) listed the New Mexico Meadow Jumping Mouse as an endangered species based on substantial habitat loss and fragmentation from grazing, water management, drought and wildfire.  Accordingly, in 2016, the USFWS designated 14,000 acres along 170 miles of streams and waterways in New Mexico, Arizona and Colorado as critical habitat for the mouse.  The U.S. Forest Service erected fencing around some streams and watering holes in the Santa Fe and Lincoln National Forests that were in the designated area   The plaintiffs, two livestock organizations, with members that graze cattle in those national forests, sued in 2018 claiming that the USFWS failed to sufficiently consider the economic impact of the critical habitat designation.  The trial court dismissed the case, finding that the USFWS was justified in its decision.  The trial court also determined that the USFWS need not compensate the plaintiffs for the reduction in value of the plaintiffs’ water rights.  The trial court reasoned that the USFWS need not consider all of the economic impacts associated with the mouse’s listing when designating critical habitat, only the incremental costs of the designation itself.  The court cited the nine-month annual hibernation period of the mouse giving it only a short time to breed and gain weight for the winter and, as such, the mouse’s habitat needed to remain ideal with tall, dense grass and forage around flowing streams in the designated area.  On appeal, the appellate court affirmed.  The appellate court held that the assessment method of the USFWS for determining the economic impacts of the critical habitat designation on the water rights of the plaintiffs’ members was adequately considered, and that the USFWS had reasonably supported its decision not to exclude certain areas from the critical habitat designation.  

Court Reduces Dicamba Drift Damage Award; Case Continues on Punitive Damages Issue

Hahn v. Monsanto Co., 39 F.4th 954 (8th Cir. 2022)

The plaintiff claimed that his peach orchard was destroyed after the defendants (Monsanto and BASF) conspired to develop and market dicamba-tolerant seeds and dicamba-based herbicides. The plaintiff claimed that the damage to the peaches occurred when dicamba drifted from application to neighboring fields.  The plaintiff claimed that the defendants released the dicamba-tolerant seed with no corresponding dicamba herbicide that could be safely applied.  As a result, farmers illegally sprayed an old formulation of dicamba herbicide that was unapproved for in-crop, over-the-top, use and was "volatile," or prone to drift.  While many cases had previously been filed on the dicamba drift issue, the plaintiff did not join the other litigation because it focused on damages to soybean crops.  Monsanto moved to dismiss the claims for failure to warn; negligent training; violation of the Missouri Crop Protection Act; civil conspiracy; and joint liability for punitive damages.  BASF moved to dismiss those same counts except the claims for failure to warn. The trial court granted the motion to dismiss in part.  Monsanto argued that the failure to warn claims were preempted by the Federal Insecticide, Fungicide, and Rodenticide Act ("FIFRA"), but the plaintiff claimed that no warning would have prevented the damage to the peaches. The trial court determined that the plaintiff had adequately plead the claim and denied the motion to dismiss this claim.  Both Monsanto and BASF moved to dismiss the negligent training claim, but the trial court refused to do so. However, the trial court did dismiss the claims based on the Missouri Crop Protection Act, noting that civil actions under this act are limited to “field crops” which did not include peaches.   The trial court did not dismiss the civil conspiracy claim based on concerted action by agreement but did dismiss the aiding and abetting portion of the claim because that cause of action is no recognized under Missouri tort law.  The parties agreed to a separate jury determination of punitive damages for each defendant.  Bader Farms, Inc. v. Monsanto Co., et al., No. MDL No. 1:18md2820-SNLJ, 2019 U.S. Dist. LEXIS 114302 (E.D. Mo. July 10, 2019).  The jury found that Monsanto had negligently designed or failed to warn for 2015 and 2016 and the both defendants had done so for 2017 to the present.  The jury awarded the plaintiff $15 million in compensatory damages and $250 million in punitive damages against Monsanto for 2015 and 2016.  The jury also found that the defendants were acting in a joint venture and in a conspiracy.  The plaintiff submitted a proposed judgment that both defendants were responsible for the $250 million punitive damages award.  BASF objected, but the trial court found the defendants jointly liable for the full verdict in light of the jury’s finding that the defendants were in a joint venture.  Bader Farms, Inc. v. Monsanto Co., et al., MDL No. 1:18-md-02820-SNJL, 2020 U.S. Dist. LEXIS 34340 (E.D. Mo. Feb. 28, 2020).  BASF then moved for a judgment as a matter of law on punitive damages or motion for a new trial or remittitur (e.g., asking the court to reduce the damage award), and Monsanto moved for a judgment as a matter of law or a new trial.  The trial court, however, found both defendants jointly liable, although the court lowered the punitive damages to $60 million after determining a lack of actual malice.  The trial court did uphold the $15 million compensatory damage award upon finding that the correct standard under Missouri law was applied to the farm’s damages.  Bader Farms, Inc. v. Monsanto Co, et al., MDL No. 1:18md2820-SNLJ, 2020 U.S. Dist. LEXIS 221420 (E.D. Mo. Nov. 25, 2020).  The defendants filed a notice of appeal on December 22, 2020.     

On appeal, the appellate court affirmed the trial court on the causation issue noting that the defendant retained direct contact with the farmers and exercised some degree of control over their actions.  As such, the defendant was aware of the foreseeable consequences that could come from not controlling the farmers’ actions more closely. On the compensatory damage issue, the defendant argued that compensatory damages should be measured by the difference in the value of the orchard before and after the damage.  The appellate court disagreed, noting that such a calculation only applied when the victim is the owner of the land and not a tenant as was the plaintiff.  Thus, compensatory damages were properly measured by lost profits.   The defendant argued the damages were speculative, but the court found that Bader Farms had provided years of financial statements to show the usual costs and profits associated with farming the orchard. The appellate court determined that there was no doubt the defendant had full control over the critical aspects of the project. In 2007, BASF had relinquished their rights to the seed technology to the defendant, so they could not control something they had no rights to. The appellate court also affirmed the finding that BASF and Monsanto had engaged in a civil conspiracy by agreeing to sell products unlawfully and enabling the widespread use of a product that was illegal to spray during the growing season. As members of the civil conspiracy, BASF was correctly found to be severally liable for the damages. The appellate court also found that Bader Farms provided clear and convincing evidence that the companies had acted with reckless indifference, but the two had different degrees of culpability. The trial court should have assessed the punitive damages of the Monsanto and BASF separately. Thus, the appellate court affirmed in part and reversed and remanded the punitive damages judgment to the trial court.

Court Decides to Resolve Property Dispute by Requiring Parties to Use the Existing Property Line

Barlow v. Saxon Holdings Trust, No. SD37361, 2022 Mo. App. LEXIS 657 (Mo. Ct. App. Oct. 21, 2022)

The plaintiff and her husband purchased land in 1987 by warranty deed that included the language, “running thence Southwesterly along the fence 40 rods.” At the time the plaintiff purchased the property, a fence that ran north to south existed and the plaintiff believed and acted like she owned the land up to that fence. The defendant purchased the neighboring land in 2011 and executed a warranty deed that included the language, “beginning at the NE corner of the NE ¼ of said Section 23 and running SW 40 rods.” In the spring of 2020, the defendant hired a surveyor who informed the defendant that his property extended onto the plaintiff’s property to the “40-rod line.” The defendant put up an electric fence on the disputed property to claim it.  In response the plaintiff hired a surveyor who determined the property line was on the original fence line. The plaintiff sued to quiet title. The trial court found ambiguity between the deeds and resolved the ambiguity in favor of the plaintiff and held the plaintiff had adversely possessed the land. The defendant appealed. The appellate court recognized that the deeds individually did not show patent ambiguity, but the difference between the two on the location of property line did create an ambiguity. The appellate court determined that one way to resolve the ambiguity would be to have the parties continue to occupy the land the way they had in accordance with one of the deeds or constructions. This was the trial court’s approach, and the appellate court affirmed the trial court on this point.  The appellate court also noted that the trial court had found the plaintiff’s surveyor credible, and that credibility of a witness was a determination to be left to the trial court’s discretion that the appellate court would not disturb.  The appellate court affirmed the trial court’s resolution of the deed in favor of the plaintiff and determined it need not address the adverse possession claim.

Oil and Gas Lease on Disputed Property Invalidates Adverse Possession

Cottrill v. Quarry Enterprises, LLC, No. 2022 CA 00011, 2022 Ohio App. LEXIS 3191 (Ohio Ct. App. Sept. 27, 2022)

The plaintiff claimed that she had successfully adversely possessed the defendant’s property by receiving title to the property in 1971 from her mother and caring for the land by mowing and maintaining it and using it for recreational events for herself and family. The trial court granted summary judgment for the defendant, finding that the plaintiff failed to establish exclusive possession over the land due to an existing oil and gas lease that the defendant had executed. The plaintiff appealed, claiming that the lease did not invalidate her exclusive use. To show exclusive use, the plaintiff did not have to be the only person who used the land but needed to be the only person who asserted their right to possession over the land. The appellate court found that the oil and gas that existed on the property began in 1958. For the entirety of the time that the plaintiff claimed she had adversely possessed the property, the oil and gas company had the right of possession over the land in dispute, invalidating the plaintiff’s claim.

Tax Issues Associated with Easement Payments – Part 2

Overview

In Part 1 of this series, I noted that an increasingly common issue for rural landowners is that of companies seeking easements across farmland.  Often the easements are sought by energy companies for the placement of pipelines or some form of transmission line.  The easement transaction involves the landowner receiving compensation for the loss of certain property rights.  In Part 1 of this series I focused on the nature of the transaction and the likely tax characterization of the payments a landowner might receive.  In today’s Part 2, I look more in-depth at the type of payments a landowner might receive and how they should be reported for tax purposes.

Tax issues associated with easement payments – Part 2 in a series.  It’s the topic of today’s post.

Types of Payments

“Bonus” payments.  Sometimes a company interested in acquiring an easement will pay an upfront amount to the landowners.  The payment will typically reserve the exclusive right to obtain an easement for a period of time with the landowner retaining the payment regardless of whether the company actually acquires an easement within the specified timeframe.  The landowner properly reports such a “bonus payment” on Schedule E with the amount flowing to Form 1040.  The company would issue a Form 1099-MISC to the landowner, showing the amount of the payment in Box 1. 

Damage payments.  As noted above, an initial payment made to a landowner for acquisition of an easement could result in income to the landowner or a reduction of the landowner’s basis in the land, or both.  That means that a lump sum payment for the right to lay a pipeline across a farm may result in income, a reduction in basis of all or part of the land or both.  An amount for actual, current damage to the property caused by construction activities on the property subject to the easement may be able to be offset by basis in the affected property.  Examples of this type of payment would be payments for damage to the property caused by environmental contamination and soil compaction. A payment for damage to growing crops, however, is treated as a sale of the crop reported either on line 2 of Schedule F or line 1 of Form 4835 for a non-material participation crop-share landlord.  Any payment for future property damage (e.g., liquidated damages), however, is generally treated as rent and reported as ordinary income.

Severance damages.  Involuntary conversion concepts may also come into play in an easement transaction.  “Severance damages” might be paid when only a part of a property is directly impacted by an easement as compensation for loss of value in the portion not directly impacted.  These damages might be paid, for example, when the easement impairs access to the property.  But it is important that the easement transaction (or condemnation proceeding if there is one) refer specifically to such damages as “severance damages.”  If they are not specifically delineated, they will be treated simply as damage payments.  This is an important distinction.  Under the involuntary conversion rules of I.R.C. §1033, it is possible for the landowner to defer gain resulting from the payment of severance damages by using the severance damages to restore the property that the easement impacts or by investing the damages in a timely manner in other qualified property. 

There is no requirement that the landowner apply the severance damages to the portion of the property subject to the easement.  Also, if the easement so impacts the remainder of the property where the pre-easement use of the property is not possible, the sale of the remainder of the property and use of the sale proceeds (plus the severance damages) to acquire other qualified property can be structured as a deferral transaction under I.R.C. §1033.

Temporary easement payments.  Some easements may involve an additional temporary easement to allow the holder to have space for access, equipment and material storage while conduction construction activities on the property subject to the easement.  A separate designation for a temporary easement for these purposes will generate rental income for allocated amounts.  As an alternative, it may be advisable to include the temporary space in the perpetual easement which is then reduced after a set amount of time.  Under this approach, it is possible to apply the payment attributable to the temporary easement to the tract subject to the permanent easement.  Alternatively, it may be possible, based on the facts, to classify any payments for a temporary easement as damage payments.

Negative easements.  A landowner may make a payment to an adjacent or nearby landowner to acquire a negative easement over that other landowner’s tract.  A negative easement is a use restriction placed on the tract to prevent the owner from specified uses of the tract that might diminish the value of the payor’s land.  For instance, a landowner may fear that their property would lose market value if a pipeline, high-power transmission line or wind aerogenerator were to be placed on adjacent property.  Thus, the landowner might seek a negative easement over that adjacent property to prevent that landowner from granting an easement to a utility company for that type of activity from being conducted on the adjacent property.  The IRS has reached the conclusion that a negative easement payment is rental income in the hands of the recipient.  F.S.A. 20152102F (Feb. 25, 2015).  It is not income derived from the taxpayer’s trade or business.  In addition, the IRS position taken in the FSA could have application to situations involving the government’s use of a taxpayer’s property to enhance wildlife and/or conservation. 

Lease Payments

A right of use that is not an easement generates ordinary income to the landowner and is, potentially, net investment income subject to an additional 3.8 percent tax.  I.R.C. §1411.  Thus, transactions that are a lease or a license generate rental income with no basis offset.  For example, when a landowner grants surface rights for oil and gas exploration, the transaction is most likely a lease.  Easements for pipelines, roads, surface sites and similar interests that are for a definite term of years are leases.  Likewise, if the easement is for “as long as oil and gas is produced in paying quantities,” it is lease. 

The IRS has ruled that periodic payments that farmers received under a “lease” agreement that allowed a steel company to discharge fumes without any liability for damage were rent.  In Rev. Rul. 60-170, 1960-1 C.B. 357, the payments from the steel company were to compensate the farmers for damages to livestock, crops, trees and other vegetation because of chemical fumes and gases from a nearby plant.  The IRS determined that the payments were rent and, as such, were not subject to self-employment tax.

Note:  A lease is characterized by periodic payments.  A lease is also indicated when failure to make a payment triggers default procedures and potential forfeiture.    In addition, lease payments are not subject to self-employment tax in the hands of the recipient regardless of the landowner’s participation in the activity.  Accordingly, the annual lease payment income would be reported on Schedule E (Form 1040), with the landowner likely having few or no deductible rental expenses. 

Eminent Domain

Proposed easement acquisitions can be contentious for many landowners.  Often, landowners may not willingly grant a pipeline company or a wind energy company, for example, the right to use the landowners’ property.  In those situations, eminent domain procedures under state law may be invoked which involves a condemnation of the property.  The power of eminent domain is the right of the state government (it’s called the “taking power” for the federal government) to acquire private property for public use, subject to the constitutional requirement that “just compensation” be paid.  While eminent domain is a power of the government, often developers of pipelines and certain other types of energy companies are often delegated the authority to condemn private property.  The condemnation award (the constitutionally required “just compensation”) paid is treated as a sale for tax purposes. 

Note:  The IRS view is that a condemnation award is solely for the property taken.  But, if the condemnation award clearly exceeds the fair market value of the property taken, a court may entertain arguments about the various components of the award.  Thus, it’s important for a landowner to preserve any evidence that might support allocating the award to various types of damages. 

Involuntary conversion.  While a condemnation award that a landowner receives is treated as a sale for tax purposes, it can qualify for non-recognition treatment under the gain deferral rules for involuntary conversions contained in I.R.C. §1033.  Rev. Rul. 76-69, 1976-1 C.B. 219; Rev. Rul. 54-575, 1954-2 C.B. 145.  I.R.C. §1033 allows a taxpayer to elect to defer gain realized from a condemnation (and sales made under threat of condemnation) by reinvesting the proceeds in qualifying property within three years.  See, e.g., Rev. Rul. 72-433, 1972-2 C.B. 470

The election to defer gain under I.R.C. §1033 is made by simply showing details on the return about the involuntary conversion but not reporting the condemnation gain realized on the return for the tax year the award is received.  A disclosure that the taxpayer is deferring gain under I.R.C. §1033, but not disclosing details is treated as a deemed election. 

Note:  If the taxpayer designates qualified replacement real estate on a return within the required period and purchases the property at the anticipated price within three years of the end of the gain year, a valid election is complete. If the purchase price of the replacement property is lower than anticipated, the resulting gain should be reported by amending the return for the election year. If qualified replacement property within the required three-year period, the return for the year of the election must be amended to report the gain.

Conclusion

Rural landowners are facing easement issues not infrequently.  Oil and gas pipelines, wind energy towers, and high voltage power lines are examples of the type of structures that are associated with easements across agricultural land.  Seeking good tax counsel can help produce the best tax result possible in dealing with the various types of payments that might be received.

Tax Issues Associated With Easement Payments - Part 1

Overview

Rural landowners often receive payment from utility companies, oil pipeline companies, wind energy companies and others for rights-of-way or easements over their property.  The rights acquired might include the right to lay pipeline, construct aerogenerators and associated roads, electric lines and similar access rights.  Payments may also be received for the placement of a “negative” easement on adjacent property so that the neighboring landowner is restricted from utilizing their property in a manner that might decrease the value of nearby land.

How are these various types of payment to be reported for tax purposes.  It’s an important issue for many farmers, ranchers and rural landowners.

Tax issues with easement payments Part 1 of a series – it’s the topic of today’s post.

Characterizing the Transaction

The receipt of easement payments raises several tax issues.  The payments may trigger income recognition or could be offset partially or completely by the recipient’s income tax basis in the land that the easement impacts.  Also, a sale of part of the land could be involved.  In addition, a separate payment for crop damage could be involved.

Sale or exchange.  A sale or exchange triggers gain or loss for income tax purposes.  I.R.C. §1001.  Is the grant of an easement a taxable event?  It depends.  In essence, a landowner’s grant of an easement amounts to a sale of the land if after the easement grant the taxpayer has virtually no property right left except bare legal title to the land.  For instance, in one case, the grant of an easement to flood the taxpayer’s land was held to be a sale.  Scales v. Comr., 10 B.T.A. 1024 (1928), acq., 1928-2 C.B. 35.  In another situation, the IRS ruled that the grant of an easement for air rights over property adjoining an air base that caused the property to be rendered useless was a sale.  Rev. Rul. 54-575, 1954-2 C.B. 145.  The grant of a perpetual easement on a part of unimproved land to the state for a highway, as well as the grant of a permanent right-of-way easement for use as a highway have also been held to be a sale.  Rev. Rul. 72-255, 1972-1 C.B. 221; Wickersham v. Comr., T.C. Memo. 2011-178.  Also, the IRS has determined that the grant of a perpetual conservation easement on property in exchange for “mitigation banking credits” was held to be a sale or exchange.  Priv. Ltr. Rul. 201222004 (Nov. 29, 2011).  Under the facts of the ruling, the taxpayer acquired a ranch for development purposes, but did not develop it due to the presence of two endangered species.  The taxpayer negotiated a Mitigation Bank Agreement with a government agency pursuant to which the taxpayer would grant a perpetual conservation easement to the government in return for mitigation banking credits to allow the development of other, similarly situated, land.  The IRS determined that the transaction constituted a sale or exchange. 

Note:  The buyer of mitigation credits is likely to be a dealer that won’t hold the credits long enough to achieve capital gain status on sale.  But, the ultimate answer to the question of the buyer’s tax status is a fact-dependent determination. 

Ordinary income or capital gain?  If the payments for the grant of an easement are, in effect, rents for land use the characterization of the payments in the hands of the landowner is ordinary income.  For example, in Gilbertz v. United States, 574 F. Supp. 177 (D. Wyo. 1983), aff’d., and rev’d. by, 808 F.2d 1374 (10th Cir. 1987), the taxpayers, a married couple, raised cattle on their 6,480-acre ranch.  They held title to the surface rights and a fractional interest in the minerals.  The federal government reserved most of the mineral rights.  In 1976 and 1977, the taxpayers negotiated more than 50 contracts with oil and gas lessees and pipeline companies to receive payments for anticipated drilling activities on the ranch.  The taxpayers reported the payments as non-taxable recovery of basis in the entire ranch with any excess amount reported as capital gain.  The IRS disagreed, asserting that the payments were taxable as ordinary income.  The taxpayers paid the asserted deficiency and sued for a refund.

The trial court dissected the types of payments involved concluding that the “Release and Damage Payments” were not rents taxable as ordinary income.  Instead, the payments from pipeline companies for rights-of-ways and damage to the land involved a sale or exchange and were taxable as capital gain – the pipeline companies had obtained a perpetual right-of-way.  On further review, the appellate court held that the “Release and Damage Payments” were not a return of capital to the taxpayers that qualified for capital gain treatment to the extent the amount received exceeded their basis in the land.  However, the appellate court affirmed the trial court’s holding that the amounts received from the pipeline companies were properly characterized as the sale of a capital asset and constituted a recovery of basis with any excess taxable as capital gain. 

Limited Easements.  The grant of a limited easement is treated as the sale of a portion of the rights in the land impacted by the easement, with the proceeds received first applied to reduce the basis in the land affected.  Thus, if the grant of an easement deprives the taxpayer of practically all of the beneficial interest in the land, except for the retention of mere legal title, the transaction is considered to be a sale of the land that the easement covers.  That means that gain or loss is computed in the same manner as in the case of a sale of the land itself under I.R.C. §1221 or §1231.  In addition, only the basis of the land that is allocable to that portion is reduced by the amount received for the grant of the easement.  Any excess amount received is treated as capital gain.  The allocation of basis does not require proration based on acreage.  Instead, basis allocation is to be “equitably apportioned” based likely on fair market value or assessed value at the time the easement is acquired. 

Location of the easement.  In rare situations where the entire property is impacted by the easement, the entire basis of the property can be used to offset the amount received for the easement.  This might be the situation where severance damage payments are received.  These types of payments may be made when the easement bisects a landowner’s property with the result that the property not subject to the easement can no longer be put to its highest and best use.  This is more likely with commercial property and agricultural land that has the potential to be developed.  Severance damages may be paid to compensate the landowner for the resulting lower value for the non-eased property.  If severance damages exceed the landowner’s basis in the property not subject to the easement, gain is recognized. 

Note:  Whether the easement impacts the entire parcel is a question of fact.  An easement located across a corner of a tract or along a fence line, may be less likely to be found to impact the entire parcel than would an easement down the middle of a tract. 

Conclusion

In Part 2 in this series, I will break down the various types of payments that landowners receive for easements and the proper reporting of those payments.  I will also look at the possibility of eminent domain concepts applying to the easement transaction.

Tax Ethics Seminar/Webinar

Overview

On December 16 I will be doing a two-hour ethics seminar on income tax ethics.  If you are in need of ethics hours to help satisfy your CPE/CLE requirements, this will be a good opportunity for you to gain two hours of credit.

Details

The seminar will consist of two 50-minute sessions.  During the first session I will focus on several specific client situations that can raise ethical issues.  For example, what if a client fails to inform the tax preparer of relevant information that impacts the return?  What is the responsibility of the preparer to ask questions?  How should an engagement letter be used and worded?  What is required “due diligence” of Circular 230? 

Another situation might involve the deferral of self-employment tax as a result of the CARES Act.  This legislation presents unique ethical problems for practitioners.  Again, the issue is often the information that the practitioner has from the client and IRS notices.  On the legislative front, recent changes to penalty-free withdrawals from retirement plans have created confusion among clients and tax preparers.  I will discuss several ethical scenarios these changes create for practitioners.

Another issue that creates ethical concerns for practitioners involves the carryover of suspended losses, capital losses, qualified business losses and net operating losses.  Sometimes these issues arise when a preparer inherits a client from another preparer.  In those situations, what ethical responsibilities does the new preparer have?  What are the rules involving correspondence with the IRS? 

During the second session I will address ethical issues involving other carryover issues such as charitable contributions and I.R.C. §179 carryovers.  There are also numerous credits that can carryover and create various ethical issues for tax preparers.  Also, debt forgiveness from prior years can present difficult ethical issues.  I will also address ethical issues associated with S corporation or partnership basis and education credits. 

To conclude the seminar, I will go over a suggested client questionnaire and go back to the scenarios that have been discussed and evaluate appropriate practitioner approaches as related to Circular 230.

Conclusion

The seminar will be live at Washburn Law School and will also be simulcast over the web.  You may learn more about the ethics seminar and register here:  https://www.washburnlaw.edu/employers/cle/taxethics.html 

Are Crop Insurance Proceeds Deferrable for Tax Purposes?

Overview

There still seems to be a misunderstanding among some farmer about the tax deferability of crop insurance proceeds.  I have seen several comments recently on social media by farmers communicating with each other stating to the effect that crop insurance is always deferable.  That is not correct.  With today’s post, I sort through the proper way to determine whether the receipt of crop insurance is deferable for income tax purposes.

The income tax deferability of crop insurance – it’s the topic of today’s post.

In General

The proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received.  In effect, destruction or damage to crops and receipt of insurance proceeds are treated as a “sale” of the crop.  But taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's practice to report income from sale of the crop in the later year.  I.R.C. §451(d).  A “practice” requires that the taxpayer establish that a substantial part of the crops (more than 50 percent) has been carried over into the following year.  Rev. Rul. 74-145, 1974-1 C.B. 113.  Eligible payments are those made because of damage to crops or the inability to plant crops.  The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”

Summary:  Deferability is possible if the farmer is on the cash method of accounting and has a practice of deferring the reporting of crop income.  Payments eligible for deferral are payments for crop damage, payments for inability to plant and payments for damage on account of “any other natural disaster.”  The insurance payment must be received in the year of the crop loss.  If payment is received the year after the crop loss, it is not deferable to the next year.

Details

Election.  The election is made by attaching a separate, signed statement to the income tax return for the tax year of damage or destruction or by filing an amended return, and it covers insurance proceeds attributable to all crops representing a trade or business. 

Multiple crops.  If multiple crops are involved, the “substantial portion” test must be met with respect to each crop if each crop is associated with a separate business of the taxpayer.  Otherwise, the 50 percent text is computed in the aggregate if the crops are reported as part of a single business.  Also, a taxpayer may not elect to defer only a portion of the insurance proceeds to the following year.

Revenue and yield policies.  A significant issue is whether the deferral provision also applies to new types of crop insurance such as Revenue Protection (RP), Revenue Protection with Harvest Price Exclusion (RPHPE), Yield Protection (YP) and Group Risk Plan (GRP). As mentioned above, to be deferrable, payment under an insurance policy must have been made as a result of damage to crops or the inability to plant crops. Other than the statutory language that makes prevented planting payments eligible for the one-year deferral, the IRS position as stated in Notice 89-55, 1989-1 C.B. 698 is that agreements with insurance companies providing for payments without regard to actual losses of the insured, do not constitute insurance payments for the destruction of or damage to crops.  Accordingly, payments made under the types of crop insurance that are not directly associated with an insured's actual loss, but are instead tied to low yields and/or low prices, may not qualify for deferral depending upon the type of insurance involved.  For example, RP policies insure producers against yield losses due to natural causes such as drought, rain, hail, wind, frost, insects and disease, as well as revenue losses tied to the difference between harvest price and a projected price.

Summary:  Only the portion attributable to physical damage or destruction to a crop is eligible for deferral.  RPHPE, YP and GRP policies tie payment to price and/or yield and amounts paid under such policies are less likely to qualify for deferral. 

Correct Approach

While the IRS has not specified in regulations the appropriate manner to be utilized in determining the deferrable and non-deferrable portions, the following is believed to be an acceptable approach:

Consider the following example:

Al took out an insurance policy (RP) on his corn crop. Under the terms of the policy the approved corn yield was set at 170 bushels/acre, and the base price for corn was set at $6.50/bushel. At harvest, the price of corn was $5.75/bushel. Al’s insurance coverage level was set at 75 percent, and his yield was 100 bushels/acre. Al’s final revenue guarantee under the policy is 170 bushels x $6.50 x .75 = $828.75/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($5.75/bushel) which equals $575/acre. Al’s insurance proceeds is the guaranteed amount ($828.75/acre) less the calculated revenue ($575/acre), or $253.75/acre.  His physical loss is the 170 bushel/acre approved yield less his actual yield of 100 bushels/acre, or 70 bushels/acre. Multiplied by the harvest price of $5.75/bushel, the result is a physical loss of $402.50/acre. Al’s price loss is computed by taking the base price of $6.50/bushel less the harvest price of $5.75/bushel, or $.75/bushel. When multiplied by the approved yield of 170 bushels/acre, the result is $127.50/acre. 

So, to summarize, Al has the following:

• Total loss: (1) anticipated income/acre [170 bushels/acre @ $6.50/ bushel = $1105/acre] less (2) actual result [100 bushels/acre @ $5.75/acre = $575.00] for a result of $530.00/acre.
• Physical loss: 70 bushels/acre x $5.75/bushel harvest price = $402.50/acre
• Price loss: 170 bushels/acre x $.75/bushel = $127.50
• Physical loss as percentage of total loss:  $402.50/530 = .7594
• Insurance payment: $253.75/acre
• Insurance payment attributable to physical loss (which is deferrable):  $253.75 x .7594 = $192.70/acre
• Portion of insurance payment that is not deferrable: $253.75 – $192.70 = $61.05/acre

But what if the harvest price exceeds the base price?  Then the above example can be modified as follows:

Assume now that the harvest price of corn was $7.50/bushel. Al’s final revenue guarantee under the policy is 170 bushels/acre x $7.50 x.75 = $956.25/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($7.50/bushel) which equals $750.00/acre. Al’s insurance proceeds are the guaranteed amount ($956.25/acre) less the calculated revenue ($750.00), or $206.25/acre.  His yield loss is the 70 bushels/acre which is then multiplied by the harvest price of $7.50/bushel, for a physical loss of $525/acre.  Al’s price loss is zero because the harvest price exceeded the base price.

So, to summarize, Al has the following:

• Total loss (per acre): $525.00 (physical loss) + $0.00 (price loss)
• Physical loss as percentage of total loss:  $525/525 = 1.00
• Insurance payment: $206.25/acre
• Insurance payment attributable to physical loss (which is deferrable):  $206.25 x 1.00 = $206.25/acre
• Portion of insurance payment that is not deferrable: $206.25 – 206.25 = $0.00

Conclusion

Crop insurance will be an important component of income for many farmers this year due to drought.  Make sure you understand the rules for deferability.  Take the advice you receive on social media or at the café or coffee shop with a grain of salt.

On a related point, Emergency Relief Payments received in 2022 are not deferable.  Those payments were for loss sustained in either 2020 or 2021.

Social Security Planning for Farmers and Ranchers

Overview

Many farmers and ranchers are reaching retirement age for Social Security benefit purposes.  That raises numerous questions involving such things as benefits, earnings, what counts as “wages” and the cash renting of farmland.  These are all important questions for farmers and ranchers to have answers to so that appropriate planning can be engaged in and expectations realized.

Details on Social Security benefits - it's the topic of today’s post.

Full Retirement Age

Once a person reaches “full retirement age” (according to the Social Security Administration) earnings don’t impact Social Security benefits.  The full retirement age used to be 65 for those born in 1937 or earlier. Those born between 1943 and 1954 have a full retirement age of 66. The full retirement age further increases in two-month increments each year to 66 and 10 months for those born in 1959.  For those who turned 62 in 2022, the full retirement age is 67.

During the calendar year in which an individual reaches age 66, an earnings limit applies for the months before the individual reaches full retirement age.  For example, for an individual who turns age 66 during 2022, there is a monthly earnings limit of $4,330 ($51,960 ¸ 12 months) for the months before full retirement age is reached.  Excess earnings for this period result in a $1 reduction in benefits for each $3 of excess earnings received before attaining the age of 66 years and four months.  But, for a person who hasn’t reached full retirement age, benefits are reduced by $1 for every $2 of earnings over the annual limit of $19,560 (for 2022).  As noted above, for those drawing benefits after reaching full retirement age, there is no limit on earnings – benefits are not reduced.

Drawing Benefits

An individual can receive full Social Security benefits if they aren’t drawn until full retirement age is achieved.  Another way to state it is that if an individual delays taking Social Security benefits until reaching full retirement age, the individual receives additional benefits for each year of postponement until reaching age 70.  The rate of increase is a fraction of one percent per month.  In essence, the impact of drawing Social Security benefits before reaching full retirement age is that such a person must live longer to equalize the amount of benefits received over their lifetime compared to waiting until full retirement age to begin drawing benefits.   

Taxability of Benefits

Federal.  About 20 million people each year, some who are undoubtedly farmers and ranchers, pay tax on their Social Security benefits.  These people are commonly in the 62-70 year age range.  Taxing Social Security benefits seems harsh, inasmuch as the person has already paid income tax and Social Security payroll taxes on the earnings that generated the benefits.   But not every dollar of benefits is taxed.  What matters is a person’s total income from non-Social Security sources such as wages and salaries, investment income (and capital gains on those investments), and pension income.  To that amount is added one-half of the person’s Social Security income.  The total amount then is measured against a limit.  For example, a person who files as married-filing-jointly (MFJ) will subject 50 percent of their Social Security benefits subject to tax if the total amount exceeds a base amount - $32,000 for 2022 (it’s $25,000 for a single filer).  The 50 percent changes to 85 percent once the total amount exceeds $44,000 (MFJ) or $34,000 (single) for 2022.  Those are the maximum percentages in theory.  In reality, however, there is a complex formula that often results in less Social Security benefits being taxed than that maximum percentage.  For instance, for taxpayers that fall in the 50 percent taxability range, the amount of Social Security benefits that are included in income is the lesser of one-half of the Social Security benefits for the year or one-half of the difference between combined income and the base amount.  The formula is more complex for those who trigger the 85 percent test. 

Note:  The IRS provides a worksheet to calculate Social Security tax liability in IRS Publication 915.  The formula often results in about 20 percent of Social Security benefits being taxed once the total amount threshold is exceeded. 

State.  The following states tax Social Security benefits to some extent:  Colorado; Connecticut; Kansas; Minnesota; Missouri; Montana; Nebraska; New Mexico; Rhode Island; Utah; Vermont and West Virginia.  The taxability of benefits varies from state to state.  In Kansas, for example, Social Security benefits are exempt if federal AGI is $75,000 or less. Above that threshold, Social Security benefits are taxed to the same extent they are taxed at the federal level.  By comparison, Nebraska, for 2021, did not tax Social Security for joint filers with a federal AGI of $59,960 or less and other taxpayers with a federal AGI of $44,460 or less (the 2022 threshold is not available yet).  For taxpayers exceeding these thresholds, Social Security benefits are taxed to the same extent they are taxed at the federal level.  For 2022, taxpayers can choose to deduct 40% of Social Security benefits on the state return that are included in federal AGI instead of having them taxed in accordance with the above rule.  The optional deduction percentage increases to 60% for 2023, 80% for 2024, and 100% for 2025 and thereafter.

Special Considerations

The “donut” hole.    The computation of Social Security retirement benefits is based on an individual’s earnings record.  That record can include 40-plus years of earnings up to age 62 when eligibility for benefits begins.  Earnings are adjusted based on wage inflation to equivalent dollars when an individual turns 60.  That is the last year earnings are indexed for wage inflation.  Earnings after age 60 are added to the earnings record but are not adjusted for inflation.

A cost-of-living adjustment (COLA) kicks in each year starting at age 62.  The two-year gap where there is neither a wage inflation adjustment nor a COLA is particularly evident this year because of an inflation rate not seen in over 40 years.  Presently this affects people born in 1960 and 1961.  There is nothing that can be done about this; it’s simply tied to when an individual turns age 62. 

Wages in-kind.  Some farmers receive wages in-kind rather than in cash.  In-kind wages such as crops or livestock, count toward the earnings limitations test.  The earnings limit test includes all earnings, not just those that are subject to Social Security (FICA/Medicare) tax.  But, employer-provided health insurance benefits are not considered to be “earnings” for purposes of the earnings limitation test.  They are not taxed as wages.  I.R.C. §3121; SSA Program Operations Manual System, §§RS 01402.040; 01402,048.

Farm programs.  Federal farm program payments that a farmer receives are not deemed to be “earnings” when calculating each calendar year's earnings limitation.  SSA Program Operations Manual System §RS 02505.115.  That is the case except for the initial year of Social Security benefit application.  In that initial year, all FSA program payments are counted along with other earned income and earnings for purposes of the annual earnings limitation test.

Cash rent.  For farmers who cash rent farm ground to their employer, the cash rental income that the farmer receives will likely be treated as “earnings” even though the farmer is getting a wage from the employer.  This is particularly the case if the farmer is farming the ground on the employer’s behalf.  The result would be a “doubling-up” of the wage income and the cash rent income for purposes of the age 62-66 earnings test. 

CRP payments.  For a farmer who is drawing Social Security benefits, whether retired or not, Conservation Reserve Program Payments received are not subject to Social Security tax.  I.R.C. §1402(a)(1). 

Conclusion

Social Security benefit planning is an item that is often overlooked by farmers and ranchers.  However, it is useful to know how such planning may fit into the overall retirement plan.  It is just one piece of the retirement, succession, estate plan that should be considered in terms of how it fits in with other strategies.  While a farmer or rancher may never actually “retire,” there is a benefit to properly timing the drawing of Social Security benefits.  In addition, as noted above, there are some special situations that a farmer or rancher should be aware of.

Also, the Social Security Administration website (ssa.gov) has some useful online calculators that can aid in estimating retirement benefits.  It may be worth checking out. 

Tax Treatment of Crops and/or Livestock Sold Post-Death

Overview

When a farmer sells a harvested crop, the tax rules surrounding the reporting of the income from the sale are well understood.  But what happens when a farmer dies during the growing season?  The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord.  In addition, if the decedent was a landlord, the type of lease matters. 

The tax rules involving the post-death sale of crops and livestock – that’s the focus of today’s post.

General Rule and the IRD Exception

For income tax  purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death.  I.R.C. §1014(a)(1).   But there is an exception to this general rule.  Income in respect of decedent (IRD) property does not receive any step-up in basis.  I.R.C. §691.  IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.

In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.

1. The decedent entered into a legal agreement regarding the subject matter of the sale.
2. The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).
3. No economically material contingencies that might have disrupted the sale existed at the time of death.
4. The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.

The case involved the sale of calves by a decedent’s estate.  Two-thirds of the calves were deliverable on the date of the decedent’s death.  The other third was too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered.  The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death.  In addition, the estate’s activities with respect to the calves were substantial and essential.  The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied. 

Active farmer or landlord?  Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.

1. Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters. 
2. If the decedent was a farm landlord, was the decedent a materially participating landlord or a non-materially participating landlord?

For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366.  See also Estate of Burnett v. Comm’r, 2 TC 897 (1943).  The rule is the same if the decedent was a landlord under a material participation lease.  These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014.  No allocation  is made between the decedent’s estate and the decedent’s final income tax return.  Treas. Reg. §20.2031-1(b).

From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.

If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964).  That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death.  If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final return.  No prorations would have been required.  If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula. 

IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.

Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction.  Rev. Rul. 75-11, 1975-1 CB 27.

Character of Gain

Sale of grain.  Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes. However, when a farmer dies and the estate (or the person acquiring the property) sells grain inventory the rule had been that if the sale occurred within six months after death, the income from the sale qualified as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule.  I.R.C. §1223(9).  That is now one year.  I.R.C. §1223(9)(B).  The two-year holding period requirement still applies to cattle and horses.  However, ordinary income treatment occurs if the crop was raised on land that is leased to a tenant.  See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959). 

Entity.  If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business.  Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.  

Conclusion

The sale of crops and livestock post-death are governed by specific tax rules.  Because death often occurs during a growing period, it’s important to know these unique rules.

When Can Depreciation First Be Claimed?

Overview

A recent Tax Court opinion starts out with, “During 2015-2017 petitioners were actively engaged in the farming business, growing and selling corn and soybeans. In July 2015, after seeing an advertisement in a farming magazine…”.   That statement gave me the feeling that the court’s opinion was going to quickly head south for the farmer.  I was right.  While the case did not involve the purchase of farm equipment or a farm building, with the onset of fall comes the onset of agribusinesses promoting year-end “deals” on equipment and farm buildings – and the provision of bad tax “advice.”  The common ploy is for the sale to be made in 2022 with the farmer thinking that they will be able to take a sizable deduction on their 2022 taxes for depreciation.  But, the tax year in which depreciation can first be claimed on an asset depends on when an asset is “placed in service.”

When can an asset that is used in the farming business begin to be depreciated?  The “placed in service” issue – it’s the topic of today’s post

“Placed in Service”

A taxpayer can claim a depreciation deduction for assets that are used in the taxpayer’s trade or business or held for the production of income. I.R.C §167(a).  Any depreciable business asset is only depreciable if it has been placed in service during the tax year. Treas. Reg. §1.167(a)-10(b).  “Placed in service” means that the asset is in a state of readiness for use in the taxpayer’s trade or business.  See, e.g., Brown v. Comr., T.C. Sum. Op. 2009-71.  In the year that an asset is placed in service, all or part of the income tax basis can be deducted currently.  Taxpayers generally prefer an earlier placed-in-service date due to the time value of money.  The IRS generally prefers the opposite position.  So, when is a building placed in service?  What about machinery or equipment?  What if equipment was acquired this year but not first used until next year? 

Code, Regulations and Interpretations of IRS and the Tax Court

A key point is that it is not actually necessary that the asset be used in the taxpayer’s trade or business for the taxpayer to begin claiming depreciation attributable to that asset.  Treas. Reg. §1,167(a)-(11)(e)(1) says that property is considered to be placed in service when it is “first placed in a condition or state of readiness and [available] for a specifically assigned function.” 

As noted above, property that is “placed in service” means that it is placed in a state of readiness or availability for use in the taxpayer’s trade or business, regardless of the time of year that the asset is placed in service.  Treas. Reg. §1.167(a)-10(b).  That means that the asset must be ready for the taxpayer to use by the end of the tax year if the taxpayer so desires.  It doesn’t mean that the taxpayer must have begun using the asset in the taxpayer’s trade or business by the end of the tax year.  Unfortunately, the IRS has not been consistent in applying the regulation.  For example, in F.S.A. 199916040 (Apr. 23, 1999), the IRS construed the regulation to require actual operational use in the taxpayer’s trade or business.  The taxpayer purchased compressors to maintain gas pressure in pipelines.  The IRS said deprecation couldn’t begin until the compressors were installed in the pipelines.  In Consumers Power Co. v. Comr., 89 T.C. 710 (1987), the said that an electricity-generating unit should not be deemed to be placed in service until it could operate at rated capacity.   See also Oglethorpe Power Corp., v. Comr., T.C. Memo. 1990-505; Rev. Rul. 73-518, 1973-2 C.B. 54.

However, the IRS has also utilized a less restrictive view on what constitutes placed-in-service.  In Rev. Rul. 76-238, 1976-1 C.B. 55, IRS determined that a building was placed in service when its construction was complete, and it was ready for machinery and equipment to be installed.  Likewise, in Livingston v. Comr., T.C. Memo. 1966-49, the Tax Court held that depreciation was allowable on the completed portions of a building for use in the taxpayer’s business regardless of whether the entire building was completed.

The Stine Case

In Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. Jan. 27, 2015), non-acq., 2017-02 (Apr. 10, 2017), the taxpayer operated a retail business that sold home building materials and supplies. The taxpayer built two new retail stores. As of December 31, 2008, the buildings were substantially complete and partially occupied and the taxpayer had obtained certificates of completion and occupancy and customers could enter the stores. However, the stores were not open for business as of the end of 2008. The taxpayer claimed the 50 percent GoZone depreciation allowance for 2008 on the two buildings which created a tax loss for 2008 and allowed the taxpayer to carry back the losses to the 2003-2005 tax years and receive a refund. The IRS disallowed the depreciation deduction on the basis that the taxpayer had not placed the buildings in service and assessed a deficiency of over $2.1 million for tax years 2003-2008. The taxpayer paid the deficiency and sued for a refund. The IRS argued that allowing the depreciation would offend the "matching principle" because the taxpayer's revenue from the buildings would not match the depreciation deductions for a particular tax year. The court held that this argument was "totally without merit."  

On the placed-in-service issue, the IRS maintained that the two buildings were not “open for business” as of the end of the tax year so no depreciation could be claimed for that year.  The court disagreed, noting the government’s own regulation that defied that argument.  The court noted that Treas. Reg. §1.167(a)-11(e)(1) says that placed in service means that the asset is in a condition of readiness and availability for its assigned function. With respect to a building, the court noted that this meant that the building must be in a state of readiness and availability without regard to whether equipment or machinery housed in the building has been placed in service. The court held that there was no requirement that the taxpayer's business must have begun by year-end. Cases that the IRS cited involving equipment (in one case an airplane) being placed in service were not applicable, the court determined. The court also noted that the IRS's own Audit Technique Guide for Rehabilitation Tax Credits stated that "[A] 'Certificate of Occupancy' is one means of verifying the 'Placed in Service' date for the entire building (or part thereof)". The court noted that the IRS had failed to cite even a single authority for the proposition that "placed in service" means "open for business," and that during oral arguments IRS had admitted that no authority existed.  Thus, the court granted summary judgment for the taxpayer and also specified that the taxpayer could pursue attorney fees against the government if desired.

The IRS reaction.  The court’s decision in Stine was based precisely on the regulation.  It’s common sense, also.  For retail businesses that are constructing stores, once the product is received to be placed into the display shelves at the constructed building, the building will be considered to have been placed in service.  That’s what the regulation seems pretty clear about.  The court sure believed so. 

The IRS did not file an appeal with the U.S. Court of Appeals for the Fifth Circuit.  That’s not surprising, considering how badly the IRS lost the case.  Recently, however, the IRS issued a non-acquiescence to the court’s decision.  A.O.D. 2017-02.  That means that the IRS disagrees with the court’s decision and will continue to audit the issue outside of the Western District of Louisiana.  Unfortunately, the IRS didn’t give any reason(s) why it disagreed with its own regulation and audit technique guide on the matter.  That’s understandable – they have none.

Application to Farm Asset Purchases

So, what can we learn from this for a farmer’s later in the tax year purchase of machinery, equipment or a farm building?  An item of property is not deemed to be placed in service if it is simply manufactured and is sitting at the dealership, or if an order has been placed but the property has not yet been built.  Simply signing a purchase contract or taking delivery of a depreciable materials (such as for the construction of a pole barn, etc.) to be used in the taxpayer’s business does not mean that those assets are depreciable – they aren’t yet ready for use in the taxpayer’s business. It doesn’t matter that the taxpayer has paid for the asset.  The key is whether the asset is ready for use in the taxpayer’s business.  But remember, actual use by the end of the current tax year doesn’t matter either.  For a building in which the taxpayer’s retail business is conducted, for example, the store doesn’t have to be open for business in order for the building by the end of the tax year for the building to be deemed to be placed in service for depreciation purposes for that tax year.  Treas. Reg. §1.167(a)-11(e)(1)(i).  The building is considered to be placed in service on the date that its construction is considered to be substantially complete or in the state or readiness and availability regardless of whether depreciable items in the building meet the placed in-service test.  Id.

Conclusion

Be on the lookout for end-of-year promotional ads in farm magazines stating that a contract could be signed, or delivery be taken before year-end to which will allow a depreciation deduction to be available for that year.  That’s not correct.  While the asset need not be “used” by the taxpayer to be placed in service, it still has to be ready and available for use.  Merely signing a contract or taking delivery of parts and materials that have to be assembled is not enough.  Thus, for a farmer that buys equipment this year that will not be ready for use in the farming business until next year, no depreciation deduction will be allowed until 2023.  This is particularly a big issue this year because first-year “bonus” depreciation, while 100 percent for 2022, is schedule to drop to 80 percent for next year and supply chain issues may cause delays.

Make sure you know the rules and don’t get lured into a bad tax result by inaccurate sales information.  Remember, retailers are trying to sell products in a down economy.  They aren’t in the business of providing sound tax advice.

Handling Expenses of Crops with Pre-Productive Periods - The Uniform Capitalization Rules

Overview

In the Midwest and the Great Plains, we often think of crop production involving the production a crop within a calendar year.  From a tax standpoint, that means that the deductions for producing the crop and the income from the crop generally offset in the same tax year (assuming the farmer is on the cash basis of accounting and utilizes a calendar tax year).  Of course, expenses can be pre-paid and income deferred, but there is generally an offset.    But the singular year comprising the planting and harvesting of a crop is not the case with fruit and vegetable crops.  Producers of those crops have a significant time-lag between planting and harvest in marketable quantities.

The tax Code allows farmers that have a long-term crop (which includes a fruit, nut or other crop-bearing tree; ornamental tree; vine; bush; sod; or any other crops or yield of a plant that will have more than one crop or yield) to use a special rule for handling crop production expenses.  I.R.C. §263A.  These rules, known as the “uniform capitalization rules” apply to taxpayers that have a long-term crop with more than a two-year pre-productive period.  The rules operate to bar deductions for the costs associated with the crop during the pre-productive period. Instead, the taxpayer must add the associated costs to their tax basis in the crop, or the costs must be included in inventory costs.  They cannot be claimed as a current deduction. 

Note.  Production costs can include everything from direct labor and material costs to indirect rents, taxes and other costs.  For plants, pre-productive period costs include the costs of items such as irrigation, pruning, frost protection, spraying and harvesting. 

Background

Farmers that are not required to use the accrual method of accounting could elect to not have the I.R.C. §263A rules apply with respect to pre-productive period costs.  If an election out is made, the plants are treated as I.R.C. §1245 property and the gains rom selling the plants are I.R.C. §1245 gains to the extent of any expenses that would have been required to be capitalized under I.R.C. §263A as if the election had not been made.  In addition, alternative depreciation (ADS) then had to be used on all farm property and bonus depreciation was not available (but, expense method depreciation could still be utilized).  Under a law passed in 2015, an election was provided to allow bonus depreciation for certain “specified” plants equal to 50 percent of their cost (for 2016) that were planted or grafted after 2015.  Eligible plants were trees or vines that produce nuts or fruits and any other plant with a more than two-year pre-productive period. 

What is the Pre-Productive Period?

For plants, the pre-productive period begins when the seed is planted, or the plant is first acquired by the taxpayer. The pre-productive period ends when the plant is ready to be produced in marketable quantities or when the plant can reasonably be expected to be sold or otherwise disposed of. The pre-productive period, however, is determined not in light of the taxpayer’s personal experience but in light of the weighted average pre-productive period determined on a nationwide basis.

Crops with a Pre-Productive Period Exceeding Two Years

In Notice 2000-45, I.R.B. 2000-36, the IRS provided a list of plants that are grown in commercial quantities in the U.S. having a nationwide weighted average pre-productive period in excess of two years.  Blackberries, raspberries and papaya plants were on the original list, but were removed in 2013.  The current list is as follows:

Almonds           Coffee beans     Kumquats         Oranges                        Pomegranates

Apples              Currants            Lemons                                                Prunes

Apricots            Dates                Limes               Peaches                       

Avocados          Figs                  Mac. Nuts           Pears                          Tangelos

                        Grapefruit         Mangoes           Pecans                          Tangerines

Blueberries       Grapes              Nectarines         Persimmons                  Tangors

Cherries            Guavas             Olives               Pistachio Nuts              Walnuts

Chestnuts          Kiwifruit           Plums

Application to Grapes

The uniform capitalization rule is particularly problematic for grape growers. If the rule requires that all of the expenses associated with growing grapes be capitalized until the time the wine is sold, that would be a really tough rule for wineries because the wine-making process can take many years.  The IRS treats grape growing and winery functions as separate businesses, even though:

1. the grapes are never subject to sale or other disposition as those terms are used in tax law; and
2. the taxpayer does not operate their business as two separate and distinct businesses. C.A. 200713023 (Nov. 20, 2006).

In conjunction with that reasoning, the IRS view is that the actual pre-productive period of a grape crop ends no later than the onset of the crushing of the grapes.  Id.  As for the costs incurred between the harvest of the grapes and blossoming of a later crop, IRS requires that a taxpayer must capitalize the direct costs and an allocable portion of the indirect costs of producing the vine. Treas. Reg. §1.263A-1(e).  Preparatory costs of the vine and the pre-productive period costs of the vine that are incurred during the actual pre-productive period of the vine must be capitalized.  The actual pre-productive period of the vine ends when the vine first becomes productive in marketable quantities.  After the end of the actual pre-productive period, pre-productive period costs are generally capitalized to a crop during the pre-productive period o the crop and are deducted as a cost of maintaining the vine when incurred between the end of the actual pre-productive period of one crop and the beginning of the actual pre-productive period of the subsequent crop. 

Note:  Direct and indirect costs include administration costs, depreciation and repairs on farm buildings and farm overhead.  Id. 

Exception for “Field Costs”

A special exception for “field costs” such as irrigating, fertilizing, spraying, and pruning applies to the period between harvesting and the sale of the crop.  Treas. Reg. §1.263A-4(b)(2)(i)(C) (2)(i).  These costs are not required to be capitalized because they do not benefit, and are unrelated to, the harvested crop. They merely maintain and improve the health of the vines, but they do not provide any benefits to the crop which has already been severed from the vines. This field crop exception, however, ends when the pre-productive period of the crop ends, which is the onset of the crush. Thus, pre-productive period costs incurred between the end of the pre-productive period and the blossoming of the later crop are generally deductible as the cost of maintaining the vine.

The bottom line, therefore, is that costs incurred between the harvest of the crop and the end of the pre-productive period must be capitalized unless they are “field costs” that provide no benefit to the already severed crop.   When there is a marketable harvest, the total capitalized costs are depreciated on a straight-line basis over 10 years (for orchards and vineyards).    Expense method depreciation or bonus depreciation is also available. 

TCJA

Under the Tax Cuts and Jobs Act (TCJA), 100 percent bonus depreciation is available through 2022.  In addition, farmers with gross receipts of $25 million or less ($27 million for 2022) can expense all of the direct and indirect costs associated with plantings - including the costs of the plants.  This means that the requirement of using I.R.C. §263A is eliminated for these farmers.  For those farmers that made the election to expense direct and indirect costs of production, but not have bonus depreciation available, it is not known whether an election can be made to come back into the system.  If such an election can be made and the taxpayer’ gross revenue is less than the applicable threshold, all costs can be deducted currently under the 100 percent bonus provision.  If an election cannot be made, costs must be expensed but bonus is not available on all farm assets.  This will be the case even if the taxpayer had not planted any orchards or vineyards for several years. 

This raised a question.  What if a farmer elected under I.R.C. §263A(d)(3) to expense the direct and indirect costs of production, thereby becoming unable to claim bonus depreciation and being required to use ADS?  Many farmers with vineyards and orchards did this to be able to deduct costs as incurred.  It was in irrevocable election, but the TCJA raised a question as to whether they could elect to come back into the system.  The problem was that these farmers had no way to revoke the election and utilize the TCJA provision eliminated the uniform capitalization rules for a qualified “small business” other than to request (at great expense) an IRS Private Letter Ruling. 

Example:

Raymond and Verda, a farm couple, planted an orchard in 2012.  Their gross revenues are less than the threshold for utilizing cash accounting.  They elected to expense all costs of the orchard.  That had the effect of barring them from claiming bonus depreciation on any farm assets.  In 2018, they bought $1,500,000 of farm equipment.  If they cannot elect back into the prior system, they won’t be able to claim any bonus depreciation on the new farm equipment and can only take expense method depreciation.  If they can elect back into the old rules, that then entire $1,500,000 of farm equipment purchased in 2018 will qualify for bonus depreciation.

In the spring of 2020, the IRS provided a mechanism for taxpayers that had elected out of I.R.C. §263A under prior law to revoke the election. Rev. Proc. 2020-13, 2020-11 I.R.B.  Under the election, a taxpayer with average annual gross receipts of $25 million or less (adjusted for inflation) over the prior three years (through 2025) are excluded from I.R.C. §263A.  For tax years beginning after 2018, the revocation election is to be made on the taxpayer’s original return, including extensions, for the tax year for which the taxpayer wants to revoke the election.  The election is accomplished by not capitalizing the costs of plants; changing depreciation to GDS unless the property at issue is otherwise required to use ADS (e.g., bonus depreciation is not allowed); and continuing to treat plants that are or have been treated as I.R.C. §1245 property for prior tax years as I.R.C. §1245 property. 

Conclusion

For farmers with a crop that has more than a two-year pre-productive period, the tax rules for handling the associated expenses can be confusing. 

IRS Audits and Statutory Protection

Overview

Much has been made of the provision in the “Inflation Reduction Act” that would allow the IRS to hire over 80,000 agents.  To an extent, this is necessary.  The IRS currently has 78,000 agents, but 50,000 of them are set to retire in the next few years.  Title I, Part 3, Sec. 10301 of H.R. 5376 is entitled, “Enhancement of Internal Revenue Service Resources.”  The provision allocates $3,181,500 to “taxpayer services,” $45,637,400,000 to “enforcement,” $25,326,400,000 to “operations support,” $4,750,700,000 to “Business Systems Modernization,” $15,000,000 for IRS to develop a report to the Congress within nine months of enactment of the law on the cost of developing and running a free direct efile tax return system; $403,000,000 to the Treasury Inspector General for Tax Administration; $104,533,803 to the Office of Tax Policy; $153,000,000 to the U.S. Tax Court; and $50,000,000 to the Treasury Department Offices for implementation.

It’s the enforcement funding that received much of the public’s attention.  The enforcement funding provision is by far the most funded provision and reads as follows:

“For necessary expenses for tax enforcement activities of the Internal Revenue Service to determine and collect owed taxes, to provide legal and litigation support, to conduct criminal investigations,… to provide digital asset monitoring and compliance activities, to enforce criminal statutes related to violations of internal revenue laws and other financial crimes….”

Clearly the emphasis of the Congressional funding is to ramp up taxpayer audits rather than improving IRS service.  Taxpayers preparing their own returns will certainly be targeted – that’s “low hanging fruit” for the IRS.  Also, small businesses will likely be in the crosshairs of the IRS as will any businesses that deal in cash.  It also appears the emphasis is intended to include cryptocurrency transactions. 

Experiencing a tax audit can be a traumatic experience.  Often, the level of trauma depends on the examining agent(s).  It can also depend on how aggressive the IRS National Office is on the issue under examination.  With the massive increase in funding, IRS can “afford” to be more aggressive. But, a question is that once an audit is completed can the IRS return to the same issue involving the same tax year and with the same taxpayer and get a “do-over”?  In other words, how many times can the IRS audit the same issue?  The increased funding will give the IRS the chance to do this.  But can it?

The ability of IRS to re-audit issues that have been examined and resolved – it’s the topic of today’s post.

Applicable Code Section

In 1921, the Congress enacted I.R.C. 7605(b) as a reaction to constituent complaints that the IRS was abusing its power by subjecting taxpayers to unnecessary audits.  See H.R. Rep. No. 67-350, at 16 (1921).  Based on the recorded legislative history, the purpose of the new Code section was to relieve taxpayers from “unnecessary annoyance” by the IRS.  See statement of Sen. Penrose at 61 Cong. Rec. 5855 (Sept. 28, 1921). 

I.R.C. §7605(b) states as follows:

“No taxpayer shall be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the Secretary, after investigation, notifies the taxpayer in writing that an additional inspection is necessary.”

Thus, the provision bars the IRS from conducting “unnecessary examination or investigations” and conducting more than a single investigation of a taxpayer’s “books of account” for a tax year.  But, if any investigation is legitimate, the courts generally don’t get in the way of the IRS.  Instead, the courts have tended to focus on the “unnecessary” language in the statute rather than the “single investigation” part of the provision.  See, e.g, United States v. Schwartz, 469 F.2d 977 (5th Cir. 1972); United States v. Kendrick, 518 F.2d 842 (7th Cir. 1975).  In addition, the provision has been interpreted so as to not prevent an IRS agent from “diligently exercising his statutory duty of collecting the revenues.”  Benjamin v. Comr., 66 T.C. 1084 (1976).  The public purpose of collecting revenues duly owed is of utmost importance to the courts, and the statutory provision is not to be read in such a broad manner as to defeat that purpose.  At least that’s how the U.S. Court of Appeals construed the statute in a 1963 case.  DeMasters v. Arend, 313 F.2d 79 (9th Cir. 1963).   

Recent Case

In 2020, the U.S. Tax Court addressed the application of I.R.C. §7605(b) in a case involving a surgeon (the petitioner) that inherited his mother’s IRA upon her death in 2013 – one that she had received upon her husband’s (the petitioner’s father) death.  In Essner v. Comr., T.C. Memo. 2020-23, the petitioner then took distributions from the IRA in 2014 and 2015.  He didn’t tell his return preparer that he had taken sizable distributions in either 2014 or 2015, and didn’t ask for guidance from the preparer on how to treat the distributions for tax purposes.  Even though he received a Form 1099-R for the distributions received in 2014 and 2015, he didn’t report them in income for either year.  The IRS Automated Underreporting (AUR) program, caught the discrepancy on the returns and generated a notice to the petitioner seeking more information and substantiation.  After a second notice, the petitioner responded in handwriting that he disagreed with having the distributions included in income.  While the AUR review was ongoing, the IRS sent the petitioner a letter in late 2016 informing him that his 2014 return had been selected for audit and requesting copies of his 2013 through 2015 returns.  The audit focused on various claimed expenses, but did not focus on the IRA distributions.  The examining agent was unaware of the AUR’s actions concerning the 2014 and 2015 returns.  The examining agent sent the petitioner a letter in early 2017 with proposed adjustments, later revising it upon receipt of additional information.  Neither letter mentioned the issue with the IRA distributions, and the petitioner sent a letter to the IRS agent requesting confirmation that his IRA distribution received in 2014 was not taxable.  17 days later, the petitioner filed a Tax Court petitioner challenging a notice of deficiency that the AUR had generated seven days before the examining agent’s original letter proposing adjustments to the 2014 return.  About seven months later the IRS issued a notice of deficiency to the petitioner asserting a $101,750 tax deficiency for the 2015 tax year and an accuracy-related penalty.  The petitioner filed another Tax Court petition concerning the 2015 tax year. 

At trial, the petitioner couldn’t establish that any portion of the distributions he received represented a return of his father’s original investment and the Tax Court sustained the IRS position that the distributions were fully taxable.  The petitioner also claimed that I.R.C. §7605(b) barred the IRS from assessing the proposed deficiency for 2014 because the concurrent review of the 2014 return by the AUR and the agent constituted a “second inspection” of his books and records for 2014.  The Tax Court, based on its prior decision in Digby v. Comr., 103 T.C. 441 (1994), framed the issue of whether the examination was unnecessary or unauthorized, and noted that the U.S. Supreme Court has explained that I.R.C. §7605 imposes “no severe restriction” on the power of the IRS to investigate taxpayers.  United States v. Powell, 379 U.S. 48 (1964).  The Tax Court noted that the AUR didn’t inspect the petitioner’s books, but merely based its review on third-party information returns – there was no “examination” of the 2014 return.  Accordingly, the Tax Court concluded that the AUR program’s matching of third-party-reported payment information against his already-filed 2014 return was not an “examination” of his records.  There was no violation of I.R.C. §7605(b).  The Tax Court also upheld the accuracy-related penalty.

Recent Chief Counsel Legal Advice

In 2021, the IRS Chief Counsel’s Office addressed the I.R.C. §7605(b) issue with respect to net operating loss (NOL) carrybacks.  This time the outcome was favorable for the taxpayer.  Under the facts of CCM 20202501F (May 7, 2020), the taxpayer was a hedge fund operator and a former investment banker that bought a vineyard.  The vineyard also included a house, guesthouse, caretaker’s house, and olive grove. The IRS conducted an audit resulting in the issuance of a Notice of Proposed Adjustment disallowing all expenses and depreciation deductions related to the vineyard for the prior tax years under audit. The IRS took the position that the vineyard was a hobby activity under I.R.C. §183 for those years.

On further review, the IRS Appeals Office determined that the taxpayer’s vineyard activity was not a hobby for those tax years based on its conclusion that all of the nine-factors contained in Treas. Reg. §1.183-2(b) were in the taxpayer’s favor and, as a result, the deductions and expenses claimed in those years were allowable which resulted in a net operating loss (NOL). The IRS again audited the taxpayer in a later year on the hobby activity issue.  Also at issue was whether the taxpayer could deduct an NOL carryforward originating from the tax years that had previously been audited and for which IRS Appeals had determined that the vineyard activity was not a hobby The taxpayer asserted that the second audit stemmed from previously audited tax years and violation I.R.C. §7605(b) as a repetitive audit. The IRS sought guidance from the IRS Chief Counsel’s Office (CCO).

The CCO noted that I.R.C. §7605 bars the IRS from conducting more than a single inspection of a taxpayer’s books of account for a tax year to prevent an “unnecessary” examination or “unnecessary annoyance.” As noted above, existing caselaw does not prevent the IRS from auditing a later year based on a taxpayer’s transactions that originated from records that had been part of a prior audit.  However, the CCO concluded the taxpayer’s situation was different. Here, the CCO noted, the taxpayer had been previously examined and prevailed at the IRS Appeals Office level. The losses allowed in the prior years under examination were properly carried forward, and IRS was disallowing the NOL carryforward on the second audit for the same reason that the IRS Appeals Office had previously considered and ruled in the petitioner’s favor. The CCO determined that this amounted to a “second examination” or “repetitive audit” that I.R.C. §7605 barred. Had the NOL carryforward been disallowed for a different reason, the CCO noted, a second examination would have been proper. 

Conclusion

Almost 100 years ago, the Congress determined that taxpayers needed protection against abuses from the IRS.  That determination manifested itself in I.R.C. §7605(b) which was enacted within the first ten years of the creation of the tax Code.  But, whether or not the IRS can get a “second-bite” at the audit apple is highly fact-dependent. 

With the increased funding, if it stays in place, will certainly lead to increased audits.  There is some statutory protection, however, against IRS audit abuse.

Court Says COE Acted Arbitrarily When Declining Jurisdiction Over Farmland

Overview

An issue that troubles many farmers and ranchers is the federal government’s regulation of farmland and farming activities.  Two primary regulatory agencies are the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE).  They have jurisdiction to regulate the “waters of the United States” (WOTUS) and the scope of that jurisdiction has been a big issue for many years and has generated innumerable court decisions. 

A recent case involved the issue of the COE deciding not to regulate a wet area on a farm and whether the decision not to exercise jurisdiction was done properly.  The court’s decision is instructive on the procedure for determining the existence of a wetland, what “prior converted cropland is” and how the agency should properly decline to regulate

The COE’s regulation of farmland - it’s the topic of today’s post.

Background

Facts of the case.  In Hoosier Environmental Council, et al. v. Natural Prairie Indiana Farmland Holdings, LLC, et al., 564 F. Supp. 3d 683 (N.D. Ind. 2021), the defendant acquired farmland to build and operate a concentrated animal feeding operation (CAFO) with over 4,350 dairy cows.  The COE inspected the property and concluded that much of the land was not subject to the Clean Water Act. The plaintiffs, two environmental groups sued alleging that the defendant violated the Clean Water Act (CWA) and that the COE’s administrative jurisdictional determination violated the Administrative Procedures Act (APA).  The land at issue was drained in the early 1900's via the creation of several large ditches and drainage canals to move surface water into the Kankakee River 9.5 miles downstream.  The CAFO was constructed on what had been a lakebed over a century ago, and two of the drainage ditches are on the defendant’s land. 

Note:  The lake was totally drained in the early 1990s to make farmland.  Vested with that is the right to maintain the drain.  See, e.g., Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).  It is immaterial what the size of the lake was or whether it was where a marsh was at some time in the past.  The land at issue was completely transformed to farmland long before the defendant acquired the land at issue. 

The plaintiffs claimed that the defendant filled nearly half a mile of one ditch and installed drainage tile to drain excess water, filled and tiled various lateral ditches attached or near both ditches.  After the alterations the plaintiffs contacted the COE to determine if the ditches, lateral ditches and land were subject to federal regulation.  The COE investigated and determined that neither the defendant’s land nor the lateral ditches were jurisdictional wetlands but did conclude that the two drainage ditches were jurisdictional.  

The plaintiffs sought judicial review of the COE’s determination to not regulate the defendant’s land or lateral ditches.  The plaintiff asserted that the defendant’s filling and tiling activities required CWA permits for dredged or fill material, and a pollution discharge permit.  The plaintiffs claimed that the manipulation of the hydrology and drainage at the CAFO site would degrade the nature and wildlife areas and waters and diminish their ability to continue using and enjoying them.  The plaintiffs also claimed that the COE’s wetland determination was arbitrary and capricious because the agency made its conclusion without relying on the relevant wetland factors articulated in the COE’s technical guidance manuals. The COE asserted that its guidance’s procedures weren’t applicable and that the administrative record supported its decision.

Standing.  The court determined that the plaintiffs had standing to sue because their members have been and would continue to be injured by the defendant’s activities, and that the plaintiffs’ restorative activities on an adjacent downstream tract that the plaintiffs’ members use for various recreational activities would be harmed.  The court also pointed out that at least three members got their water from downstream private wells.  The plaintiffs’ “wetland scientist and drainage expert” provided an opinion that the COE’s decision to not assert jurisdiction and the defendant’s continued hydrological changes to the property would “result in a loss of stream and wetland functions on the dairy’s property that would alter hydrology and water quality downstream within Kankakee Sands.” 

The court’s opinion gave no indication of the COE’s response to the opinion of the plaintiffs’ expert.  Given the recited facts of the case, hydrologic changes by the dairy’s activities would have no impact on the Kankakee Sands, a nearby 10,000-acre restored tallgrass prairie.  The topography shows that the site does not drain onto the Kankakee Sands.  Instead, the area drains into the Bogus Island Ditch which is well downstream from the dairy.  In addition, state law waste management plans protect the drinking water wells at issue from contamination.   Also, there is no public access to the ditches.  A “wetland and erosion scientist” directly attributed the consequences of the COE’s decision and the prior and ongoing activities of the dairy to “a loss of stream and wetland functions on the dairy’s property that will alter hydrology and water quality downstream within Kankakee Sands.”   But this assertion seems far-fetched.  Filling a small ditch that doesn’t drain into the Kankakee Sands will have no material effect. 

Note:  If the Congress intended this result, then a court could extend standing to environmental groups for drainage improvement projects on agricultural land.  However, the Congress did not intend that to occur. 

The court stated that the plaintiffs had explained that the dairy’s discharges created “reasonable concerns” and that were “fairly traceable” to the dairy’s actions.  However, what the plaintiffs complained about was the filling of a ditch and the replacement of its function with a tile.  “Reasonable concerns” are not relevant for a jurisdictional determination.  The issue is whether there is a hydrological connection between Kankakee Sands and the ditch fill at the dairy.  

What is a “Wetland”?

Before diving into the court’s “analysis,” a brief sidestep is necessary.  When the Congress created the CWA, it failed to provide a definition of a “wetland,” instead leaving the matter up to the administrative agencies responsible for implementing the law.  Under the COE’s rules, a wetland requires a finding of the presence of hydrophytic vegetation, hydric soil and wetland hydrology under a subject tract’s “normal circumstances.”  Under the COE’s initial procedures for delineating a wetland, it must determine that a site has been altered, and determine when the alteration occurred and characterize the land as it existed before the alterations. 

“Prior converted cropland” is wetland that was manipulated and cropped before December 23, 1985, which no longer contains key wetland indicators.  33 C.F.R. § 328.3(a)(8); 7 C.F.R. § 12.2(a)(8); COE Regulatory Guidance Letter 90-07 ¶5(a).  A “farmed wetland” is a wetland that was manipulated and cropped before December 23, 1985, but which still contains key wetland indicators.  7 C.F.R. § 12.2(a)(4); COE Regulatory Guidance Letter 90-07 ¶5(b). A farmed wetland could still be a jurisdictional wetland, but prior converted cropland is non-jurisdictional. 33 C.F.R. § 328.3(a)(8).  Thus, when recent alterations are present on agricultural land, before the COE can decide which delineation methodology to use, a detailed assessment of the changes in the hydrology, vegetation, and soil must occur.  However, in this instance, the COE noted that the land in question had been drained nearly 100 years ago and continuously row cropped since 1939 (well before the effective date of the 1985 Farm Bill), its normal circumstance was as farmland that did not contain wetland indicators and was, therefore, non-jurisdictional prior converted cropland.  While hydric soil was present, to find a jurisdictional wetland, all three indicators must be present. 

Note:  In its original version, the COE’s 1987 Manual defined “normal circumstances” as what vegetation is commonly present, not what would exist if the land was not disturbed.  This was later changed by “notes” added to the 1987 Manual when the Congress outlawed the 1989 Manual.  Those explanatory notes changed “normal circumstances” to mean vegetation that would exist if the land was not disturbed and planted.  The COE uses reference sites with similar hydrology and soils.  If wetland vegetation exists, the COE assumes that it exists on the disturbed tract.  However, hydrology still must be present for a wetland to be deemed to exist (as much as the bureaucracy wishes it did not).  B & D Land and Livestock Co. v. Veneman, 231 F. Supp. 2d 895 (N.D. Iowa 2002).

The Court’s Analysis

The primary issue before the court was whether the COE’s determination that the land was prior converted wetland (and therefore not subject to COE regulation) was arbitrary and capricious.  The court examined the record to determine if the COE followed its own guidance for delineating wetlands.  The court noted that the administrative record lacked any description of the prior drainage system (the series of medial and lateral ditches transecting the property before defendant’s alterations), the defendant’s new drainage system, how these systems were designed to function, and whether they were effective in removing wetland hydrology from the area.  

Note:  While the plaintiffs made much ado about the COE’s lack of consideration of the hydrology of the land before the farm’s alterations, that is largely an irrelevant point.  Famers are entitled to maintain the “wetland and farming regime” on the land and may engage in whatever drainage activities necessary to keep that historic farming activity and production.  The land in question had been converted to farmland many decades earlier and had been constantly maintained in that status.

The court examined aerial photographs, noting that there was an absence of data identified in the COE’s “Midwest Supplement” to assess the relevant drainage factors, including how the existing and current drainage systems were designed to function, whether they were effective in removing wetland hydrology from the area, and when any conversion occurred.  The absence of these sources, coupled with an absence of any meaningful discussion of the hydrology of the site before the defendant’s alterations, led the court to believe that the COE failed to follow the procedures outlined in its own guidance in deciding the land was prior converted cropland.  The COE also reviewed 14 aerial photographs that spanned from 1938 to 2017.  Those photos showed the presence of row cropping and offered no evidence of potential wetlands.  Relying on aerial photographs, the COE expert’s determination and a determination of the Natural Resources Conservation Service to conclude that wetlands did not exist was certainly appropriate. 

Note:  In addition, the court’s analysis on this point is suspect.  The COE did not need to find and document all three factors.  The hydrology had been materially altered to enable consistent row crop farming.  In that situation wetland hydrology is not present, and the area in question is not a wetland.  As a result, other levees, systems or dams do not alter area hydrology because there is not wetland hydrology present to alter.  The court referred to the COE’s 1987 Manual for its conclusion that the COE didn’t follow its own procedures.  However, the 1987 Manual was established to evaluate recent alterations to undisturbed wetland.  The court incorrectly applied this standard to materially hydrologically altered wetland where the alteration had occurred a century earlier.  As such, the land in issue was prior converted wetland.  The court incorrectly applied the standards of the 1987 Manual to the facts before it involving alterations that occurred over 100 years ago.    

The court also determined that there was no indication in the record that the aerial photographs were used to assess hydrology characteristics of the defendant’s land before alterations were made, how the drainage systems were designed to function, and how effectively and efficiently they could convert land from wetland to upland.  Further, the court noted there was also no explanation why the COE skipped these steps.  The COE took the position that its review of aerial photographs was sufficient to determine the land’s normal circumstances. The court disagreed, determining that the evidence did not support the COE’s claim that its decision was based on identified relevant factors.  Instead, the court concluded that the COE made impermissible post hoc justifications.  If reliance on its own manuals was not warranted in this situation, the court stated, the COE needed to provide a rationale.  As such, the court determined that the evidence did not support the COE’s argument that its decision was rationally based on the relevant wetland hydrological factors before concluding the land was prior converted cropland.  Absent that rationale, the COE’s determination of wetland status of the defendant’s farmland was arbitrary and capricious. 

Note:  The COE followed its correct procedure in this case contained in the Midwest Supplement and also accepted a prior USDA determination as to the land’s status for federal farm program purposes.  The ditches and drains that were legally installed successfully removed wetland hydrology.  The COE did not deviate from its own regulatory guidance and procedures, but the court assumed that it did.  There was no need for the COE to find and document all three wetland characteristic factors.  The elimination of wetland hydrology eliminates the possibility that the land was a wetland. 

Concerning the lateral ditch, the plaintiffs claimed that the record did not support the COE’s conclusion that the lateral ditches were irrigation canals that drained uplands and lacked relatively permanent flow.  The plaintiffs pointed to a lack of administrative record and the claimed failure of the COE to follow the relevant factors that it lists in its Approved Jurisdictional Determination Form.   The court also held that the COE’s finding of non-jurisdiction over the lateral ditches was arbitrary and capricious. 

The court remanded the case to the COE conduct a more thorough investigation of the defendant’s tract.

Conclusion

The court’s decision correctly points out that administrative agencies must follow their own rules and procedures in delineating wetlands.  Even a finding of non-jurisdiction based on prior converted cropland status must be supported by the administrative record and be sufficient to allow a court to determine that the agency followed the proper process.  That much is certainly true.  The COE did follow the correct procedure in this case or declined to assert jurisdiction.  Unfortunately, the court’s opinion reveals a lack of understanding of the process for delineating wetlands and wetland hydrology.  As part of its finding that the COE acted in an arbitrary and capricious manner in reaching its conclusion that the land in issue was prior converted wetland, the court stated that ditches and drainage tile impact hydrology in different ways.  This is not correct, and it influenced the court’s conclusion that the COE used an inappropriate delineation methodology without explanation, which was arbitrary.  However, ditches and drainage tile lines affect groundwater drawdowns identically based upon depth.  Once the COE determined that wetland hydrology wasn’t present, the matter was over.  There was no wetland.    

Aside from the questionable grant of standing, the court waded deep into a subject that is highly technical and which it did not understand sufficiently to be able to sort out proper wetland delineation procedures. Perhaps the same can be said for the dairy’s lawyers – it’s difficult to imagine how the briefs filed on behalf of the dairy didn’t provide some sort of an indication in the court’s opinion of guidance on how the COE delineates wetlands and that the COE’s decision-making process was not arbitrary and capricious.

For farmers, the case is a frustrating one.  At issue was land that had been farmed for over 80 years and the right to continue to farm consistent with the historic drainage of the property was caught up in bureaucratic red tape.  The court’s expansive view of standing and lack of understanding of the actual science behind the hydrology and geographic facts of the case created a problem for a dairy operation that should have never happened.  What was involved in the case were shallow ditches dug into prior converted wetland.  That is an activity that the CWA does not regulate.