Friday, March 18, 2022

Agritourism

Overview

Agritourism activities have expanded in recent years as an additional income stream for some farming and ranching operations and rural landowners in general, generating about $1 billion dollars nationwide.  But, engaging in an agritourism activity (or activities) on the premises means that members of the public will be invited to be present upon paying a fee.  That raises the prospect of injury and potential liability. 

The liability issue is a major concern for landowners.  In the U.S., about 80 percent of respondents to a survey listed concerns about liability as a limiting factor of engaging in agritourism activities.  Chase, et al., Agritourism and On-Farm Direct Sales Survey:  Results for Vermont, University of Vermont extension (2021).   Also, about that same percentage were worried about the cost and availability of insurance.  Id.  To address landowner liability and other concerns, and incentivize agritourism activities, many states have enacted agritourism statutes.  What does such legislation do?  What liability protection is provided?

Agritourism laws – it’s the topic of today’s post.

In General

Agritourism generally includes numerous activities on a rural property associated with either entertainment, recreational, educational and even commercial activities.  The USDA defines agritourism (and recreational) activities generally as “hunting, fishing, farm or wine tours, hayrides, etc.” USDA National Agricultural Statistics Service (NASS), 2017 Census of Agriculture, Explanation and Census of Agricultural Report Form, B-24 Appendix B (2019)).  Also commonly treated as agritourism are famers markets, roadside farm stands and “U-Pick” operations, but a permit may be required.  See e.g., Utah Code Ann. §26-15B-105.  It is also possible that the definition of “agritourism” could be statutorily defined to include certain types of overnight accommodations, hayrides, corn mazes, riding on tractors and other farm equipment, riding on horses, playing around or climbing on hay bales, and weddings.  See, e.g., Va. Code Ann. §3-2-6400.  The definition may also include camping and tours of the property.  But some states exclude some of these activities from the definition of agritourism.  The key is to always check the specifics of state law.

Federal Law

In early 2022, H.R. 6408 was introduced into the U.S. House of Representatives.  The bill would create a Department of Agritourism.  The bill defines “agritourism” to include education, outdoor recreation, entertainment, direct sales. the provision of certain types of accommodations, and dining on a farm.  The bill was introduced into the House Agriculture Committee on January 13, 2022, where it presently remains. 

State Laws 

Liability.  In recent years, numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.”  A majority of states now have enacted such laws. Typically, the legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and [who] provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity.  See, e.g., Tenn. Code Ann. §43-39-103 (requiring posting of warning signs informing of no liability for injury or death arising from inherent risks).  Without such liability protection a landowner is generally held liable for an injury to an invited guest under a high standard of care that requires the landowner to make sure the premises is safe, exercise reasonable care under the circumstances, and warn of hidden dangers. 

The statutes tend to be written very broadly and have various standards of care that might apply to a landowner.  For instance, legislation introduced into the Illinois legislature in early 2022 would grant liability protection to landowners for claims arising from participation in broadly defined agritourism activities.  IL H.B. 5487.  If the “agritourism operator” posts the statutorily required warning notice, the operator is not liable for the injury or death of a participant resulting from the inherent risks of participating in an agritourism activity.  The operator is not protected, however, if the operator acts with willful or wanton disregard for the participant’s safety and the operator’s conduct is causally related to the participant’s injury or death.  The same is true if the operator fails to disclose known inherent risks. 

Note:  Many states have statutory provisions similar to what Illinois is considering.  For instance, with many state statutes, the landowner must post warning signs to receive the protection of the statute, and in some states the landowner must register their property with the state. See, e.g., 3 Pa. Stat. §2604.

This modification in the standard of care under an agritourism statute is common among the states with an agritourism statute. See, e.g., N.C. Gen. Stat. §99E-1(a); 4 Tex. Admin. Code §75A.002(a)(1)-(2).  Under these state statutes, liability is limited in situations where the landowner acted wantonly or with willful negligence, and liability is excluded for injury arising from the inherent risks associated with an active farming operation.  In many of the states that have agritourism statutes, the posting of specific signage is required to get the liability protection and, of course, the person claiming the protection of the statute must meet the definition of a covered person and the activity that gave rise to the liability claim must be a statutorily covered activity.  Further, in some states (such as Iowa), liability release forms, at least with respect to minors, may be deemed to violate “public policy” (as decided by judges rather than the public). 

Exclusions.  Some activities may be excluded from the definition of “agritourism” under a state’s statute. Common activities that might be excluded are roadside fruit and vegetable stands; operations that are solely for the purpose of selling or merchandising food; marijuana-related activities (even if permissible under state law); rodeos; sky and water diving; paintball; various types of bicycling; activities in structures primarily intended for use by the general public; and various types of animal therapy activities.  Again, the point is that each state statute is unique to that particular state and before starting an agritourism activity, the landowner/operator must be familiar with the applicable rules.

Compensation.  There are also differences among state agritourism statutes as to whether charging participants a fee changes the landowner/operator’s duty of care.  In most of the states with an agritourism statute, the liability protection of the statute applies if the landowner charges a fee.  That is the case in AR, CO, DE, FL, KS, KY, ME, MN, MO, NC, ND, OK, OR, SD, TN, TX, VA and WI.  But, in Alaska, no heightened liability protection is provided by the agritourism statute if a fee must be paid to access the land at issue to engage in an agritourism activity.  Alaska Stat. §09.65.202(c)(1). 

Other states with an agritourism statute do not mention the issue of compensation and whether charging a fee changes the liability protection of the statute. 

Financial incentives.  Some state laws related to agritourism relate to financial incentives via tax credits or cost-sharing, promotion, exemption from permits, protecting the ag real property tax classification of the property involved or providing special classification for structures used for agritourism activities. See, e.g., Md. Code Pub. Safety §12-508 (exempting buildings used for agritourism from performance standards and building permit requirements); Neb. Rev. Stat. §75-303(3)(exempting motor carriers from certain requirements if engaged in transportation related to agritourism); S.C. Code Ann. §6-9-67 (classifying certain structures without a commercial kitchen used in agritourism activity as ag and removes sprinkler system requirement). 

Some states address agritourism activities either via laws governing agriculture in general or via land-use/zoning laws.  This is particular true for activities that are “events.”  For example, Pennsylvania law doesn’t provide any liability protection for injuries occurring during weddings or concerts on the premises.  3 Pa. Stat. §§2603(c)(2)-(3) et seq. 

On the tax classification issue, Ohio law includes agritourism in the definition of “land exclusively used devoted to agriculture” for tax assessment purposes.  Ohio Rev. Code. §5713.30(A)(4).  Thus, the definition of “agritourism” is critical in receiving ag classification.  On that issue, the Ohio Supreme Court, in Columbia Township Board of Zoning v. Otis, 663 N.E.2d 377, 104 Ohio App. 3d 756 (Ohio 1995), held that haunted hay rides on farm property did not constitute the use of land for agricultural purposes because the addition of a Halloween theme with shrieks and flashing lights was completely inconsistent with traditional agricultural activity.  Similarly, in Shore v. Maple Lane Farms, LLC, 411 S.W.3d 405 (Tenn. Sup. Ct. 2013), the Tennessee Supreme Court reversed a determination by the court of appeals that music concerts on a farm were within the definition of farm activities within the scope of the agritourism statute and were exempt from a county zoning provision.  The Tennessee Supreme Court said the activity was not “agriculture” as defined by the statute.  Likewise, in Forster v. Town of Henniker, 167 N.H. 745 (2015)the court held that the use of a Christmas tree farm for weddings did not meet the definition of agritourism and, as a result, was not “agriculture” for zoning purposes. 

Note:  On the tax classification/zoning issue, a state agritourism statute may define an agritourism activity involving an event (such as a wedding, concert or festival, etc.) by reference to local zoning rules and ordinances.  Such local rules and ordinances may set size limitations, require certain permits, set operational standards and address issues involving sound and light, and restrict the number of guests/participants based on local conditions. 

Insurance.  Any landowner conducting an agritourism activity on their property should make sure insurance coverage is adequate.  It is not likely that a comprehensive farm/ranch liability policy will cover any claims arising from the activity.  That’s because an agritourism activity will likely be classified as a non-farm business pursuit of the insured that is excluded from policy coverage.  Thus, a separate rider (or policy) may be necessary to provide adequate insurance coverage.

Conclusion

Agritourism activities on a farm or ranch or other rural land can provide an additional income stream for the landowner.  For farmers and ranchers, that may be particularly important if current ag markets in Russia, China or Ukraine become lost in the long-term. 

March 18, 2022 in Civil Liabilities | Permalink | Comments (0)

Wednesday, March 16, 2022

Family Settlement Agreement – Is it a Good Idea?

Overview

A family settlement agreement is a way for heirs to agree to a distribution of the decedent’s estate that is different from how the decedent desired.  While most estates are handled and the decedent’s property is distributed in the manner the decedent wanted, sometimes there might be a mistake in the will or some other unanticipated result as a consequence of poor drafting of an estate plan.  In those instances, a family settlement agreement may be appropriate.

When will a family settlement agreement be effective to resolve a decedent’s estate and distribute estate property – it’s the topic of today’s post.

In General

Contract.  A family settlement agreement is a contract.  Thus, if it meets the requirements for a valid contract, it is a binding agreement that the probate court must respect.  It’s not up to the probate judge to approve or disapprove the document.  About the only issue a probate judge would deal with concerning a family settlement agreement is if there are creditors of the decedent’s estate and the funds available to pay estate debts. 

As a contract, a family settlement agreement must be agreed to by all of the heirs and beneficiaries, provide that the decedent’s will is not to be probated, and provide a plan for the distribution of the decedent’s assets that replaces the disposition of assets set forth in the decedent’s will.  In addition, it is critical that the terms of the agreement be negotiated as part of a transaction entered into at arm’s-length.  That means that the terms of the agreement shouldn’t simply be standard “boilerplate” terms that aren’t discussed by the family.  Also, it is important that the family members be represented by legal counsel, and it’s helpful that they have some understanding of business matters.  Legal representation s particularly important for a family member that is complaining about the disposition of assets under the terms of the decedent’s will.  It’s also important that the release language in the agreement be clear, and the agreement must evidence that the parties (heirs) were working to achieve final settlement of all claims.  If these factors are satisfied, the agreement is binding on the parties and will provide protection against future liability and claims. 

Appropriate use.  A family settlement agreement can be appropriate when surviving family members agree as to the disposition of a deceased family member’s estate that is different from how the decedent had specified in a testamentary instrument.  Often, they arise when a deceased parent has not devised property equally to all of the decedent’s children, but the children (and, perhaps a surviving spouse) agree that an equal division should be made.  In addition, a family settlement agreement might lead to a better tax result for the estate over what would have occurred based on how the decedent’s estate plan was drafted.  Or, perhaps the decedent’s will made a simple mistake – such as a specific devise of a tract of farmland to the wrong child as the farming heir.  A family settlement agreement can be an efficient way to “clean up” the error. 

Another common situation for the use of a family settlement agreement can occur with second (or subsequent) marriages and each spouse has their own child or children.  Consider the following example:

Example:  Sam and Lisa are married.  It is the second marriage for each of them, and they each have adult children from a prior marriage, but none from their marriage.  Sam farmed during his life and dies with a will that leaves all of his property to his children.  Under state law, Lisa is entitled to a “family allowance” and the use of their home that she can claim as her homestead.  But, Lisa would rather live near her children in a different state.  The problem is that if she moves from the homestead, she loses it along with her family allowance.  Sam’s children would like to have the homestead – 160 acres of irrigated farmland.  Via a family settlement agreement, Sam’s children and Lisa might be able to agree that instead of Lisa receiving a family allowance, she could receive annual payments for a number of years with which she could buy a home near her children.  Sam’s children could use the rental income from the farmland to fund the payments to Lisa, or sell the home and the farmland and use a part of the sale proceeds to fund the annual payments to Lisa. 

A family settlement agreement may also be used to prevent a will challenge by a disaffected heir that might result in a drawn-out probate proceeding, as well as a spendthrift heir likely to squander their inheritance and seek more from the estate. 

Recent Case

A recent case from Texas illustrates the use and enforceability of a family settlement agreement.  In Austin Trust Co. v. Houren, No. 14-19-00387-CV, 2021 Tex. App. 1955 (Tex. Ct. App. Mar. 16, 2021), the decedent (former Mayor of Houston, Texas, and real estate developer) died in 2014, having outlived his wife by 30 years.  The couple had five children.  The pre-deceased spouse’s will created a marital trust upon her death for the decedent, naming him the sole trustee and beneficiary for life.  The trust was funded with about $54 million, which represented her half of the couple’s community property.  Under the trust’s terms, he could also pay himself any amounts he deemed necessary for his “health, support, or maintenance in his accustomed standard of living.”  He could also utilize trust principal for this purpose, and he was also given a testamentary power of appointment over the balance of principal in the marital trust in favor of their children, their spouses, or unspecified charities.  In his will, he exercised the power and directed that the balance of trust assets passed to a trust for the benefit of the children.  The decedent’s other asset passed to his second wife and her two children. 

The marital trust terminated upon the decedent’s death and a bank became the trustee for purposes of administration and making final distributions.  The decedent’s attorney served as the executor of the estate.  Because the marital trust was a qualified terminable interest property (QTIP) trust, the decedent’s estate was entitled to recover from the marital trust and the trust for the children any federal estate tax that the decedent’s estate owed.  Thus, the bank (as trustee of the marital trust) would not make distributions until a federal estate tax return was filed and an estate tax closing letter was received from the IRS.  Because of this anticipated delay in distributions from the trust, the children expressed their desire for the marital trust to distribute its assets to their trust before the estate tax return was filed and a closing letter received.  To accommodate this desire without fear of any future claims, the decedent’s attorney set up a meeting with the couple’s children, bank and the children of the surviving wife.  The couple’s children and the bank were represented by their own legal counsel.  At the meeting the attorney proposed a family settlement agreement.  Various disclosures were made, including one that the plaintiff relied upon to claim that the decedent either owed the marital trust $37 million or breach a fiduciary duty by taking excessive distributions of principal totaling $37 million. 

The family settlement agreement released, “any and all liability arising from any and all Claims,” including “claims of any form of sole contributory concurrent, gross, or other negligence, undue influence, duress, breach of fiduciary duty, or other misconduct” and defined “covered activities” to include “(1) the formation, operation, management, or administration of the Estate,…or the Trusts, (2) the distribution of any property or asset of or by…the Estate,…or the Trusts, (3) any actions taken (or not taken) in reliance upon this Agreement or the facts listed in Article I,” (4) “any Claims related to, based upon, or made evident in the Disclosures,” and (5) “any Claims related to, based upon, or made evident in the facts set forth in Article I.”   

Ultimately, after review by the attorneys involved and disclosure and review by the parties, all of the parties signed the family settlement agreement agreeing to all of the release and indemnity language that it contained.  Funds then began to be distributed in mid-2015 and the federal estate tax return was filed in early 2016.  After the IRS closing letter was received in mid-2016, the balance of the estate’s assets were distributed except for a small amount to cover administration costs. The alleged debt was not listed as part of the estate.

The plaintiff sought repayment of the alleged debt that the estate owed.  The plaintiff based its claim on accounting entries in the marital trust’s general ledger.  The claim was denied on the basis that the entries represented distributions from the trust rather than receivables.  The plaintiff then changed amended its claim as one for breach of fiduciary duty against the estate on the basis of excessive distributions by the decedent from the marital trust.  The trial court disagreed.

On appeal, the plaintiff claimed that the trial court incorrectly determined that the heir’s had “released their right to collect any debt from the Executor or the Estate…by executing the … Family Settlement Agreement” and that the breach of fiduciary duty claim had also been released.  The attorney for the estate replied that the trial court had correctly determined that the family settlement agreement had “unambiguously and specifically released all clams” the plaintiff may have had against the parties to the family settlement agreement, including a breach of fiduciary claim.  The appellate court affirmed the trial court, upholding the family settlement agreement. 

The appellate court noted that public policy in Texas favored freedom to contract, and that the parties freely entered into the agreement with the full opportunity to be represented by legal counsel in furtherance of their own respective interests.  The court noted six factors used by Texas court to consider when determining the validity of a family settlement agreement:

  1. Whether the terms of the agreement were negotiated rather than being boilerplate terms that were not specifically discussed by the parties;
  2. Whether the complaining party was represented by counsel;
  3. Whether negotiations occurred as part of an arms-length transaction;
  4. Whether the parties were knowledgeable in business matters;
  5. Whether the release language was clear; and
  6. Whether the parties were working to achieve a final settlement of all claims to enable them to part ways.

The appellate court determined that all six factors were satisfied.  Accordingly, the appellate court did not have the determine whether a fiduciary duty had been breached because the parties had waived the claim.

Conclusion

While a family settlement agreement can be an efficient way to resolve family disputes, it must be carefully entered into and drafted properly.   The agreement in the Texas case was done properly. 

March 16, 2022 in Estate Planning | Permalink | Comments (0)

Monday, March 14, 2022

What if Tax Rates Rise?

Overview

Current geo-political events and domestic policies are having an impact on the United States economy.  Farmers are facing incredibly higher input costs (particularly fuel and fertilizer) associated with planting spring 2022 crops.  Higher energy costs will ripple throughout the entire economy with the burden felt primarily by the middle to lower income groups. 

During practically all of 2021, talk in the Congress focused on increasing taxes.  But Senators Manchin and Sinema put a stop to that.  However, the enormous amount of government spending hasn’t stopped.  The Senate, on March 10 approved another massive $1.5 trillion omnibus spending bill.  The legislation will be signed into law.  That spending is on top of the massive amounts of spending that has occurred since the enactment of the CARES Act in late March of 2020.  The infusion of all of these dollars into the economy has caused the money supply to quadruple and is fueling inflation. 

As problems continue to rise around the world, the temptation, of course, will be for the Congress to increase taxes to generate even more revenue for itself to fund U.S. involvement in these affairs.  Will it be able to push through a tax increase before the fall Congressional elections?  If so, what might be some good tax moves to make if rates increase?

Tax strategies in anticipation of higher tax rates – it’s the topic of today’s post.

Tax Strategies

In a stable tax environment (which hasn’t been present for some time) when tax rates are not anticipated to change, the typical strategy is to delay income recognition and accelerate deductions.  But, when tax rates are expected to rise, the opposite strategy is true – accelerate income into the current (lower tax rate) year and postpone deductions to the next (higher tax rate) year. 

So how can this technique be accomplished?  Here are some possibilities:

Income acceleration.    Numerous techniques can be available based on the facts of each particular taxpayer.  One strategy is to currently sell appreciated assets.  This will trigger capital gain in the current year, rather than waiting until a later year when rates might be higher.  Also, instead of using a like-kind exchanges for real estate consider a taxable exchange.  If cancellation of debt income needs to be recognized, it might be better to time transactions such that the income is triggered in the current year.  For installment sales, such as the tax reporting for deferred grain contracts, elect out of installment treatment by reporting the income currently.  If an investment has been made in a qualified opportunity fund, consider selling or gifting it this year. 

For farming (and other) businesses, review depreciable asset to see if any assets need to be demolished or have become obsolete or otherwise abandoned, or are no longer in service.  Is there any depreciation recapture that could be triggered in the current year?  Depreciation recapture is taxed at (higher) ordinary income tax rates.  Also, if the business is presently structured as an S corporation, consider changing to a partnership.  For a farming business, not only may this result in an increase in payment limits under the farm programs, it could trigger gain recognition on the appreciation of assets in the S corporation and result in a higher income tax basis. 

Defer deductions.  As noted above, another general strategy to employ when tax rates are anticipated to be higher in the future is to defer claiming deductions.  Doing so maximizes the value of the deductions.  This can be accomplished, depending on the facts of each situation, by purchasing capital assets used in the trade or business in the higher tax rate year and otherwise making business-related investments when rates are higher.  Also, it might be better in some circumstances and with respect to certain business assets to depreciate them rather than claim either expense method depreciation or first-year bonus depreciation.  On that point, give consideration to what might be done with the assets.  Is near term depreciation recapture a possibility?  Also, an evaluation should be made of whether it might be better to structure a lease as an operating lease rather than a capital lease.  A common aspect of an operating lease is that it usually has fewer upfront expenses. 

Another way to move deductions into a future higher tax year is to pay employee accrued vacation time and bonuses after March 15.  As applied to farming and ranching operation this point is limited to those that have employees, but for those that do, the strategy will cause the deduction and the expense to match on the tax return.  In that same vein, wait to establish a qualified retirement plan until the future, higher tax rate, year.  That will generate a larger deduction.  In the current year, a non-qualified retirement plan could be created. 

If charitable deductions are a normal or desired part of the overall tax plan, bunch them up in a higher tax rate year.   This has been a strategy that some have employed in recent years as the result of tax law changes, but it also works when rates are anticipated to be higher in the future. 

Farm income averaging.  A major tool for farmers is the ability to elect to income average over a three-year period.  The technique works well when rates rise because it allows the farmer to reduce income in the high tax rate year and spread it back over prior lower rate years and fill up any unused bracket amount. Of course, the technical rules must be followed, and only “electable farm income” counts, but it is a helpful strategy that many farmers and utilize. 

Conclusion

Tax planning always takes a bit of foresight as to how economic conditions will impact a client and that client’s business.  If the Congress reacts to those economic conditions with a political response that results in higher taxes, that has a bearing on tax planning.  While it is not possible to predict the future, having a tax plan (as well as an estate/business plan) in place that is flexible enough to change with the rules can provide lasting benefits. 

Also, I am sure that you can think of tax strategies in addition to those I have listed above.

March 14, 2022 in Income Tax | Permalink | Comments (0)

Saturday, March 12, 2022

Income Tax Deferral of Crop Insurance Proceeds

Overview

Generally, crop insurance proceeds must be reported into income in the year they are received.  But crop insurance proceeds received in 2021 for crops damaged in 2021 can, by election, be reported into income in 2022.  However, to be deferable, crop insurance must be paid on account of actual physical damage or destruction to the taxpayer’s crops.  That means that some types of crop insurance may not be deferable or may only be partially deferable.  In that event, how is the determination made as to what is deferable and what is not?

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

General Rules

What does deferral apply to?  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 normal business practice to report income from sale of the crop in the later year.  I.R.C. §451(f); Treas. Reg. §1.451-6(a)(1).  Included are payments made because of damage to crops or the inability to plant crops (prevented planting payments). I.R.C. §451(f)(2).   The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”  I.R.C. §451(f)(1). 

Note:  USDA Wildfire and Hurricane Indemnity Program Plus (WHIP+) payments are considered to be the equivalent of “crop insurance.”  Thus, payment for damage occurring in 2021that was reimbursed under the WHIP+ program and was received in 2021 may be deferred to the 2022 tax year.

The 50 percent test.  Based on Rev. Rul. 74-145, 1974-1 C.B. 113, to be eligible to make an election to defer, the taxpayer must establish that a substantial part of the crop income (more than 50 percent) would have been reported in the following year under the taxpayer’s normal business practice.  If the 50 percent test is satisfied, an allocation may not be made between the two years – the taxpayer cannot elect to defer only a portion of the insurance proceeds to the following year.  It is an all or nothing election with respect to a single business.  But, when insurance proceeds are received on multiple crops, the “substantial portion” test applies to each crop independently if each crop is associated with a separate business of the taxpayer.  Otherwise, as noted, the 50 percent test is computed in the aggregate if the crops are reported as part of a single business and the election to defer is all or nothing.

The election.  The election is made by attaching a separate, signed statement to the income tax return (or an amended return) for the tax year of damage or destruction. The statement must include the taxpayer’s name and address (or that of the taxpayer’s agent), and must contain the following information:

  • A declaration that the taxpayer is making an election under I.R.C. 451(f) and Treas. Reg. §1.451-6(b)(1);
  • Identify the specific crop or crops destroyed or damaged;
  • State that under the taxpayer’s normal business practice the income derived from the crop(s) destroyed or damaged would have been included in gross income in the taxable year after the taxable year of the destruction or damage;
  • Note the cause of the destruction or damage of the crops and the date(s) on which the destruction or damage occurred;
  • Specify the total amount of payments received from insurance carriers; and
  • Provide the name(s) of any insurance carrier that made payment.

Note:  As noted, the election covers insurance proceeds attributable to all crops representing a trade or business.  A separate election should be made for each of the taxpayer’s distinct farming businesses for which separate books and records are maintained.  In addition, the election is binding for the tax year for which it is made and may only be revoked with IRS consent.  Treas. Reg. §1.451-6((b)(2). 

Tax Reporting

A farmer will receive Form 1099-Misc. for crop insurance and either Form 1099-G or Form CCC-1099-G for federal disaster payments.  As for the tax return, the election to defer crop insurance proceeds and disaster assistance is made by checking the box on line 6c of Form Schedule F and attaching the statement to the return.  The total crop insurance and federal crop disaster payments received for the tax year is reported on line 6a, even if an election is in place to include those amounts in income the next year.  The taxable amount is then entered on line 6b.  This amount does not include the proceeds that are elected to be include in income in the following year.  Then, if any crop insurance or disaster payments were deferred from the prior year into the current year, that amount is to be reported on line 6d. 

Deferral of Revenue/Yield-Based Insurance

A significant issue is whether the deferral provision also applies to crop insurance such as Revenue Protection (RP), Revenue Protection with Harvest Price Exclusion (RPHPE), Yield Protection (YP) and Group Risk Plan (GRP). These policies pay based on low revenue or yield.  However, the Code requires that, to be deferrable, payment under an insurance policy must have been made as a result of damage or destruction 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.

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 or may not qualify in their entirety. 

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 that would withstand IRS scrutiny:

Consider the following example (from, Principles of Agricultural Law, McEowen, Rel. 49-50 (Jan. 2022)):

Al Beback 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

IRS Position

The above approach was developed several years ago by Paul Neiffer and I as we worked on the issue. I then pitched the approach to appropriate IRS personnel in the IRS National Office in Washington, D.C. and was informally told that the approach looked to be appropriate.  To this date, however, IRS has not made any official pronouncement that the allocations in the example meet with its approval.

In the 2021 IRS Pub. 225 (Farmer’s Tax Guide) the IRS notes that proceeds received from revenue insurance policies may be the result of either yield loss due to physical damage or to a decline in price occurring from planting to harvest.  The IRS states, “For these policies, only the amount of the proceeds received as a result of yield loss can be deferred.”  That’s a recognition that an allocation should be made to separate out the deferable portion (relating to yield loss) from the non-deferrable portion (relating to lost revenue).  While statements in an IRS publication are not “official” IRS policy and are not substantial authority, the statement is a recognition that an allocation is appropriate.     

Conclusion

Weather damage to crops is an issue that arises somewhere across the country on an annual basis, and the deferral rule under I.R.C. §451 can be helpful to maintain consistent tax reporting treatment when crop insurance proceeds and/or federal disaster payments replace the anticipated crop income.  However, the rules on deferral are important to follow, and the type of insurance policy may influence the amount, if any, of proceeds that can be deferred.  The portion of the insurance proceeds related to yield may be deferred.  The portion related to price is not deferable.  A crop insurance agent is likely to be able to break out the two components.

As a final note, several high-profile crop insurance fraud cases have been in the courts in recent years.  That means that the federal government is examining crop insurance claims closely.

March 12, 2022 in Income Tax | Permalink | Comments (0)

Friday, March 11, 2022

Farm Wealth Transfer and Business Succession – The GRAT

Overview

The Tax Cuts and Jobs Act (TCJA) significantly increased the federal estate and gift tax exemption, and it is presently at $12.06 million for deaths occurring or gifts made in 2022.  That effectively makes federal estate and gift tax a non-issue for practically all farming and ranching operations, with or without planning.  But it is for some, and business succession planning remains as important as ever. 

Earlier this week I wrote about one possible strategy - the Intentionally Defective Grantor Trust.  Today, I discuss another possible succession planning concept – the grantor-retained annuity trust (GRAT).  It’s another technique that can allow the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.  The GRAT technique “freezes” the value of the senior family member’s highly appreciated assets at the value as of the time of the transfer to the GRAT, while providing the senior family member with an annuity payment for a term of years.  Thus, the GRAT can deliver benefits without potential transfer tax disadvantages. 

Transferring interests in a farming business (and other investment wealth) to successive generations by virtue of a GRAT – it’s the topic of today’s post.

GRAT Basics

A GRAT is an irrevocable trust to which assets are transferred.  In return, the grantor receives the right to a fixed annuity payment for a term of years, with the (non-charitable) remainder beneficiaries receiving any remaining assets at the end of the GRAT term.  The fixed payment is typically a percentage of the assets’ initial fair market value computed so as to not trigger gift tax.  In other words, the amount of the taxable gift on the transfer to the GRAT is the fair market value (FMV) of the property transferred less the value of the grantor’s retained annuity interest.  At the end of the grantor’s reserved term, the value of the remainder interest is included in the grantor’s estate for tax purposes.  See I.R.C. §2036; I.R.C. §2039. 

The term of the annuity is fixed in the instrument and is either tied to the shorter of the annuitant’s life or a specified term of years.  The annuity payment can be structured to remain the same each year or (as explained more further below) it can increase up to 120 percent annually.  However, once the annuity is established, additional property cannot be added to the GRAT.  Treas. Reg. §25.2702-3(b)(5).

Note:  The grantor receives the annuity amount annually regardless of the income that the GRAT’s assets produce.  Thus, the trustee’s job is to maximize the total return on the GRAT’s assets from income or principal appreciation.  If the GRAT income is insufficient to pay the annuity, the trustee must be required to invade the GRAT’s principal to do so.  Thus, the assets transferred to the GRAT must produce enough cash flow to pay the annuity amount or must be able to be liquidated by the trustee to pay the annuity.

Because a GRAT is a technique that is based largely on assumptions about what the interest rate will be, ideal assets to transfer to a GRAT are those that are likely to appreciate in value (such as real estate) at a rate exceeding the rate that the IRS applies (the I.R.C. §7520 rate) to the annual annuity payment the GRAT will make.  In that event, the appreciation in the GRAT assets will pass to the GRAT’s beneficiaries without triggering federal gift or estate tax to the grantor.  The actuarial value of the remainder interest in the GRAT that passes to the beneficiaries when the GRAT terminates is a gift to the remainder beneficiaries that is subject to gift tax.  But, if that actuarial value equals the value of the property transferred to the GRAT, there won’t be any gift tax. 

If the grantor outlives the term of the annuity term, the remainder passes to the beneficiaries with no additional estate tax. 

Example:  Faye, at age 55, funded an irrevocable trust with $1,000,000 in March of 2022.  The trust specified that Faye would receive an annual annuity of $50,000 for the next 10 years.  The March 2022 I.R.C. §7520 rate is 2.0 percent.   Based on the IRS specified formula, the value of Faye’s retained interest is $449,130 and the value of the remainder interest is $550,870.  The value of the remainder interest would be subject to gift tax upon the GRAT’s creation.  Because the funding of the GRAT involved a completed gift, when the GRAT terminates there will be no gift tax consequences.  The assets remaining in the GRAT are paid to the remainder beneficiaries without Faye incurring any additional gift tax.  If Faye were to die during the GRAT term with the right to receive further annuity payments, a portion of the GRAT will be included in her estate.  The included portion is that fraction of the GRAT which would be required to be invested at the I.R.C. §7520 rate in effect on Faye’s death to produce income equal to the required annuity payment.  If Faye is married and the right to the balance of the annuity payments passes to her spouse, the interest will qualify for the marital deduction if the spouse receives annuity payments that either pass outright to the surviving spouse or the surviving spouse’s estate, or will pass to a marital trust over which the spouse has a general power of appointment. 

Technical Requirements

Perhaps the most important part of a GRAT is that the trust instrument be drafted property to satisfy I.R.C. §2702.  If I.R.C. §2702 is satisfied, the grantor’s retained interest is a “qualified interest” and is subtracted from the value of the property gifted to the remainder beneficiaries.  If I.R.C. §2702 is not satisfied, the grantor’s retained interest is valued at zero and the entire value transferred to the remainder beneficiaries is a taxable gift.  To be a qualified interest, the grantor’s retained interest must be an interest consisting of the right to receive a fixed amount payable not less than annually that is a fixed percentage of the fair market value of the property in the GRAT determined on an annual basis.  The annuity’s term must be the shorter of the life of the grantor or a specified term of years (but see the discussion surrounding the Tax Court’s decision in Walton, infra.).

Note:  The value of the qualified annuity is determined via I.R.C. §7520.

It is critical to have an accurate appraisal of the assets/interests to be contributed to the GRAT.  If the appraisal is not accurate, the annuity may be determined to not be a qualified interest.  See Atkinson v. Comr., 309 F.3d 1290 (11th Cir. 2002), aff’g., 115 T.C. 26 (2000); C.C.A. 202152018 (Oct. 4, 2021).  This is a particular issue when a potential sale or merger is involved when valuing assets to be contributed to the GRAT. 

A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from either the GRAT’s income or principal.  Treas. Reg. §25.2702-3(b)(1).  There is a 105-day window within which the GRAT can satisfy the annual annuity payment requirement.  This is the case if the annuity payment is based on the GRAT’s anniversary date.  Treas. Reg. §25.2702-3(b)(4).  The window runs from the GRAT creation date, which is based on state law.  Notes cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make payments to any person other than the annuitant during the qualified interest term.

Note:  The annuity payment may, alternatively, be based on the taxable year of the GRAT.  If so, the annuity must be paid in the subsequent year by the date on which the trustee must file the GRAT’s income tax return (without extension).  Treas. Reg. §25.2702-3(b)(4).   As noted, the annuity cannot be prepaid.  Treas. Reg. §25.2702-3(d)(4). 

The GRAT must be drafted to require the trustee to actually pay the annuity amount, it is not sufficient for the grantor to merely have a withdrawal right.  Treas. Reg. §25.2702-(3)(b)(1)(i). 

A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust.  Treas. Reg. §25.2702-3(b)(1)(ii).  There is also a formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for gift tax purposes.  The provision must require adjustment of the annuity amount.  

Note:  The fixed amount need not be the same for each year, but one year’s amount may not vary by more than 120 percent from the amount paid in the immediately prior year.  Treas. Reg. §25.2702-3(b)(1)(ii). 

From a financial accounting standpoint, the GRAT is a separate legal entity.  The GRAT’s bank account is established using the grantor’s social security number as the I.D. number.  Annual accounting is required, including a balance sheet and an income statement.

Tax Consequences of Creating, Funding, Administering and Terminating a GRAT

Grantor trust status.  For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained interest exceeds five percent of the value of the trust at the time the trust is created.  I.R.C. §673.  Thus, there is no gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity.  There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s basis.  Also, when a partnership interest is contributed there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities exceeds the partner’s share of the tax basis in the partnership assets).  

Note:  It is possible that a GRAT could be a grantor trust for some but not all purposes.  Generally, a GRAT should be a grantor trust for all purposes.  Language can be drafted into the GRAT document ensuring classification as a grantor trust for all purposes. 

Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends, rents and royalties, as well as pass-through income from business entity ownership.  The grantor also can claim the GRAT’s deductions.  However, the grantor is not taxed on annuity payments, and transactions between the GRAT and the grantor are ignored for income tax purposes.  A significant tax benefit of a GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or loss.  The transaction is treated as a tax-free installment sale of the asset.  Also, the GRAT is permitted to hold “S” corporation stock as the trust is a permitted S corporation shareholder, and the GRAT assets grow without the burden of income taxes. 

Gift tax treatment.  For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less the value of the grantor’s retained annuity interest.  In essence, the transferred assets are treated as a gift of the present value of the remainder interest in the property.  That allows asset appreciation to be shifted (net of the assumed interest rate that is used to compute present value) from the grantor’s generation to the next generation.

It is possible to “zero-out” the gift value so there is no taxable gift.  This occurs when the value of the grantor’s retained interest equals the value of the property transferred to the trust.  An interest rate formula determined by I.R.C. §7520 is used to calculate the value of the remainder interest.  If the income and appreciation of the trust assets exceed the I.R.C. §7520 rate, assets remaining at the end of the GRAT term that will pass to the GRAT beneficiaries.  The basic idea is to transfer wealth to the subsequent generation with little or no gift tax consequences. 

The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries.  Rev. Rul. 2004-64, 2004-27 I.R.B. 7.  Also, if the trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax, the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the grantor’s estate.  But, it’s important that the trustee be an independent trustee. 

Underperforming GRAT.  If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax consequences (assuming the GRAT is a wholly-owned grantor trust).  Rev. Rul. 85-13, 1985-1 C.B. 184.  Then, the repurchased property can be placed in a new GRAT with a lower annuity payment.  The original GRAT would then pay out its remaining cash and collapse.   

Death of Grantor During GRAT Term

If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the grantor’s gross estate under I.R.C. §2036.  The amount included in the grantor’s estate is the lesser of the fair market value of the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in effect during the month of the grantor’s death).   Rev. Rul. 82-105, 1982-1 C.B. 133.  

Example:  Bubba died in June 2018 with $700,000 of assets held in a 10-year GRAT.  At the time the GRAT was created in June of 2010 with a contribution of $1.5 million, the annuity was calculated to be $183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift).   The amount included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the time of death) or $5,385,255.88 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.034)).  Thus, the amount included in Bubba’s estate would be $700,000.   

To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are generally selected for older individuals.  There is no restriction in the law as to how long a GRAT term must be.  For example, Kerr v. Comr., 113 T.C. 449 (1999), aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the court’s opinion that the term was challenged.  In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT with a two-year term.  

Perhaps the risk of the grantor dying during the GRAT term has been minimized.  In Walton v. Comr., 115 T.C. 589 (2000), the Tax Court concluded that the value of an annuity payable over a term to the grantor and to the grantor’s estate if the grantor dies during the GRAT term is not reduced by the value of the contingent interest in the grantor’s estate.  The reason the Tax Court gave was because a fixed annuity payable to the grantor or the grantor’s estate does not constitute a “qualified interest” under I.R.C. §2702.  Thus, a GRAT may be created with a fixed term that will not end upon the grantor’s death, and the annuity that is paid to the grantor during life and to the estate at death during the GRAT’s term will be included in the value of the retained annuity interest – and, thus, give a value to the remainder interest.  The IRS may not agree with the result in Walton (particularly outside of the Eighth Circuit).  But, the Tax Court’s opinion is a full Tax Court opinion that is applicable nationwide.

GRAT Advantages and Disadvantages

Advantages.  For large transfers, a GRAT reduces the gift tax cost of transferring assets as compared to a direct gift.  Also, the GRAT receives grantor trust status which allows the grantor to borrow funds from the GRAT and the GRAT can borrow money from third parties (however, the grantor must report as income the amount borrowed).  Tech. Adv. Memo. 200010010 (Nov. 23, 1999)).  Also, the GRAT term can safely be as short as two years. 

Disadvantages.  Upon formation, some of the grantor’s applicable exclusion might be utilized.  But this likelihood has been reduced in recent years given the substantial increase in the federal estate and gift tax exemption amount.  Also, the grantor must survive the GRAT term to avoid having any part of the GRAT assets being included in the grantor’s gross estate (but see the discussion about the Walton case above).  Another potential disadvantage of a GRAT is that notes or other forms of indebtedness cannot be used to satisfy the required annuity payments.  Treas. Reg. §25.2702-3(d)(2).  In addition, the grantor continues to pay income taxes on all of the GRAT’s income that is earned during the GRAT term. 

When to Consider Using a GRAT

So, when should a GRAT be utilized as a part of an estate/business succession plan?  If the grantor has assets that are likely to appreciate more than the I.R.C. §7520 rate, it is a good way to transfer value to the grantor’s children.  Also, in situations where the unified credit exemption has already been used, a zeroed-out GRAT may still be used because it does not trigger a taxable gift to the remainder beneficiaries.   

Conclusion

The GRAT is another way to pass interests in the farming or ranching operation to the next generation.  While it’s not a technique for everyone, it can be helpful for those with substantial wealth a a desire to pass the business to the next generation.  Also, keep in mind that the present level of the federal estate and gift tax exclusion amount of $12.06 million is scheduled to “sunset” after 2025.  After that, under present law, the exclusion will drop to $5 million (in 2011 dollars) with an inflation adjustment. 

March 11, 2022 in Business Planning, Estate Planning | Permalink | Comments (0)

Monday, March 7, 2022

Should An IDGT Be Part of Your Estate Plan?

Overview

Because of the failure of the “Build Back Better” legislation last year, the federal estate tax remains a non-concern for the vast majority of people.  But, for some larger farming operations as well as some non-ag businesses and high-wealth individuals, planning to avoid the full impact of the federal estate tax is necessary.   

Note:  If the Congress does nothing, the federal estate and gift tax exemption will fall to $5,000,000 (in 2011) dollars beginning January 1, 2026. That will subject more estates to potential taxation.

If an estate planning goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT).  The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.  

The use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner – it’s the topic of today’s post.

What Is An IDGT?

In general.  An IDGT is an irrevocable trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. Normally, an irrevocable trust is a tax entity distinct from the grantor and has its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return.  Because of the irrevocable nature of the trust, the assets transferred to the trust are generally removed for the grantor’s estate for federal estate purposes. Conversely, a grantor trust is a trust where the income is taxed to the grantor because the grantor is treated as the owner for federal and state income tax.  Thus, a separate return need not be prepared for the trust, but the trust assets are generally included in the grantor’s estate at death. 

An IDGT is characterized by having advantages of both an irrevocable trust for estate tax purposes and a grantor trust for income tax purposes.  For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §§671-678.  That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes.  For example, common IDGT provisions include (1) a power exercisable by the grantor (in a non-fiduciary capacity) to reacquire trust assets by substituting assets of equivalent value. I.R.C. §675(4)(C); (2) a power held by a non-adverse party to add to the class of beneficiaries (other than the grantor’s after-born or after-adopted children). I.R.C. §674(a); or (3) a power to enable the trustee to loan money or assets to the grantor from the trust without adequate security. I.R.C. §675(2).

However, those retained powers do not cause the trust assets to be included in the grantor’s estate under I.R.C. §§2036-2042.  This is what makes the trust “defective.”   The seller (grantor) and the trust are treated as the same taxpayer for income tax purposes.  However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected for federal estate and gift tax purposes.  For example, the transfer of property to the trust qualifies for the gift tax annual exclusion of §I.R.C. §2503(b)(1)-(2).  In addition, grantor trust status still applies even though the grantor retains a withdrawal power over income and/or corpus.  See, e.g., Priv. Ltr. Rul. 200606006 (Oct. 24, 2005); Priv. Ltr. Rul. 200603040 (Oct. 24, 2005); Priv. Ltr. Rul. 200729005 (Mar. 27, 2007). 

Note:  The IDGT’s income and appreciation accumulates inside the trust free of gift tax and also free of generation-skipping transfer tax (if the grantor allocates the grantor’s generation-skipping transfer tax exemption to the assets transferred to the trust). 

The IDGT transaction is structured so that a completed gift occurs for gift and estate tax purposes, with no resulting income tax consequences (because the trust is a grantor trust).  

Note:  Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.

How Does An IDGT Transaction Work?

Gift.  One approach to funding an IDGT is by the grantor gifting assets to the trust.  If the value of the assets transferred are less than the applicable exclusion amount (presently $12.06 million for deaths or gifts made in 2022 - $24.12 million for a married couple), gift tax is not triggered on the transfer, but the applicable exclusion would be reduced by the amount of the gift.  Form 709 would need to be filed reporting the gift and showing the reduction in the applicable exclusion unified credit. 

Note:  A variant of the outright gift approach involves a part-gift, part-sale transaction.  This is done where it is beneficial to leverage the amount of assets transferred to the IDGT, preserve the applicable exclusion or retain income.    

Sale and note.  Another technique to fund an IDGT involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note (such as a self-canceling installment note).  There is no capital gains tax on the sale.  In addition, the trust is an eligible S corporation shareholder.   I.R.C.  §1361(c)(2)(A).   The grantor is also not taxed on the interest payments received from the trust.   Rev. Rul. 85-13, 1985-1 C.B. 184.  The installment sale also freezes the value of appreciation on assets sold at the Applicable Federal Rate (AFR).  This is a particularly effective strategy in a low interest rate environment. 

The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor.  The sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.

Interest on the installment note is set at the Applicable Federal Rate (AFR) for the month of the transfer that represents the length of the note’s term.  I.R.C. §1274.

Note:  The mid-term AFR for March of 2022 is 1.73 percent (semi-annual compounding).  Rev. Rul. 2022-4, 2022-10 I.R.B.

The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments.   Given the current low interest rates, it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest.  Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).

The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995).  I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer.  However, an “applicable retained interest” is not a creditor interest in bona fide debt.   The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.  If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold.  For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments. 

Note:  For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).

A crucial aspect of the installment note from an income tax and estate planning/business succession planning standpoint is that it must constitute bona fide debt.  If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate.  In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701-2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt.  The case was settled before trial on terms favorable to the taxpayer (the only adjustment was a reduction of the valuation discount from 42 percent to 37 percent) with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied.  However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013).  The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016, that resulted in no additional gift or estate tax.  The total amount of the gift tax, estate tax, and penalties at issue was $152 million. 

Another concern is that I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it.  But, again, in the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.

All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt.  Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes.  That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short.  These are all indicia that the note represents bona fide debt.      

Pros and Cons of IDGTs

Value freezing.  An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the low interest rate on the installment note payable.  Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. 

Note:  Any valuation discount will increase the effectiveness of the sale for estate tax purposes. 

Payment of income tax liability.  If the grantor uses funds from outside the IDGT to pay the tax liability on income generated by the assets in the IDGT, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries that would result if the trust were a standard irrevocable trust.  It also reduces the grantor’s taxable estate in an amount equal to the income taxes that the grantor pays and helps to preserve the trust by not reducing it with the trust’s payment of the income taxes. 

Because the grantor pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the income tax to the trust beneficiaries for gift tax purposes.  Rev. Rul. 2004-64, 2004-27 I.R.B. 7.  However, there is a difference in the estate tax treatment depending on the trust’s language.  For instance, if the trust’s language (or state law) requires the trustee to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, then the full value of the trust’s assets is includible in the grantor’s gross estate via I.R.C. §2036(a)(1) for federal estate tax purposes  This is true even though the trust’s beneficiaries are not treated as making a gift of the amount of the income tax to the grantor.  Id.   Conversely, if the trust language gives the trust the discretion to reimburse the grantor for that portion of the grantor’s income tax liability attributable to the trust’s income, the discretion (whether exercised or not) will not (by itself) cause the value of the trust’s assets to be includible in the grantor’s gross estate.  But such discretion combined with other facts (such as a pre-existing arrangement regarding the trustee’s exercise of discretion) could cause inclusion of the trust assets in the grantor’s estate.  Id. 

Life insurance.  An IDGT can purchase an existing life insurance policy on the life of the grantor without subjecting the policy to taxation under the transfer-for-value rule. Rev. Rul. 2007-13, 2007-1 C.B. 684.

Grantor’s death during term of note.  On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. 

Income tax basis.  There is no stepped-up basis in trust-owned assets upon the grantor’s death. 

Cash flow.  Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. 

Funding.  There is possible gift and estate tax exposure if insufficient assets are used to fund the trust.  As noted above, 10 percent seed funding is recommended to reduce the risk that the sale will be treated as a transfer with a retained interest by the grantor.    

Administrative Issues with IDGT’s

An IDGT is treated as a separate legal entity.  That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account.   An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.

Conclusion

Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost.  That’s especially true for highly appreciating assets and family business assets.  It can be used to shift large amounts of wealth to heirs and create estate tax benefits.  The trust language should be carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate.  In other words, the trust language must contain sufficient provisions requiring the trust to be deemed a revocable trust for income tax purposes, but an irrevocable trust (as a completed transfer) for estate tax purposes. 

Given the highly technical nature of the IDGT rules, it is critical to get good legal and tax counsel before trying the IDGT strategy.

March 7, 2022 in Business Planning, Estate Planning | Permalink | Comments (0)

Saturday, March 5, 2022

Summer 2022 Farm Income Tax/Estate and Business Planning Conferences

Overview

In December, I posted a “hold-the-date” announcement for the 2022 summer national farm income tax/estate and business planning conferences that Washburn Law School will be conducting this summer.  The itineraries for each event are now finalized and registration will open soon.  Some have already booked their lodging and made travel plans.  The events are the highest quality, most practical professional tax and legacy planning conferences for practitioners with farm and ranch clients you can find anywhere in 2022.  Both conferences will also be simulcast live online in the event you aren’t able to attend in person.  In addition, each conference provides one hour of ethics for attorneys, CPAs and other tax practitioners. 

On June 13 and 14, the conference will be held at the Chula Vista Resort near the Wisconsin Dells.  On August 1 and 2, the conference will be at Fort Lewis College in Durango, Colorado.

In today’s article, I detail the speakers and the itineraries for each location.  2002 summer seminars – it’s the topic of today’s post.

The Speakers

In addition to myself, the following make the line-ups for the conferences:

Wisconsin Dells 

Joining me on Day 1 will be Paul Neiffer.  Paul is a CPA with CliftonLarsonAllen out of Walla Walla Washington.  He and I have worked together on numerous tax conferences for the past decade.  He specializes in income taxation, accounting services, and succession planning for farmers and agribusiness processors.  He is also a contributor at agweb.com and writes the Farm CPA Today blog. 

Also making presentations at the Wisconsin Dells conference will be Carlos Ramon, Dr. Allen Featherstone and Prof. Peter Carstensen.  Here are their brief bios:

Carlos Ramon.  Carlos is the Program Manager, Cyber & Forensic Services, with the IRS Criminal Investigation Division (IRS-CID).  He has over nineteen years of federal law enforcement experience, the last 16 of which have been with the IRS-CID.  With IRS-CID, Carlos has served (among other things) as an ID Theft Coordinator, and Program Manager for Cyber and Forensic Services. He is specially trained in different IRS-CI programs responsible for investigating criminal violations of the Internal Revenue Code and related financial crimes involving tax, money laundering, public corruption, cyber-crimes, identity theft, and narcotics.  Carlos holds a bachelor’s degree in Animal Science from Penn State University, a master’s in business administration from the Inter American University of Puerto Rico, and a Doctorate in Business Administration in Management Information System from the Ana G Mendez University. 

Dr. Allen M. Featherstone.  Dr. Featherstone is the Department Head of the Agricultural Economics Department at Kansas St. University where he also is the Director of the Master in Agribusiness Program.  His academic focus is on agriculture finance and his production economics research has investigated issues such as ground water allocation in irrigated crop production, comparison of returns under alternative tillage systems, the costs of risk, interactions of weather soils, and management on corn yields, analysis of the returns to farm equity and assets, and analysis of the optimizing behavior of Kansas farmers, examining the stability of estimates using duality, and examining the application of a new functional forms for estimating production relationships.

Peter C. Carstensen.  Prof. Carstensen is Professor of Law Emeritus at the University of Wisconsin School of Law.  From 1968-1973, he was an attorney at the Antitrust Division of the United States Department of Justice assigned to the Evaluation Section, where one of his primary areas of work was on questions of relating competition policy and law to regulated industries.  He has been a member of the faculty of the UW Law School since 1973.  He is also a Senior Fellow of the American Antitrust Institute.  His scholarship and teaching have focused on antitrust law and competition policy issues.  IN 2017, he published Competition Policy and the Control of Buyer Power, which received the Jerry S. Cohen Memorial Fund Writing Award for best antitrust book of 2017. 

Durango

The Day 1 lineup and topics are the same at the Durango event as they are at the Wisconsin Dells event.  Joining me on Day 2 at Durango will be the following:

Timothy P. O’Sullivan.  Tim is a senior partner with the Foulston law firm in Wichita, Kansas.  He represents clients primarily in connection with their estate and tax planning and the administration of trusts and estates. As part of his practice, Mr. O’Sullivan crafts wills, testamentary trusts, revocable living trusts, irrevocable trusts, dynasty or other types of generation-skipping trusts, “special needs” trusts, financial and healthcare powers of attorney, living wills, premarital agreements, stock purchase or buy-sell agreements, strategic gifting and estate tax planning, asset protection planning, governmental resource planning (e.g., Medicaid and SSI), family business succession plans, premarital agreements, IRA, 401k or other tax deferred beneficiary designations and deferral strategies, life insurance structures, family limited partnerships and limited liability companies, grantor retained annuity trusts (GRATs), private annuities, self-canceling installment notes (SCINs) and other instruments and estate planning techniques. A substantial portion of Mr. O’Sullivan’s practice also involves advising clients on strategies and provisions which enhance the preservation of family harmony in the estate planning process.

Mary Ellen Denomy.  Mary is a CPA with a specialty in oil and gas accounting, valuations and audits.  She is an Accredited Petroleum Accountant, Certified Fraud Deterrent Analyst and Master Analyst in Financial Forensics.  She has spoken across the country on oil and gas issues, been interviewed frequently and has testified as a successful expert.  Mary Ellen is a former member of the Board of the National Association of Royalty Owners (NARO), the Board of Examiners of the Council of Petroleum Accountants Societies, Past President of NARO-Rockies and former Trustee of Colorado Mountain College.  She is currently a licensed CPA in both Colorado and Arizona.

Mark Dikeman.  Mark is the Associate Director of the Kansas Farm Management Association as part of the Department of Agricultural Economics at Kansas State University.  Mark is responsible for implementing and maintaining an Extension educational farm business management program for commercial farms, resulting in the development of financial and production information to be used for comparable economic analysis by the farms as well as for research, policy and teaching.

John Howe.  John practices law in Grand Junction, Colorado with the law firm of Hoskin, Farina and Kampf.  John was raised in Southwestern Colorado and attended the Colorado School of Mines, graduating in 1983 with a bachelor’s degree in geophysical engineering. After a short stint in the oil and gas exploration industry, John attended the University of Colorado School of Law, graduating in 1989.  Following graduation, he clerked for Justice William H. Erickson of the Colorado Supreme Court and has practiced water and real estate law in Grand Junction for more than thirty years.

Michael K. Ramsey.  Mike is a partner in the firm of Hope, Mills, Bolin, Collins & Ramsey LLP located in Garden City, Kansas.  His law practice includes water rights, landowner oil and gas rights, agricultural business and estate planning.  Mike is a partner in an irrigated farming operation located in southwest Kansas. He has spoken on water law topics in Kansas to attorneys, financial institutions, utility company board members, agricultural producers, legislative committees and others. His clients have included users of surface and groundwater for irrigation, livestock, industrial and municipal purposes and groundwater management districts.  He a co-author with Peck, J. and Pitts, D. of "Kansas Water Rights: Changes and Transfers," 57 J.K.B.A. 21 (July 1988) and author of "Kansas Groundwater Management Districts: A Lawyer's Perspective," Vol. XV No. 3 Kan. J. of Law & Pub. Policy 517 (2006).  Mike’s law degree is from the University of Kansas School of Law.

Andrew Morehead.  Andy is a Public Accountant and Certified Financial Planner with a farm and small business practice in Eaton, Colorado and Torrington, Wyoming. He is a Past President of the National Society of Accountants, and is also a Past President of the Public Accountants Society of Colorado.  Andy is a former cattle rancher and farm equipment dealer in western Wyoming, and has taught at various tax-related professional continuing education programs for many years.

Shawn Leisinger.  Shawn is the Associate Dean for Centers and External Programs where he oversees development of Center programs and events that are held throughout the year. He also coordinates all continuing legal education programs sponsored by Washburn Law and other special events.  Shawn joined Washburn University School of Law on a full-time basis in 2010. Previously he served as Assistant General Counsel to the Kansas Corporation Commission Oil and Gas Conservation Division and as Assistant Shawnee County (Kansas) Counselor. Leisinger has coached the Washburn Law American Bar Association Client Counseling competition team since 2003 and the Negotiation competition team since 2008. He has also taught the Interviewing and Counseling and the Professional Responsibility courses and regularly teaches continuing legal education sessions.

Daily Schedules

Wisconsin Dells.  Here is how the topical sessions break out each day at the Wisconsin Dells conference (the speaker for each topic is indicated in parenthesis after the title of each session):

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.   

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. (Morning Break)

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Lunch

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)

The potpourri session continues…and concludes.

Day 2:

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:50 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:50 – 10:10 a.m. – Morning Break

10:10 a.m. – 11:25 a.m. – The Ag Economy and the Impact on Farm/Ranch Clients (Part 1)

Between the Upper and Nether Stone: Anticompetitive Conduct Grinding Down Farmers (Carstensen)

Enforcement of antitrust and related competition laws has become a major focus of the Biden Administration.  One primary area of concern is agriculture.  Farmers face significant risks of harm in their supply markets.  The impacts come from a variety of places: equipment which they cannot repair because of restraints imposed by the manufacturer, seeds and other inputs sold by a limited number of suppliers who restrict resale and lower cost distribution, increased prices of fertilizer associated with increased concentration in the production of that input.  On the output side, there is increased concentration in the markets into which farmers sell many of their crops and livestock.  Recently litigation has highlighted how a cartel of poultry integrators exploited growers, consumers, and workers.  Similar claims are pending in other output markets.  This presentation will provide a survey of the issues and the potential for positive or negative impact on farmers and their bottom line.

11:25 a.m. – Noon - Post-Death Dissolution of S Corporation Stock and Stepped-Up Basis; Last Year of Farming; Deferred Tax liability and Conversion to Form 4835 (McEowen)

Noon – 1:00 p.m. – Luncheon

1:00 p.m. – 2:15 p.m. - The Ag Economy and the Impact on Farm/Ranch Clients (Part 2)

Agricultural Finance and Land Situation – (Featherstone)

The current agricultural finance situation and land will be discussed.  Information will be provided on past, recent, and future developments.  Information on the income situation, the financial health of farm operations, and current land market trends will be provided.

2:15 – 2:55 p.m. – Post-Death Basis Increase – Is Gallenstein Still in Play?; Using an LLC to Make an S Election – (McEowen)

Can surviving spouses in non-community property states get a full basis step-up in jointly held property when the first spouse dies?  Gallenstein may still apply for some clients – what are those situations and what does it mean?  Also, the session will examine the procedures involved and the Forms to be filed when an S election is made via a limited liability company. 

2:55 p.m. – 3:15 p.m. Afternoon Break

3:15 p.m. – 3:25 p.m. – Getting Clients Engaged in the Estate/Business Planning Process – (McEowen)

In this brief session, a checklist will be provided designed to assist practitioners in getting clients engaged in the estate, business and succession planning process.  What can be done “jump start” the process for clients?

3:25 p.m. – 4:25 p.m.  – Ethical Problems in Estate and Income Tax Planning – (McEowen)

This session focuses on ethical situations that practitioners often encounter when counseling clients on estate/business planning or income tax planning.  The governing ethical rules are often not carefully tailored for estate and tax planners/preparers, and competing responsibilities often bedevil the professional.  So, how can the estate planning and/or income tax preparer stay “within the rails”?  This session will address the primary rules including the application of relevant portions of Circular 230.

Durango Seminar

Day 1:

8:00 a.m.-8:05 a.m. – Welcome and Announcements

8:05 a.m.-9:05 a.m. - Tax Update – Key Rulings and Cases from the Past Year (or so) (McEowen)

This opening session begins with a review of the most significant recent income tax cases, IRS rulings and other tax administrative developments.  This session will help you stay on top of the ever-changing interpretations of tax law that impact your clients.  

9:05 a.m.-9:35 a.m. - Reporting of WHIP and Other Government Payments (Neiffer)

Farmers that participate in federal farm programs have unique tax reporting requirements and the programs have unique tax rules that apply.  This session will provide a review of the basic tax rules surrounding farm program payments, including new USDA programs that have been created for farmers in recent years.  Also reviewed will be the options for deferring revenue protection policies.

9:35 a.m.-9:55 a.m. - Morning Break

9:55 a.m.-10:20 a.m. - Fixing Bonus Elections and Computations (McEowen)

The TCJA made several changes to bonus depreciation and the IRS issued a Revenue Procedure in 2019 allowing modifications of a bonus election.  Final regulations were published in late 2020 that withdrew a “look-through” rule for partnerships and clarify the application of I.R.C. §743(b) adjustments.  This session brings tax preparers up-to-date on dealing with changes to bonus elections and related computations.

10:20 a.m.-10:50 a.m. - Research and Development Credits (Neiffer)

Beginning in 2022, taxpayers must provide particular information when claiming a refund for research and development credits under I.R.C. §41 on an amended return.  What information is required?  What business components must be identified, and how are research activities performed to be documented?  How can an insufficient claim be perfected?  These issues and more will be addressed.

10:50 a.m.-11:20 a.m. – Farm NOLs (Neiffer)

In 2021, the IRS issued guidance on how farm taxpayers are to handle carryback elections related to farm net operating losses (NOLs) in light of all of the legislative rule changes in recent years.  This session reviews the guidance and illustrates how a farm taxpayer can elect to not apply certain NOL rules of the CARES Act, and how the COVID-Related Tax Relief Act (CTRA) election can be revoked. 

11:20 a.m.-Noon  -  The Taxability of Retailer Reward Programs; Tax Rules Associated with Demolishing Farm Structures (McEowen)

This session addresses the tax issues associated with farm clients receiving “rewards” from retailers that they transact business with.  How are the “rewards” to be reported?  Is the information that the retailer provides to the farmer correct?  This session sorts it out.  In addition, this session covers the proper tax treatment of demolishing farm structures.  Significant weather events in recent months in large areas of farm country destroyed or significantly damaged many farm structures.  When those structured are beyond repair and are demolished, what is the proper way to handle it for tax purposes? 

Noon-1:00 p.m. – Luncheon

1:00 p.m.  – 2:15 p.m. IRS-CI: Emerging Cyber Crimes and Crypto Tax Compliance (Ramon)

This session explains how to identify a business email compromise and/or data breach and how to respond to it.  The session will also identify what the Dark Web is and how it is utilized for cybercrimes and identity theft.  Likewise, the session will help attendees to recognize the general terminology and tax treatment pertaining to virtual/crypto currency. In addition, the session will allow participants to gain a better understanding of the efforts by IRS-Criminal Investigation to combat cyber criminals and illicit activity.

2:15 p.m. – 2:45 p.m.  Potpourri – Part 1 (McEowen and Neiffer)

This session includes discussion of numerous tax issues of importance to farmers and ranchers.  The topics covered include how machinery trade transactions are handled and reported on Form 4797 and Form 4562; inventory accounting issues (what is included in inventory; how the Uniform Capitalization Rules impact inventory accounting; when accrual accounting is required; inventory valuation methods; and crop accounting).  Also covered will be the tax treatment of early termination of CRP contracts; partnership reporting; weather-related livestock sales; and contribution margin analysis

2:45 – 3:05 p.m. - Afternoon Break

3:05 p.m. – 4:25 p.m. Potpourri (cont.) (McEowen and Neiffer)  

The potpourri session continues…and concludes.

DAY 2: 

7:30 a.m. – 8:00 a.m. – Registration

8:00 a.m. – 8:05 a.m. – Welcome and announcements

8:05 a.m. – 9:00 a.m. - Estate and Business Planning Caselaw and Ruling Update (McEowen)

Day 2 begins with a review of the big developments in the courts and with the IRS involving estate planning, business planning and business succession.  Stay on top of the issues impacting transition planning for your clients by learning how legal, legislative and administrative developments impact the estate and business planning process.

9:00 a.m. – 9:45 a.m. – The Use of IDGTs (and other strategies) For Succession Planning (McEowen)

Estate planning with intentionally defective grantor trusts (IDGTs) can have many advantages. This session will discuss the ins and outs of IDGTs, including how they may be a part of developing comprehensive estate plans and how they can be tax “effective” for federal estate tax purposes.

9:45 a.m. – 10:05 a.m.  – Morning Break

10:05 – 11:00 a.m. – Estate Planning to Minimize Income Taxation:  From the Mundane to the Arcane (O’Sullivan)

With the failure of the Biden legislative agenda in 2021 that would have had a deleterious effect on many estate planning techniques, and with estate and gift tax reduction techniques continuing to be relevant (for the immediate future) to a small minority of the population, income tax reduction techniques continue to be the major tax focus of the estate planner’s regimen.  This session will initially address simple, well understood but infrequently utilized- estate planning strategies, and then gravitate to more advanced complex techniques both within and without non-grantor trusts. These techniques can substantially reduce the income taxation burden on beneficiaries of estate plans while carrying out the grantor’s/testator’s other important estate planning goals, including asset protection, maintenance of plan integrity, flexibility and charitable giving.  Learn the techniques that can be implemented for particular clients.

11:00 a.m. – Noon – Oil and Gas Royalties and Working Interest Payments:  Taxation, Planning and Oversight (Denomy)

This presentation will cover how to properly report royalties and working interest payments on current tax returns.  We will then begin to look at estate planning recommendations for your clients.  Also discussed will be issues that you may be able to advise your clients about concerning whether they are being paid according to their agreements.  The session concludes with what it means to be called to be an expert as your client’s CPA.

Noon – 1:00 p.m. - Luncheon

1:00 p.m. – 1:50 p.m. - Economic Evaluation of a Farm Business (Dikeman)

This session will address key components of analyzing the economic health of a farm business.  How much did a farm really make?  Evaluating the economic performance of an agricultural business can be complicated.  With prepaid expenses and generous depreciation options, it is difficult to gauge farm performance especially by looking only at a tax return.  This session will look at the impact of income tax management decisions on the economic performance of a farm business.

1:50 p.m. – 3:05 p.m. – Appropriation Water Rights - Tax and Estate Planning Issues (Mike Ramsey; Andy Morehead; John Howe)

The panel will explore the nature and types of appropriation water rights that practitioners may encounter with their clients, jurisdictional differences and whether the rights are real or personal property interests.  Common ownership, conveyance and title problems will be discussed. Valuation issues will be addressed. There will be discussion about IRC Section 1031 exchanges and depletion issues with examples commonly encountered in sale and transfer transactions.   Concerning estate planning and estate, gift and generation skipping taxation, the potential use and utility of SLATS (spousal lifetime interest trusts), IDGTs (intentionally defective grantor trusts) and IRC Sections 2032A and 6166 will be covered. The emphasis will be on identification of issues with reference materials for further study.  

3:05 -3:25 p.m. – Afternoon Break

3:25 – 4:25 p.m. - Ethically Negotiating End of Life Family Issues (Leisinger)

This ethics exercise takes a look at the sometimes complex processes and issues that arise at end of life for family members.  Participants will be given confidential information and motivations from two different children of a parent who is at end of life and needing to liquidate assets to pay for nursing home care and other expenses.  Ethical rules for attorneys will be discussed and applied to the negotiation exercise and outcomes that participants will be asked to complete as part of the program. 

Conclusion

Registration will open soon for both events and will be available through my website – washburnlaw.edu/waltr.  I will also post here when registration is open and provide the link for you.  Again, if you aren’t able to attend in person, you may attend online.  Also, if you are a law student or undergraduate student interested in attending law school, please contact me personally for details on a discounted registration rate.

March 5, 2022 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, February 28, 2022

Expense Method Depreciation and Leasing - A Potential Trap

Overview

For tangible depreciable personal property (and some types of qualified real estate improvements), all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer's trade or business), regardless of the time of year the asset was actually placed in service.  This is known as “expense method depreciation” and it is an off-the-top depreciation allowance that may be taken at the taxpayer's election each year.  I.R.C. §179.

For farmers and ranchers, the deduction can apply to a wide array of business assets.  But there is a potential trap that can apply to farm landlords that is often overlooked.  Expense method depreciation and a trap for the unwary – it’s the topic of today’s post.

Basics of Expense Method Depreciation

On a joint return, the aggregate basis amount eligible for the deduction is $1,080,000 at the federal level (for 2022), except for certain types of vehicles.  But, the maximum amount that can be claimed is limited to the taxpayer’s aggregate business taxable income (including I.R.C. §1231 gains and losses and interest from the working capital of the business).  Treas. Reg. §1.179-2(c).  The extent of a taxpayer’s income from the active conduct of a trade or business is determined in accordance with a facts and circumstances test to determine if the taxpayer “meaningfully participates in the management or operations of the trade or business.” Treas. Reg. §1.179-2(c)(6)(ii).  Wages and salaries that the taxpayer receives as an employee are included in the aggregate amount of active business taxable income of the taxpayer.  Moreover, a spouse's W-2 wage income is considered income from an active trade or business for this purpose if the couple files a joint income tax return.

The I.R.C. §179 limitation applies at the entity level for pass-through entities in addition to also applying at the individual taxpayer level.  That’s an important point for farming operations where family members are sharing ownership of equipment.  If a co-ownership arrangement is construed as a partnership, only one I.R.C. §179 limitation would apply to equipment purchases.  If the co-ownership is not a partnership, each taxpayer could count their respective share of equipment purchases for purposes of the I.R.C. §179 limitation.

Here are some other key points about the provision:

  • Property that is eligible for expense method depreciation is tangible, depreciable personal property. This includes costs to prepare and plant a vineyard, including labor costs. C.A. 201234024 (May 9, 2012).
  • Expense method depreciation is tied to the beginning of the taxpayer’s tax year.
  • Qualified leasehold improvement property and qualified retail improvement property are eligible for expense method depreciation as are air conditioning and heating units.
  • Certain items of tangible depreciable personal property are not eligible for expense method depreciation. In general, any property that would not be eligible for investment tax credit (under the rules when the investment tax credit was available) is ineligible for expense method depreciation. 
  • In addition, property acquired by gift, inheritance, by estates or trusts and property acquired from a spouse, ancestors or lineal descendants is not eligible for expense method depreciation. However, qualifying property held by a grantor trust is eligible for I.R.C. 179, but property held by an irrevocable trust is not. 
  • For property traded in, only the cash boot that is paid is eligible for expense method depreciation.
  • Expense method depreciation is phased out for taxpayers with cost of qualifying property purchases exceeding $2,700,000 (for 2022). For each dollar of investment in excess of $2,700,000 for the year, the allowable expense amount is reduced by $1. Thus, for 2022, at $2,700,000, the full deduction is available, and at $3,780,000, nothing is available.
  • Upon disposition of property on which an expense method depreciation election has been made, special income tax recapture rules may apply.
  • For expense method depreciation assets disposed of by installment sale, all payments received under the contract are deemed to have been received in the year of sale to the extent of expense method depreciation claimed on the property.
  • The expense method election for eligible property must be made on the first return (or on a timely filed amended return) for the year the elected property is placed in service. However, an expense method depreciation election can be made or revoked on an amended return for an open tax year (generally the most recent three years).

For the farmer or rancher, expense method depreciation can be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks and business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins and silos.  But, of course, the trade-off is that if expense method depreciation is selected for a particular asset, the basis of the asset must be reduced by the amount of the expensing deduction.

Leases and the Non-Corporate Lessor Rule 

Non-corporate taxpayers that lease property to others that contains tangible property on which the landlord seeks to claim expense method depreciation, must satisfy two additional requirements.  I.R.C. §179(d)(5).  

  • First, the term of the lease must be less than 50 percent of the class life of the property.
  • Second, during the first 12 months of the lease, the deductions of the lessor with respect to the property (other than taxes, interest and depreciation) must exceed 15 percent of the rental income produced by the property. 

Note:  Presumably, the rule does not apply to S corporations. 

The rule makes it difficult for farm landlords to claim expense method depreciation with respect to many real estate improvements, particularly those that don’t require repairs and maintenance in the first 12-month period of the lease.

Note:  A non-corporate lessor is also eligible for I.R.C. §179 if the non-corporate lessor manufactured or produced the leased property.  I.R.C. §179(d)(5)(A). 

A Tax Court case a few years ago illustrates the peril posed to farm landlords by the non-corporate lessor rule.  In Thomann v. Comr., T.C. Memo. 2010-241, the taxpayers were a farm couple that owned and operated a 504-acre farm.  Around 2000, the couple orally leased 124 acres of their farmland along with buildings, grain storage bins and equipment to Circle T Farms, Inc., a hog farrow-to-finish business that the couple owned for $70,000 annual cash rent.  The corporation’s annual minutes for the years at issue, however, failed to specify what property the corporation was “renting” from the petitioners and did not provide details of any changes or additions to the lease. Instead, the minutes for the years at issue merely provided the dollar amounts without describing the property being “leased.” 

The petitioners orally leased the balance of their farmland (380 acres) to C&A, Inc., an unrelated party.  The husband also entered into an oral farming agreement with C&A that was put in writing in 2006 to state that the agreement “covered any future year[‘]s crops, so long as neither party requested a change on or before Sept[ember] 1 of the calendar year.”   

In 2004, 2005 and 2006, the petitioners purchased property that qualified for expense method depreciation.  On their tax return for 2004, they expensed $52,000 for drainage tile and a fence that was installed on the land that they leased to C&A, and $10,000 for material they purchased to remodel their farm office, including furniture and fixtures.  For 2005, they expensed $63,488 for a grain bin.  For 2006, they expensed $8,467 for a pickup truck and $31,000 for a grain bin and grain dryer.  The bin and dryer (and, presumably, the pickup truck) were orally leased to Circle T Farms for the $70,000 annual “cash rent.”  The IRS disallowed all of the expense method depreciation deductions for the farm-related property, citing the non-corporate lessor rule.

As for the office equipment, the court agreed with the IRS that the couple didn’t substantiate the deduction on their return and, as such, the court couldn’t determine whether the office material was eligible for expensing as “other property” under I.R.C. Sec. 1245.  Importantly, the court did not hold that the office materials were not I.R.C. §1245 property, but did hold that the taxpayers failed to present sufficient evidence to allow the court to determine whether the office materials were not “structural components” and would, therefore, be eligible for expense method depreciation.  So, an expense method deduction was denied for those items.  The court did not address the non-corporate lessor rule with respect to the office equipment.  

As for the grain bins, grain dryer, drainage tile, pickup truck and fence, the non-corporate lessor rule was applicable.  The couple claimed that the lease was for a year, renewable annually for another year and was, therefore, less than 50 percent of the class life of the farm-related property.  The Tax Court disagreed.  None of the leases were in writing and the couple didn’t provide any evidence of the actual lease terms.  As a result, the Tax Court concluded that the leases were for an indefinite period of time and did not have a term of less than 50 percent of the class life of the property.  The court also imposed an accuracy-related penalty of $16,209.

Note:  A lessor that merely rents property for the production of income isn’t eligible for expensing because the leased property is not used in the active conduct of the taxpayer’s trade or business.  Thus, cash rent leases also present a problem with respect to I.R.C. §179.  Thus, even if the non-corporate lessor test were satisfied in Thomann, I.R.C. §179 may still have been denied based on the nature of the leases involved. 

Conclusion

When it comes to many improvements on farmland, the non-corporate lessor rule is a major hurdle for farm landlords irrespective of whether the lease is cash rent or crop-share.  But, there is some doubt as to whether material participation share leases are subject to the rule. 

Farm leases may be short term, if they are in writing, but many may not even be in writing.  As Thomann illustrates, an oral lease can end up violating the rule.  Even if the test involving the length of the lease as compared to the class life of the farmland improvements is met, the improvements may not need repair and maintenance sufficient enough to allow the landlord to meet the other part of the non-corporate lessor rule.  That means that satisfaction of the “overhead” test may come down to how operating costs, if any, are allocated between the landlord and the tenant and how those costs relate to the rental amount.

The bottom line is that, for non-corporate farming operations, leases need to be in writing and drafted carefully with the non-corporate lessor rule in mind.  

February 28, 2022 in Income Tax | Permalink | Comments (0)

Friday, February 25, 2022

Tax Consequences When Farmland is Partitioned and Sold

Overview

I have had farm and ranch families tell me over years that they didn’t need to do estate/succession planning for various reasons and that they would simply “let the children figure it out.”  My retort to that is that if you do that, it’s likely that a judge will figure it out.  Indeed, one of those situations where a judge gets involved is when the parents have left farmland in co-equal ownership to multiple children after the last of the parents to die. 

What is a partition and sale action and what are the tax consequences – it’s the topic of today’s post.

Partition and Sale Action

Partition and sale of land is a legal remedy available if co-owners of land cannot agree on whether to buy out one or more of the co-owners or sell the property and split the proceeds.  It is often the result of a poorly planned farm or ranch estate where the last of the parents to die leaves the farm or ranch land equally to all of the kids and not all of them want to farm or they simply can’t get along.  Because they each own an undivided interest in the entire property, they each have the right of partition and sell to parcel out their interest.  See, e.g., Lowry v. Irish, No. 2019-0269-SG, 2020 Del. Ch. LEXIS 290 (Del. Chanc. Ct. Sept. 18, 2020). But, that rarely is the result because they aren’t able to establish that the tract can be split exactly equally between them in terms of soil type and slope, productivity, timber, road access, water, etc.  So, a court will order the entire property sold and the proceeds of sale split equally.  Tolle v. Tolle, 967 N.W.2d 376 (Iowa Ct. App. 2021); Koetter v. Koetter, No. A-17-1066, 2018 Neb. App. LEXIS 300 (Ct. App. Dec. 18, 2018). 

Note:  The court-ordered sale is most likely an unhappy result, and it can be avoided with appropriate planning in advance. 

Tax Consequences - Basics

What are the tax consequences of a partition and resulting sale?  A partition of property involving related parties comes within the exception to the “related party” rule under the like-kind exchange provision. This occurs in situations where the IRS is satisfied that avoidance of federal income tax is not a principal purpose of the transaction. Therefore, transactions involving an exchange of undivided interests in different properties that result in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties come within the exception to the related party rule. But, as noted, this is only true when avoidance of federal income tax is not a principal purpose of the transaction.

As for the income tax consequences on the sale of property in a partition proceeding to one of two co-owners, such a sale does not trigger gain for the purchasing co-owner as to that co-owner’s interest in the property.

Is a Partition an Exchange?

If the transaction is not an “exchange,” it does not need to be reported to the IRS, and the related party rules are not involved.  If the property that is “exchanged” is dissimilar, then the matter is different.  Gain or loss is realized (and recognized) from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or extent. Treas. Reg. §1.1001-1(a). In the partition setting, that would mean that items of significance include whether debt is involved, whether the tracts are contiguous, and the extent to which they differ.

IRS ruling.  In 1954, the IRS ruled that the conversion of a joint tenancy in capital stock of a corporation into tenancy in common ownership (to eliminate the survivorship feature) was a non-taxable transaction for federal income tax purposes.  Rev. Rul. 56-437, 1956-2 C.B. 507. See also Priv. Ltr. Rul. 200303023 (Oct. 1, 2002); Priv. Ltr. Rul. 9633034 (May 20, 1996).  Arguably, however, the Revenue Ruling addressed a transaction distinguishable from a partition of property insomuch as the taxpayers in the ruling owned an undivided interest in the stock before conversion to tenancy in common and owned the same undivided interest after conversion. 

Partition as a Severance

A severance is not a sale or exchange.  A partition transaction, by parties of jointly owned property, is not a sale or exchange or other disposition.  See, e.g., Priv. Ltr. Rul. 200328034 (Oct. 1, 2002).  It is merely a severance of joint ownership. For example, assume that three brothers each hold an undivided interest as tenants-in-common in three separate tracts of land.  None of the tracts are subject to mortgages.  They agree to partition the ownership interests, with each brother exchanging his undivided interest in the three separate parcels for a 100 percent ownership of one parcel. None of them assume any liabilities of any of the others or receive money or other property as a result of the exchange. Each continues to hold the single parcel for business or investment purposes. As a result, any gain or loss realized on the partition is not recognized and is, therefore, not includible in gross income.  Rev. Rul. 73-476, 1973-2 C.B. 301.  However, in a subsequent letter ruling issued almost 20 years later, the IRS stated that the 1973 Revenue Ruling on this set of facts held that gain or loss is “realized” on a partition. It did not address explicitly the question of whether the gain or loss was “recognized” although the conclusion was that the gain was not reportable as income.  Priv. Ltr. Rul. 200303023 (Oct. 1, 2002).

To change the facts a bit, assume that two unrelated widows each own an undivided one-half interest in two separate tracts of farmland. They transfer their interests such that each of them now becomes the sole owner of a separate parcel.  Widow A’s tract is subject to a mortgage and she receives a promissory note from Widow B of one-half the amount of the outstanding mortgage.  Based on these facts, it appears that Widow A must recognize gain to the extent of the FMV of the note she received in the transaction because the note is considered unlike property.  Rev. Rul. 79-44, 1979-2 C.B. 265.

Based on the rulings, while they are not entirely consistent, gain or loss on a partition is not recognized (although it may be realized) unless a debt security is received, or property is received that differs materially in kind or extent from the partitioned property. The key issue in partition actions then is a factual one. Does the property received in the partition differ “materially in kind or extent” from the partitioned property or is debt involved?

Single or contiguous tracts?  It may also be important whether the partition involves a single contiguous tract of land or multiple contiguous tracts of land. However, in two other private rulings, the taxpayer owned a one-third interest in a single parcel of property with two siblings as tenants-in-common.  Priv. Ltr. Ruls. 200411022 and 200411023 (Dec. 10, 2003).  The parties agreed to partition the property into three separate, equal-valued parcels with each person owning one parcel in fee. The property was not subject to any indebtedness. The IRS ruled that the partition of common interests in a single property into fee interests in separate portions of the property did not cause realization of taxable gain or deductible loss.  Rev. Rul. 56-437, 1956-2 C.B. 507.

What about undivided interests?  Is there any difference taxwise between a partition with undivided interests that are transformed into the same degree of ownership in a different parcel and an ordinary partition of jointly owned property? Apparently, the IRS doesn’t think so.  In one IRS ruling, the taxpayers proposed to divide real property into two parcels by partition, and the IRS ruled that gain or loss would not be recognized. Ltr. Rul. 9327069 (Feb. 12, 1993).  Likewise, in another ruling, a partition of contiguous properties was not considered to be a sale or exchange.  Ltr. Rul. 9633028 (May 20, 1996). The tracts were treated as one parcel.

Conclusion

The partition of the ownership interests of co-owners holding undivided interests in real estate is often an unfortunate aspect of poor planning in farm and ranch estates.  That problem can be solved with appropriate planning.  If that planning is not accomplished during life, then it's likely that a judge will sort it out after death.  At least the tax consequences of a partition don’t appear to present a problem if the partition amounts to simply a rearrangement of ownership interests among the co-owners. 

February 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 22, 2022

Nebraska Revises Inheritance Tax; and Substantiating Expenses

Overview

There have been several important developments in ag law and tax over the past couple of weeks worth noting.  So, before they pile up even further, I thought I would provide a quick update for you. 

A few recent developments touching ag law and tax – it’s the topic of today’s post.

Nebraska  - “The Good Life” Becomes a Better Place to Die

In 1895, Illinois was the first state to adopt a progressive inheritance tax on collateral heirs (an heir that is not in a direct line from the decedent, but comes from a parallel line.  The law was challenged as a violation of equal protection under the Constitution, but was upheld in 1898 in Magoun v. Illinois Trust and Savings Bank, et al., 170 U.S. 283 (1898).  As a result of the court’s decision, Nebraska adopted a progressive county-level inheritance tax in 1901.  The state’s inheritance tax system has changed little since that time.  Presently, Nebraska is the only state that uses the tax as a local government revenue source. 

But, this session the Nebraska Unicameral has passed (with only one vote in opposition) a bill that the Governor signed into law on February 17 revising the state’s county inheritance tax system (a tax on the privilege to inherit wealth). 

Note:  The lone vote in opposition to the bill was cast by a Senator from a district that has had counties in recent years where the inheritance tax generated zero revenue for the county.  It’s pretty easy to vote against a bill lowering (or eliminating a tax) when it doesn’t affect one’s constituents in the first place.

LB 310 changes the inheritance system for decedent’s dying after 2022.  Amounts passing to a surviving spouse remain exempt, and for “Class I relatives (near relatives – basically those persons up and down the decedent’s line), the 1 percent rate doesn’t change, but the exemption goes to $100,000 from the prior level of $40,000 per person.  For Class II relatives (aunts and uncles, nieces and nephews, and other lineal descendants of these relatives), the tax rate drops from 13 percent to 11 percent and the exemption increases from $15,000 per person to $40,000 per person.  For Class III “relatives” (everyone else), the rate is 15 percent, down from 18 percent, and the exemption will be $25,000 instead of the prior $10,000 amount.  Also included in the revised system is a provision exempting inheritances by persons under age 22 from all tax. 

Note:  Under LB 310, step-relatives are treated in the same manner as blood relatives with respect to the tax rate and exemption amounts based on their classification. 

The new inheritance tax system does require an estate’s personal representative to submit a report regarding inheritance taxes to the county treasurer of a county in which the estate is administered upon the distribution of any estate proceeds.  The Nebraska Department of Revenue must prepare a form for the personal representative’s report which will include information about the amount of the inheritance tax generated and the number of persons receiving property.  The report must also disclose the number of persons who do not reside in Nebraska that receive property that is subject to inheritance tax. 

More Substantiation Cases

In recent days, the U.S. Tax Court has issued a couple of opinions involving the expense substantiation rules of I.R.C. §274.  As we are in the midst of tax season, it is a good reminder that deductions are a matter of legislative “grace.”  If you claim a business deduction, you must substantiate it under the applicable rule(s).  Some types of expenses require more substantiation that do other expenses. 

Business Deductions Properly Denied 

Sonntag v. Comr., T.C. Sum. Op. 2022-3

The petitioners, a married couple, both had sources of income. The husband operated a music studio from a shed in their backyard. They used an electronic application to track their business expenses and receipts. On their joint 2017 return, they reported $247,201 in income from Form W-2. They claimed Schedule C deductions of $47,385, resulting in a business loss of $28,835. The deductions included amounts for travel expenses; air fare; meals and entertainment; bank charges; batteries; books and publications; a briefcase; credit card interest and fees; camera parts; costume cleaning; stage costumes; catering for special events; labor; office supplies; fees for physical training; postage/shipping; personal hygiene products; prop expenses; “research” admission fees; cable fees; Apple Music and Spotify subscriptions; Netflix subscriptions; studio supplies; cell phone expense; tools; and legal services. The IRS disallowed $37,800 of the deductions which included $11,713 of travel expenses; $5,763 of meal and entertainment expenses; and $20,324 of other expenses.

The Tax Court agreed with the IRS. Personal care expenses were properly denied. The credit card and annual fee expenses involved multiple personal transactions and weren’t substantiated as business expenses. The stage costume expense was not deductible because the husband testified that the shoes and clothes could also be worn as personal wear. The catering expenses were not properly substantiated, and the physical training expenses were also determined to be personal in nature as were the hygiene products. The research expenses were determined to be inherently personal. The cell phone expense was properly disallowed - some of the expense had been allowed. Other expenses were also disallowed for lack of substantiation – bank charges; batteries; books and publications; briefcase; camera parts; office supplies; and legal services. The claimed travel expenses were properly disallowed for failure to meet the heightened substantiation requirements of I.R.C. §274(d). Still other expenses were properly disallowed as both personal and unsubstantiated, including costume cleaning; labor; props; studio supplies; tools; and postage/shipping. 

Unreimbursed Employee Expenses Properly Substantiated 

Harwood v. Comr., T.C. Memo. 2022-8

The petitioner was a construction worker that worked for various employers over the tax years in issue. His work required him to leave home for significant “chunks of time.” He sought to deduct unreimbursed expenses for meals and entertainments, lodging, vehicle and other unreimbursed expenses that he incurred during his employment. The IRS disallowed a portion of the claimed deductions. The Tax Court upheld the petitioner’s deductions, noting that he had properly substantiated his travel, meals and lodging while away from home. He corroborated the amount, time, place and business purpose for each expenditure as I.R.C. §274(d) and Treas. Reg. §1.274-5T(b)(2)(ii)-(iii) requires. He also substantiated the auto expenses by documenting the business use and total use by virtue of a contemporaneous log. He also was “away from home” because his employment was more than simply temporary or only for a short period of time. The petitioner also proved that the dd not receive or have the right to receive reimbursement from his employer. 

Conclusion

The Nebraska modification of the county-level inheritance tax is step in the right direction for tax policy that has often ignored the inheritance tax.  On the unreimbursed business expense deduction issue, it’s imperative to maintain good records.  And not all expenses fall under the same substantiation rules.  That’s a key point that was brought out by the Tax Court last year in Chancellor v. Comr., T.C. Memo. 2021-50.  In Chancellor, the Tax Court pointed out that expenses that fall under the I.R.C. §274(d) umbrella cannot be substantiated (estimated) under the Cohan rule.  See Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930).  So, it’s important to understand which expenses are covered by the rule and those that aren’t, and what it takes to properly substantiate them.  But even if the Cohan rule applies it’s not a certainty that it will be a successful defense to an IRS audit.   

February 22, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Saturday, February 19, 2022

Proper Tax Reporting of Breeding Fees for Farmers

Overview

Farmers and ranchers enter into numerous transactions during a tax year that pose interesting questions for tax preparers.  Sometimes those questions involve the proper tax reporting treatment of income received from various activities that are related to the farming or ranching business.  Examples include Income from breeding fees; mineral and soil sales; crop share rents; livestock sales; and income from the sale of farm business assets.

Proper tax reporting of certain income sources for farmers and ranchers – it’s the topic of today’s post

Breeding Fees

Income reporting.  Amounts that a farmer or rancher receives as breeding fees are includible in gross income.  If part or all of the fee is later refunded because the animal did not produce live offspring, the breeding fees are still reported as income in the year received, with an offsetting deduction when the refund is made.

Deduct or capitalize – who’s at risk?  Normally, if a farmer pays a fee to have his own cow serviced by someone else’s bull, the fee is a deductible on Schedule F as a breeding fee.  But, a breeding fee might be classified as either a cost of raising or a cost of acquiring an animal, depending on which party bears the risk of loss that the breeding process may be unsuccessful. See, e.g. Duggar v. Comr., 71 T.C. 147 (1978), 1979-2 C.B. 1; Jordan v. Comr., T.C. Memo. 2000-206.  For example, in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982), a farmer bred cattle through an embryo transplant arrangement with a reproduction Center.  The only guarantee that the Center made was that an impregnated cow would become pregnant within 90 days of the transplant.  The famer assumed all of the risk of loss associated with the embryo and the resultant calf.  The IRS determined that the fee for the embryo transplanting service was not merely an additional cost of purchasing a calf.  Accordingly, the fee was not expended to acquire or improve a capital asset and was currently deductible (along with the cost of the embryo, the cost to prepare the recipient cow).  Again, the key to this tax result was that the Center made no guarantee that the farmer would eventually possess a live and healthy cow. 

Compare the result in Priv. Ltr. Rul. 8304020 (Oct. 22, 1982) with that of Rev. Rul. 79-176, 1979-1 C.B. 123.  Under the facts of Rev. Rul., 79-176, the taxpayer leased cows from a breeder under a breeding service agreement. Under the terms of the lease, the taxpayer was guaranteed a live calf, healthy and sound for breeding purposes, at the time of weaning. If the calf died or was not suitable for breeding, the breeder would replace the calf with one from its herd.  Based on these facts, the IRS concluded that the taxpayer could not deduct the cost under the breeding servicing agreement because the payments were capital expenditures. These facts were different, the IRS pointed out, from those of Duggar v. Comr., 71 T.C. 14 (1978), acq. 1979-2 C.B. 1.  In Duggar, under a three-part Cattle Management Agreement and Sublease, a farmer leased 40 brood cows for the purpose of building a herd of Simmental cattle.  Under a management agreement, he paid a lease fee and a fee for maintenance and care of the leased cows.  Under a separate management agreement, he paid a fee for the raising of his weaned female calves.  The Tax Court held that he could deduct the cost of maintenance and care associated with the raising of weaned calves to breeding age because he bore the risk of loss.  That was unlike the facts of Rev. Rul. 79-176, where the farmer didn’t bear any risk of loss until the calves were weaned.  That meant the costs incurred before weaning had to be capitalized as additional costs of the calves.  See also Wiener v. Comr., 58 T.C. 81 (1972), aff’d., 494 F.2d 691 (9th Cir. 1974); Maple v. Comr., 440 F.2d 1055 (9th Cir. 1971).  Similarly, in Jordan v. Comr., T.C. Memo. 2000-206, the petitioners were guaranteed live foals under stallion service contracts which resulted in the associated breeding fees being capitalized rather than deducted on Schedule F.

Note:  In Duggar, the farmer’s expenses associated with the leased brood cows were nondeductible capital expenditures. The agreement was in effect for the purchase of weaned calves.

The bottom line is that a breeding fee is classified as either a cost of "raising" or a cost of "acquiring" an animal depending upon which party bears the risk of loss that the breeding process is unsuccessful.

Purchase of impregnated cows.  In Rev. Rul. 86-24, 1986-1 C.B. 80, a corporation owned purebred cows that, after hormone treatments, were artificially inseminated with semen from a purebred bull.  The embryos were surgically removed and implanted in the non-purebred cows.  After a positive pregnancy test, the corporation offered the implanted cows for public sale.  The cows were usually resold after giving birth to purebred calves.  The purchase price of each cow impregnated with an embryo transplant was equal to its fair market value (which was about three times greater than the fair market value of a cow not so impregnated.  The sale price of a cow after it gave birth to a purebred calf was equal to that of a non-impregnated cow.  The taxpayer (cash basis, calendar year) bought 10 impregnated cows and allocated the entire purchase price to the cows, and none to the purebred embryos.  Later in the tax year, 10 purebred calves were born (which the taxpayer intended to hold for sale) and the taxpayer then sold the cows for about one-third of what they were purchased for.  The taxpayer wanted to claim an ordinary loss with respect to the sale of the cows

The IRS determined that the purchase price of the impregnated cows had to be allocated to each cow and its embryo on the basis of the fair market value of each.  The eventual sale of the cows (within 24 months of their acquisition) would trigger ordinary income or loss.  However, because the taxpayer sold the cows for the same amount of cost that had to be allocated to them, there was no gain or loss on the sale of the cows.   The balance of the acquisition cost of the impregnated cows was allocated to the embryos was determined to be an amount expended in purchasing livestock that had to be capitalized.  The calves were not capital asset because they were held primarily for sale to customers in the ordinary course of business.  Thus, any gain or loss on their eventual sale would be ordinary in nature.  Neither the cost of the cows nor the basis allocated to the calves was currently deductible on Schedule F as a business expense. 

Note:  In Rev. Rul, 87-105, 1987-2 C.B. 46, the IRS modified Rev. Rul. 86-24 by stating that if before Feb. 24, 1986, the taxpayer had purchased a cow that was pregnant with a transplanted embryo or was subject to a binding written agreement to buy an impregnated cow, the cost allocated to the embryo can be deducted as a business expense under I.R.C. §162. 

Accrual method.  For a farmer on the accrual method of accounting, breeding fees are to be capitalized and allocated to the cost basis of the animal.  G.C.M. 39519 (Oct. 11, 1985).  Under the facts of the G.C.M., the taxpayer was trying to establish a breeding herd, and purchased cattle embryos and recipient cows.  The farmer and the seller allocated costs separately to breeding, embryo transplant, and maintenance services, and to the purchase price of the cows.  The question was whether the cost of the embryo transplants were deductible under I.R.C. §162 or had to be capitalized under I.R.C. §263.  The IRS concluded that the expense incurred for each embryo transplant was to be capitalized as the cost of acquiring a capital asset (the embryo) and, hence, was to be included in the cost basis of each cow. 

Conclusion

Breeding fees can generally be deducted as a farm business expense. However, if the breeder guarantees live offspring as a result of the breeding or other veterinary procedure, the fees must be capitalized into the cost basis of the offspring. For a taxpayer on the accrual method of accounting, breeding fees must be capitalized and allocated to the cost basis of the offspring.   

February 19, 2022 in Income Tax | Permalink | Comments (0)

Thursday, February 17, 2022

Elements of a Hunting Use Agreement

Overview

Some landowners allow hunting on the farm and ranch land that they own.  Often, the use of a tract for hunting will simply be by oral permission.  But, other landowners may take the step to reduce expectations to writing to avoid misunderstandings and minimize future legal issues.  So, what are the elements of a good hunting use agreement? 

Building a solid hunting use agreement – it’s the topic of today’s post.

The Property Interest Involved

Engaging in a hunting activity on someone else’s property involves the property law concept of that of a license.  A license is a term that covers a wide range of permissive land uses which, unless permitted, would be trespasses.  Thus, a hunter who is on the premises with permission is a licensee.  The license can be terminated at any time by the person who created the license (the landowner) by denying permission to hunt.  A license is only a privilege. It is not an interest in the land itself and can be granted orally.  But, when permission to hunt is obtained in writing, what makes for a good agreement?

Elements of a Hunting Use Agreement

Legal description and map.  It is essential to include a description of the property that the “hunting operator” may hunt.  Provide the number of acres and give a general description of the property, and then provide a precise legal description attached as an “Exhibit” to the agreement.  Also, it is generally a good idea to provide a map showing any areas where hunting is not allowed and attach the map as an Exhibit to the agreement. 

Hunting rights.  The agreement should clearly specify the rights of the hunting operator.  Because the agreement is a hunting use agreement, the document should clearly state that the “hunting operator” has the right to use the property solely for the purpose of hunting wild game that is specifically described in the agreement.  That specific game should not only be listed, but bag limits, species, sex, size and antler/horn limitations should be noted as appropriate. 

The agreement should also clearly specify whether the hunting operator’s right to use the property for hunting game are exclusive or non-exclusive.  If the hunting operator is granted an exclusive hunting right, the landowner is not entitled to use the property for game hunting purposes during the term of the agreement.  If the hunting operator’s right is non-exclusive, the landowner (and/or any designees) is entitled to use the property for game hunting purposes.  With non-exclusive rights, it may be desirable to denote any limitations to the landowner’s retained hunting rights. 

On the hunting rights issue, it is usually desirable on the landowner’s part to include a clause in the agreement specifying that the landowner and the landowner’s family, agents, employees, guests and assigns retain the right to use and control the property for all purposes.  Those purposes should be listed, with the common “including but not limited to” language.  Such uses as livestock grazing; growing crops and orchards; mineral exploration; drilling and mining; irrigation, timber harvesting; granting of easements and similar rights to third parties; fishing; horseback riding; hiking; and other recreational activities, etc., may want to be listed.

Specification of the beginning and ending date of the hunting operator’s right to use the property should be included.  It is suggested to denote that the property may be used for game hunting purposes limited to legal hunting seasons and hours tied to the particular wild game at issue.  The agreement should not extend the hunting operator’s rights beyond the applicable hunting season(s). 

Consideration.  What is a “fair” rate to charge for the granting of hunting rights?  The answer to that question will depend upon rates charged for similar properties and game in the area. That could be difficult to determine, but data might be available for comparison.  Check your state’s land grant university Extension Service for any information that might be available.  County Extension agents may be a good place to start.  

The agreement should describe how payment is to me made and when it is due.  In addition, give thought to including clause language noting that the landowner might have lien rights under state law and state whether a security deposit is required and/or security agreement is or has been executed to secure payment. 

Think through whether and to what extent (if any) payment is required if the property (or a part thereof) becomes unavailable to hunting because of unanticipated events such as flood; fire; government taking or condemnation; drilling, mining or logging operations, etc.  Is payment to be adjusted?  If so, how? 

Improvements.  Is the hunting operator to be given the right to construct improvements on the property?  If so, the right needs to be detailed.  Is the landowner obligated to construct any improvements?  For larger hunting operations the landowner commonly constructs certain improvements such as new roads; fences; gates; hunting camps; wildlife crops and feeding facilities; water facilities; blinds; tree stands, and similar structures.  List a completion date for constructed improvements.  Also, give thought to including a provision in the agreement for the cleaning, repair and maintenance of improvements.  Which party does what, and which party pays? 

Prohibited uses.   Clearly state what uses on the property are not allowed.  Are campfires allowed?  What about the use of dogs?  What about camping overnight on the property?  Are pack animals to be used?  If so, specify that the animals must be in compliance with any applicable branding or other identification requirements.  If pack animals are allowed, that might mean that corrals will be needed and feeding requirements will have to be met.  Also, with respect to pack animals, make sure the document requires that the hunting operator complies with inspection, inoculation, vaccine and health requirements.  The landowner should be provided with reports and certificates, etc. 

The driving of vehicles should be restricted to particular areas and if gates are to be driven through, include a provision requiring the hunting operator to be responsible for leaving the gates in the condition found (locked, unlocked, etc.). 

Insurance coverage.  An important aspect of any fee-based activity on the premises is insurance.  The agreement should specify whether which party (or both) is to maintain liability insurance coverage and in what amount.  Make sure the insurance covers any improvements on the property.  Also, for landowners, don’t rely on coverage under an existing comprehensive liability policy for the farm or ranch.  That policy likely has an exclusion for non-farm (or ranch) business pursuits of the insured. Being compensated for hunting on the property would likely fall within the exclusion. 

Miscellaneous.  There may be numerous miscellaneous provisions that might apply. These can include provisions for the landowner’s warranty of ownership; whether the agreement is to be recorded; and the maintenance of trade association memberships and licenses and permits. 

Liability Issues

Numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.”  Typically, such legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity.  The statutes tend to be written very broadly and can apply to such things as corn mazes, hayrides and even hunting and fishing activities.

Recognizing the potential liability of owners and occupiers of real estate for injuries that occur to others using their land under the common law rules, the Council of State Governments in 1965 proposed the adoption of a Model Act to limit an owner or occupier's liability for injury occurring on the owner's property. The Council noted that if private owners were willing to make their land available to the general public without charge, every reasonable encouragement should be given to them. The stated purpose of the Model Act was to encourage owners to make land and water areas available to the public for recreational purposes by limiting their liability toward persons who enter the property for such purposes. Liability protection was extended to holders of a fee ownership interest, tenants, lessees, occupants, and persons in control of the premises.  Land which receives the benefit of the act include roads, waters, water courses, private ways and buildings, structures and machinery or equipment when attached to the realty. Recreational activities within the purview of the act include hunting, fishing, swimming, boating, camping, picnicking, hiking, pleasure driving, nature study, water skiing, water sports, and viewing or enjoying historical, archeological, scenic or scientific sites.  Most states have enacted some version of the 1965 Model legislation.

Note:  The point is to check state law with respect to both agritourism statutes and recreational use statues.  Generally, they will provide liability protections to the landowner for hunting activities on the premises if the landowner does not act willfully or wantonly (with reckless disregard to the safety of the hunting operator).  State laws vary on the protection of the statutes if a fee is charged. 

Conclusion

Allowing hunting activities to be engaged in on farming or ranching property can provide an additional source of income.  But, it’s important to enter into written agreements with hunters.  The points made above should be an guide for helping construct a good agreement that will benefit the parties involved.

February 17, 2022 in Contracts, Real Property | Permalink | Comments (0)

Monday, February 14, 2022

What’s the Character of the Gain From the Sale of Farm or Ranch Land?

Overview

Normally, when a farmer or rancher sells farm or ranch land the resulting gain is treated as capital gain.  That’s also the case for an investor in land that later sells it as an investment asset.   In both instances, the land is a capital asset that was being used in the seller’s trade or business or as an investment asset.  But, once the facts move outside of those confines the tax result can change.  For instance, what if  urban development was moving toward the farm or ranch and the seller, to take advantage of the upward price pressure on the land, started to parcel out the land and sell it in small tracts?  What if the seller had the land platted?  What if marketing steps were taken?  What if the buyer believed the land had a strategic location at the time of purchase, farmed it for a period of time and then began steps to prepare it to be sold off in smaller residential tracts at substantial gain?  Do those factors change the character of the gain? recognized on sale?  Possibly. 

General Rule

Sales that are deemed to be in the ordinary course of the taxpayer’s business generate ordinary income.  I.R.C. §1221(a)(1).  However, the sale of a capital asset (such as land) generates capital gain.  The different tax rates applicable to ordinary income and capital gain are often large for many taxpayers (sometimes as much as a 15 percentage-point difference) with the capital gain rates being lower.  So, a farmer, rancher or land investor will want to treat the gain from the sale of land as a capital gain taxed at the preferential lower rate.   That will be the outcome, unless the land is determined to have been held by the seller for sale to others in the ordinary course of their business. 

Facts Matter

Farmers and ranchers don’t normally sell land in the ordinary course of their farming or ranching business.  As noted above, the determination of the character of gain on sale is fact-dependent, with those facts bearing on the taxpayer’s primary purpose for holding the property.  If real estate is acquired for use in the taxpayer’s trade or business or for investment purposes, and retains that character, it is a capital asset, and the gain from sale will receive capital gains treatment.  That is a factual determination.

No single factor or combination of factors is controlling.  Based on decades of caselaw on the issue, the major factors appear to be as follows:  1) the taxpayer’s purpose in acquiring the property and holding the property before sale; 2) the frequency continuity, regularity and substantiality of sales of real properties; 3) the taxpayer’s everyday business and the relationship of the income from the property to the taxpayer’s total income; 4) the substantiality of sales of real properties; 5) the length of time the taxpayer held the real properties; 5) the extent of the taxpayer’s efforts to sell the property by advertising or otherwise; 6) whether the taxpayer used a business office for the sale of properties;  and 7) any improvements the taxpayer made to the real properties to increase sales revenue.  See Sovereign v. Comr., 281 F.2d 830 (7th Cir. 1960).

  • In Allen v. United States, No. 13-cv-02501-WHO, 2014 U.S. Dist. LEXIS 73367 (N.D. Cal. May 28, 2014), a married couple sold 2.63 acres of undeveloped land that generated over $60,000.  They reported the income as capital gain, but the IRS claimed that the income was "other income" taxable as ordinary income.  The couple admitted that they bought the land for the purpose of development, and they did attempt to find a partner to develop the property.  Ultimately, the property was sold to a developer and the couple received a payment each time a developed portion of the property was sold.  The IRS denied capital gain treatment, asserting that the income was from property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." 

Note:          The term “customers” has been given a broad meaning except in those cases involving taxpayers dealing or trading in securities.  Basically, the IRS presumes that in real estate transactions a sale to any purchaser is a sale to a “customer.”  See, e.g., Pointer v. Comr., 48 T.C. 906 (1967).  The burden is on the taxpayer, based on solid facts, to establish otherwise.

The court noted that the determination of the nature of the income is a fact-based determination, and that the facts supported the IRS.  The taxpayers intended to develop and sell the property at the time it was acquired, and the taxpayers were active in getting the property developed.  The fact that the property was the only one purchased for development was not determinative.  The court granted summary judgment to the IRS. 

  • A U.S. Tax Court case, Fargo v. Comr., T.C. Memo. 2015-96, involved a partnership that acquired a leasehold interest in a tract of land with the intent to develop an apartment complex and retail space.  The lease originally ran for 20 years, but was extended for another 34 years.  The property generated only rental income and the taxpayer made no substantial effort to sell the property for 13 years. Ultimately, the property was sold for $14.5 million plus a share of the profits from the homes to be developed on the property.  The partnership reported $628,222 of capital gain, but IRS took the position that the transaction triggered $7.5 million of ordinary income.  The court agreed with the IRS.  The court noted the following factors were important in making the gain characterization distinction: (1) the property was initially acquired for developmental purposes; (2) efforts to obtain financing and continue that development were made; (3) the sale was to an unrelated party with the plan for the petitioner to develop the property; and (4) efforts continued to develop the property up until the purchase date.  While there were some factors that favored the taxpayer (only minor improvements were made; there were no prior sales; and no advertising or marketing had been performed), the court held that the factors weighed in the favor of the IRS and the sale was in the ordinary course of business under I.R.C. §1221(a)(1).
  • In Long v. Comr., 772 F.3d (11th Cir. 2014), the plaintiff, a real estate developer, entered into a contract with another party to buy land on which the plaintiff was planning on building a high-rise condominium building.  The plaintiff hired architects, sought a zoning permit, printed promotional materials about the condominium, negotiated contracts with purchasers of condominium units and obtained deposits for units.  However, the seller of the land unilaterally terminated the contract.  The plaintiff sued for specific performance and the trial court ordered the seller to honor the contract.  While the trial court's decision was on appeal, the plaintiff sold his position as the plaintiff in the contract litigation to a buyer for $5.75 million.  The IRS characterized the $5.75 million as ordinary income rather than capital gain.  The Tax Court agreed with the IRS on the basis that the plaintiff held the property (which the court said was the land subject to the contract) primarily for sale to customers in the ordinary course of business.  On appeal, the court reversed on the basis that the taxpayer never actually owned the land and instead sold a right to buy the land - a contractual right.  Accordingly, there was no intent to sell contract rights in the ordinary course of business.  The plaintiff intended the contract to be fulfilled and develop the property, and the sale of the right to earn future undetermined income was a capital asset. 
  • The Tax Court, in SI Boo, LLC v. Comr., T.C. Memo. 2015-19, held that ordinary income and self-employment tax was triggered on sale of properties acquired by tax deeds. The court noted that the taxpayers regularly did this.  While they bought the tax liens primary to profit from redemptions of the liens, the court determined that the repeated sales of properties forfeited to them as lien holders constituted ordinary income as a dealer in real estate.  They had also hired persons to act on their behalf to acquire the tax deeds, prepare the tracts for sale and maintain business records.  The court also held that, under another rule, the income from the sales was not reportable on the installment method. 
  • Boree v. Comr., 837 F.3d 1093 (11th Cir. Sept. 2, 2016), aff’g., T.C. Memo. 2014-85, involved a taxpayer that was a self-described real estate professional who received income from land sales.  The taxpayer reported the income as capital gain, but the Tax Court held that it was ordinary income because the taxpayer was found to have held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business.  The court noted that the issue of whether the taxpayer was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status.  That was the result because he held his business out to customers as a real estate business, and he engaged in development and frequent sales of numerous tracts over an extended period of time.  Also, in prior years, he had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed. 

Conclusion

The bottom line is that for most sales of farm or ranch land, the income from the sale will be characterized as capital gain.  However, with the right (or wrong) set of facts, the sale income could be characterized as ordinary.

February 14, 2022 in Income Tax | Permalink | Comments (0)

Friday, February 11, 2022

What to Consider Before Buying Farmland

Overview

Buying farmland is a major decision.  That means that it’s important to carefully consider numerous things before signing the purchase contract.  Many persons have bought farmland only to encounter unanticipated problems.

So, what can be done to avoid the unexpected?  A lot of it boils down to making sure that the buyer has full information about the property they are interested in buying.  This is especially important with respect to farmland. 

Considerations when buying farmland – it’s the topic of today’s post.

Environmental Issues – Due Diligence

Endangered Species.  Rural landowners can have issues with various state and federal regulatory agencies such as the Natural Resources Conservation Service (NRCS); the Environmental Protection Agency (EPA); the U.S. Army Corps of Engineers (COE); the Interior Department; and the Fish and Wildlife Service (USFWS).  The extent to which any of those government agencies has regulatory authority over the land in question is tied to where the land is located.  Some parts of the country are more susceptible to government regulations.  States such as Florida, California and Tennessee, for example, are a few of the states with a substantial agricultural economy that have many endangered or threatened species and animals and plants.  A “habitat” designation for protected species on privately owned land can severely restrict farming and ranching activities on that land.  Some pre-purchase research as to listed species in the state where you are considering and then determining whether a habitat designation might influence the land is worthwhile.    

Comprehensive Environmental Response Compensation & Liability Act (CERCLA).   CERCLA focuses on the cleanup of hazardous waste sites, but it can have significant ramifications for agricultural operations because the term “hazardous waste” has been defined to include most pesticides, fertilizers, and other chemicals commonly used on farms and ranches and its presence can lead to huge liability. 

Perhaps the most important defense to CERCLA liability is the “innocent purchaser” defense.  This defense applies if the defendant purchased land not known at the time of purchase to contain hazardous substances, but which is later determined to have some environmental contamination at the time of the purchase or is contiguous to land not known at the time of the purchase to be contaminated.  A buyer attempting to utilize this defense must establish that the real estate was purchased after the disposal or placement of the hazardous substance, and that the buyer didn’t know or had no reason to know at the time of purchase that a hazardous substance existed on the property.  To utilize the defense, the buyer, as of the purchase date, must have undertaken “all appropriate inquiry” into the previous ownership and uses of the property in an effort to minimize liability.  The phrase “all appropriate inquiry” generally depends upon the existence or nonexistence of five factors:  (1) the buyer’s knowledge or experience about the property; (2) the relationship of the purchase price to the value of the property if it was uncontaminated; (3) commonly known or reasonably ascertainable information about the property; (4) the obviousness of the presence or likely presence of contamination of the property; and (5) the ability to detect such contamination by appropriate inspection.

A buyer of farmland can take several common-sense steps to help satisfy the “appropriate inquiry obligation”.  Certainly, a title search should be made of the property.  Any indication of previous owners that may have conducted operations that might lead to contamination should be investigated.  Aerial photographs of the property should be viewed, and historical records examined.  Likewise, investigation should be made of any government regulatory files concerning the property.  A visual observation of the premises should be made, soil and well tests conducted, and neighbors questioned. However, the execution of an environmental audit may be the best method to satisfy the “all appropriate inquiry” requirement.  Some states have enacted legislation requiring the completion of an environmental audit upon the sale of agricultural real estate.  Today, many real estate brokers, banks and other lenders utilize environmental audits to protect against cleanup liability and lawsuits filed under CERCLA.      

Drainage records.  In some parts of the country farmland is tile drained.  This is particularly the case in areas of the corn belt east of Nebraska.  Public records are a good place to look for information about a tract of farmland.  Checking drainage records with the local Auditor’s office (at least in some states) is a good place to discover drainage information.  Those records may not be in the Recorder’s records and probably won’t show up in an abstract.  Also, there may be private drainage agreements and/or easements that exist.  Those agreements will likely be recorded and appear in the Recorder’s office records for the property. 

USDA records.  USDA records about the land should be examined.  This includes Farm Service Agency (FSA) and NRCS records.  Many sellers will choose to make all of the records open concerning a particular farm.  So, that can be a good way to get your hands on USDA maps and documents.  This will also allow the buyer to determine if there are any government contracts or easements on the property, such as the Conservation Reserve Program or the Wetlands Reserve Program.  Also, the USDA information will allow the buyer to determine if any of the land is highly erodible or has wetland status. 

Wetlands.  A wetland designation on even a small part of the farmland can create significant problems for the owner.  There are two possible aspects to such a designation.  One aspect is regulation via the USDA’s Swampbuster rules.  Under those rules, land designated as a wetland cannot be farmed.  Doing so can bring substantial penalties.  This makes it imperative to analyze any available aerial photos, soil maps and the type of vegetation that is growing on various areas of the land. 

The other aspect with respect to wetland is the “waters of the United States” (WOTUS) issue under the jurisdiction of the EPA and the COE.  Under the current regulatory interpretation of the extent of federal jurisdiction, virtually any connection with a WOTUS can bring substantial restrictions on what can be done on the designated location(s) and result in substantial penalties.  In addition, a wetland designation with Swampbuster and/or WOTUS implications can have a substantial negative effect on the land’s value. 

Note:  Any time that a governmental agency gets involved, the administrative process can drag on for months and even years.  It can be a horrible and costly process.  Due diligence before the purchase can help steer you away from a tract that might get you caught up in a bureaucratic web.

Other Issues

Existing lease.  It’s important to determine whether the land being purchased is leased to a tenant.  In some states, long-term farm leases must be recorded.  In that situation, check the publicly filed records.  But most farm leases are oral leases that run from year-to-year.  Relatedly, for farmland purchases from an individual (or entity) seller or an estate, it is important to understand whether the lease will continue (and, if so, for how long) or whether it has been properly terminated in accordance with state law.  The mere sale of the land, absent some written agreement, will not terminate any existing lease. 

Note:  Do not take a realtor’s (or auctioneer’s) word for it that an existing lease has been terminated or that the purchase will terminate the lease. 

If the land is leased, determine who the tenant is.  Is there only one tenant or multiple tenants?  Ask the existing owner/seller to check the FSA records to see how the government program payments (if any) are being paid and who signed up for them as “tenant.”  If multiple tenants are involved, have they all been properly terminated in accordance with state law?

Local Development Plans

The erection of either wind turbines or solar panels on adjacent or nearby property will have an impact on land value of the tract you buy.  If there currently is no such development, are plans in the works?  Check archives of local newspapers for information on county commissioner meetings as well as with the county clerk.  What’s the talk in the community?  Have easements been acquired on adjacent tracts, but development not begun.  Get the seller to sign-off on a disclosure statement about what they know concerning potential development in the area, and whether the seller has been approached by wind or solar developers. 

Note:  The seller’s failure to disclose key information when required by law as well as an untruthful disclosure that the buyer can prove, can serve as the basis for cancelling a farm sale before closing occurs if the failure pertains to information that serves as the basis of the bargain. 

Also check county records for long-range planning documents.  Are plans in place to widen a road that borders the property that would take some of the land out of production?  If so, how would that impact your plans for the property? 

Signatures.  Make sure to obtain all appropriate signatures (that means a spouse, when applicable), and determine whether the sale is part of a family settlement agreement.  Also, it is important to make sure that the legal description matches what is being purchased.  On this point, take great care when using the abstract and bring it up to date before the purchase and have it carefully examined for accuracy and for defects in title.

Sometimes a tract of land won’t have precisely the acres that the buyer thinks it has.  A half-section, for example, may not actually contain a full 320 acres.  That’s especially likely if the tract lies on the edge of a township, county or a state border.  Similarly, if a “correction” line is present (to account for the curvature of the earth), that can impact the actual number of acres being purchased.  In other words, a “section” may not actually be a full section. 

Physical Inspection

From a practical standpoint, put your boots on and physically walk the tract.  Look at the fences.  Are they on the actual, intended location or boundary?  If not, had the adjoining landowners mutually recognized the existing fence location for a long-enough period of time (determined by state law) so that it is the actual dividing line irrespective of what a survey shows?  Is there a written fence agreement that has been recorded?  Probably not, but it’s a good idea to check the real estate records.  Look for paths that might be easements.  Relatedly, are existing paths wide enough to allow equipment into fields and locations where planting is desired?  How much of the land is consumed by ditches and roads?  The seller will try to sell in accordance with deeded acres, but a buyer that plans on farming the property is interested in paying only for tillable ground.  Not much, if any, value is assigned to non-tillable ground other than pasture. 

Valuation

Land grant universities have good survey data on the value of various classifications of land.  That is a good place to start on determining what a fair/average price for the land might be based on its location and soil type/grassland classification.  Also, actual local sale data (if it exists) is very helpful in determining market value. 

Of course, economic conditions and markets change over time, so current cash flow projections can be off as time passes, so it’s a good idea to build in a buffer to account for negative changes in economic conditions, or unexpected weather issues.

Taxes

How much of the purchase price can be allocated to depreciable items such as fences, farm structures, drainage tile, feeding floors, residual fertilizer supply, etc.?  To the extent that the purchase price can be allocated to such items, it effectively lowers the out-of-pocket cost of the purchase.

Conclusion

There are many things to think about and get clarified when buying farmland.  I am sure that I have not covered them all in this brief article.  What would you add to the list?

February 11, 2022 in Contracts, Real Property | Permalink | Comments (0)

Wednesday, February 9, 2022

Ag Law and Tax Potpourri

Overview

I haven’t done a “potpourri” topic for a couple of months, so it is time for one.  There are always interesting developments happening in the courts and with the IRS.  Today’s edition of the “potpourri” is no different.

Recent miscellaneous developments in the courts and with the IRS – it’s the topic of today’s post.

No WOTC For “Weed” Business 

C.C.A. 202205024 (Nov. 30, 2021)

The taxpayer is a business that is engaged in the trade or business of trafficking marijuana.  Under federal law, marijuana is a Schedule I controlled substance under the Controlled Substances Act.  The taxpayer hires and pays wages to employees from one or more targeted groups provided under I.R.C. §51, and is otherwise eligible for the Work Opportunity Tax Credit (WOTC).  The IRS noted that I.R.C. §280E bars a deduction or credit for a business that traffics in controlled substances as defined by state or federal law.  Thus, the taxpayer was not eligible for any WOTC attributable to wages paid or incurred in carrying on a business of trafficking in marijuana. 

Note:  The IRS position is correct, based on the statute.  But, the discrepancy between federal law and the law of some states creates confusion and inconsistency.

IRS Email Approval of Supervisor Penalty Approval

C.C.A. 202204008 (Sept. 13, 2021)

Under I.R.C. §6751(b)(1), when an IRS agent makes an initial determination to assess penalties against a taxpayer, the agent must obtain “written supervisory approval” before informing the taxpayer of the penalties via a “30-day” letter.  Here, the IRS agent received written supervisory approval of the penalty recommendation via an email from his supervisor before issuing the 30-day letter to the taxpayer. The taxpayer sought to have the IRS remove the tax lien securing penalties imposed for his failure to furnish information on reportable transactions on the basis that IRS had failed to comply with I.R.C. §6751.  The taxpayer claimed that such failure made the penalties invalid and required the lien to be released.  The IRS Chief Counsel’s Office disagreed, finding that the IRS had complied with I.R.C. §6751.  The Chief Counsel’s Office noted that the U.S. Tax Court has held that compliance with the supervisory approval requirement doesn’t require written supervisory approval to be given on a specific form and that an email satisfied the statute, if not the Internal Revenue Manual. 

Low Soil Quality Doesn’t Reduce Assessment Value 

Reichert v. Scotts Buff County Board of Equalization, No. 20A 0061, (Neb. Tax Equal. And Rev. Com. Jan. 31, 2022)

The petitioner owned low soil quality farmland in western Nebraska and challenged the assessed value of the land of $312,376 for 2020 as determined by the county assessor.  The value had been set at $289,186 for 2020. The petitioner sought a value of $269,595 for 2020 in accordance with the land’s lower 2019 classification. The County Board of Equalization (CBOE) determined the taxable value of the property was $289,186 for tax year 2020.  The petitioner’s primary issue with the county’s valuation was that the county had upgraded the soil quality of the land from 2019 to 2020 to justify the higher valuation.  The petitioner provided a Custom Soil Resource Report conducted by the Natural Resources Conservation Service (NRCS) showing that the soil had a farmland classification of “not prime farmland” and should be put back to its prior classification at the lower valuation.    The CBOE determined that the value should be $289,186 for 2020.  The petitioner appealed. 

On review, the Nebraska Tax Equalization and Review Commission (Commission) affirmed the CBOE’s valuation.  The Commission noted that the CBOE’s valuation was based on state assessment standards that became law in 2019 as a result of LB 372 that amended Neb. Rev. Stat. §77-1363.  Under the revised law, the Land Capability Group (LCG) classifications must be based on land-use specific productivity data from the NRCS.  The Nebraska Dept. of Revenue Property Assessment Division used the NRCS data to develop a new LCG structure to comply with the statutory change.  Each county received the updated LCG changes and applied them to the land inventory in the 2020 assessment year.  The Commission noted that the petitioner’s NRCS report did not show the classification that each soil type should receive under the LCG system and, thus, did not rebut the reclassifications of the soil types for his farmland under an arbitrary or unreasonable standard. 

Note:  The case points out that the burden is in the taxpayer to establish that the assessed value is incorrect.  To rebut the presumption, the evidence provided must be specific as to soil type.  The Nebraska farmland tax valuation system is a frustration for many farmers and ranchers despite the change in the system made with the 2019 legislation. 

ESOP Didn’t Shield Taxpayer From Income 

Larson v. Comr., T.C. Memo. 2022-3

The petitioner, a CPA and an attorney, was also the fiduciary of an Employee Stock Ownership Plan (ESOP).  He placed restricted S corporate stock in the ESOP for his own benefit.  The petitioner claimed that the ESOP met the requirements of I.R.C. §401(a) such that the related trust was exempt from income tax under I.R.C. §501(a).    The IRS claimed that the stock value was to be included in his income because he (and the other control person) failed to enforce employment performance restrictions, and “grotesquely” failed to perform fiduciary duties associated with the ESOP.  The petitioner testified that he was not aware of his duties as a fiduciary, but the court didn’t believe the testimony.  The court noted that the petitioner waived the stock restrictions and breached his fiduciary duties which revealed an effort to avoid enforcement of the restrictions.  As such, there was no way he could lose control over the S corporation.  As a result, there was no substantial risk of forfeiture associated with the stock, and the value of the stock was properly included in the petitioner’s income in accordance with Treas. Reg. §1.83-3(a)-(b).  The court also upheld the denial of deductions for claimed business expenses incurred and paid by the S corporation. 

New ESA Policy for ESA Consultations 

EPA Announcement, January 11, 2022.  Effective upon announcement   

The Environmental Protection Agency (EPA) has announced a change in policy regarding Endangered Species Act (ESA) consultations (to determine the impact on endangered or threatened species in light of critical habitat) for newly registered pesticide active ingredients being registered under the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA) for the first time.  Pesticides already registered under FIFRA or that have active ingredients already registered by EPA may not be subject to the same policy, but may still require ESA consultation but not under the ESA’s new policy. The EPA will determine whether formal or informal consultation is necessary on a case-by-case basis. 

Court Says Animal Chiropractic is Veterinary Medicine 

McElwee v. Bureau of Professional and Occupational Affairs, No. 1274 C.D. 2020, 2022 Pa. Commw. LEXIS 9 (Pa. Commw. Ct. Jan. 18, 2022)

The plaintiff is a licensed chiropractor that holds herself out to the public as an “animal chiropractor.”  She treats animals in her practice.  She is not a veterinarian and does not hold herself out as a veterinarian.  She is certified in veterinary chiropractic by the International Veterinary Chiropractic Association.  She receives medical records or x-rays when necessary from a treating veterinarian and reviews them to find infusions of the spine, breaks or fracturs of the spine, misalignments of the spine or any disk space between the vertebrae.  She then makes a treatment and care plan for the animal with or without the veterinarian’s input.  She also practices on animals of veterinarians, and requires animal owners to complete a consultation form granting authorization for her to provide chiropractic care to the animal’s owner.  All animals in her care must have a veterinarian before she will work with the animals. 

The defendant filed an order to show cause alleging that the plaintiff was subject to disciplinary action under state law because the services she performed in her practice constituted the unlicensed practice of veterinary medicine.  The plaintiff sought a hearing on the matter and the hearing examiner issued a proposed adjudication and order concluding that the plaintiff was engaged in the unlicensed practice of veterinary medicine.  The State Board of Veterinary Medicine issued a final adjudication finding the plaintiff, and the plaintiff appealed.  The court rejected the plaintiff’s claim that animal chiropractic was unregulated not subject to the Board’s authority.  The court held that even though animal chiropractic was not specifically regulated under the Veterinary Medicine Practice Act, it was regulated by the Board. 

Note:  Occupational licensure is highly questionable.  In this case, there was no allegation that the plaintiff was not performing as an animal chiropractor in any manner other than with professional competence. 

February 9, 2022 in Environmental Law, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Saturday, February 5, 2022

Purchase and Sale Allocations Involving CRP Contracts

Overview

It is not unusual for farmland enrolled in the Conservation Reserve Program (CRP) to be sold with several years remaining on the CRP contract.  Also, economic conditions may exist which provide an incentive for a landowner to terminate the contract early and put the land back into production or lease it to another farmer for a higher rent amount.  But, what are the economic and tax consequences when these situations occur?

The economic and tax consequences of selling land subject to a CRP contract and early contract termination – it’s the topic of today’s post.

In General

Under the typical CRP contract, farmland is placed in the CRP for a ten-year period.  Contract extensions are available.  Crops cannot be grown on the enrolled land, and enrolled land cannot be grazed unless the USDA authorizes it in special situations (such as drought).  The landowner is required to maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications. 

If the landowner terminates the contact early, an early termination “penalty” applies.  In reality, however, the “penalty” really amounts to liquidated damages.  The question, however, from a tax standpoint, is whether the amount the landowner must pay is a nondeductible as a fine or penalty imposed by a governmental entity for the violation of a law.  See I.R.C. §162(f).  Likewise, if land that is enrolled in the CRP is sold, the seller must pay back to the USDA all CRP rents that they have already received, plus interest, and liquidate damages (which might be waived) unless the buyer agrees to continue to have the land enrolled in the CRP.  If the buyer does not agree to continue to keep the land in the CRP, what are the tax consequences to the seller? 

Purchase Price Allocation to CRP Contract

The requirement that an owner of CRP land pay a penalty in the form of reimbursing the USDA all CRP rents received, plus interest and damages, is synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits.  For a lessee that terminates a lease and pays a cancellation fee to do so, the lessee is generally allowed a deduction.  The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right.  If, on the other hand, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the payment must be capitalized.  See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). 

Note:  While not involved in the CRP setting, when a lessee terminates an existing lease by purchasing the leased property, I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest.  The taxpayer must allocate the entire adjusted basis to the underlying capital asset. 

Selling a CRP Contract - Price Allocation

The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt.  In Priv. Ltr. Rul. 200519048 (Jan. 27, 2005), The taxpayer relinquished all rights to the CRP payments that were sold but agreed to comply will all of the provisions of the CRP contract, including the damage provisions that would apply if he breached the CRP contract terms.  The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835.  On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year.  On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer.  The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return.  The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit.  The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser.  The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date.  In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt.  On this point, the IRS cited Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).  In Cotlow, a life insurance agent bought the rights to assigned commissions for renewals of life insurance from other insurance agents and had ordinary income in the year of receipt from those assigned renewal commissions.

Note:  The purchasing party may pay the early termination costs.  In such event, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).

Early Termination Payments

Generally.  A landlord that makes a payment to the tenant to obtain early cancelation of a lease, where the payment is not considered an amount paid to renew or renegotiate a lease, is considered a capital expenditure that the landlord can amortize. Treas. Reg. §1.263(a)-4(d)(7).  The amortization period depends on the intended use of the property subject to the canceled lease, but normally the amount paid is capitalized and amortized over the lease’s remaining term.  Rev. Rul. 71-283, 1971-2 C.B. 168.  That certainly is the case if the landlord is regaining possession of the land, but if the payment is to allow the sale of the farm, the cost should be added to the landlord’s basis in the farmland and deducted as part of the sale. 

As applied to CRP contracts.  A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer should capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated.  See, e.g., Miller v. Comr., 10 B.T.C. 383 (1928).  That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property.  See, e.g., Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir.1981).  However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract.  See Montgomery v. Comr., 54 T.C. 986 (1970).  The U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term.  Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). The Ninth Circuit established the Miller case as the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.

Conclusion

Over 20 million acres are presently enrolled in the CRP.  Sometimes a landowner enrolling land in the CRP wants to sell the land or simply terminate the contract early due to economic conditions.  It’s important to know the tax consequences when engaging in those transactions.

February 5, 2022 in Income Tax | Permalink | Comments (0)

Thursday, February 3, 2022

The “Almost Top 10” of 2021 (Part 7) [Medicaid Recovery and Tax Deadlines]

Overview

With today’s article, I conclude my journey through the big developments of 2021 that didn’t make my “Top 10” list.  In Part 7 today, I look at two cases that are presently before the U.S. Supreme Court.  One case involves a state’s right to take tort recoveries from Medicaid beneficiaries.  The other case addresses whether courts can excuse a missed statutory income tax filing deadline.  Both of these issues are important – one for Medicaid planning, and asset protection strategies; the other case might be critical for determining when principles of fairness might apply when an income tax deadline is missed.   

The conclusion of the “Almost Top Ten” of 2021 – it’s the topic of today’s post.

State Medicaid Recovery

Gallardo v. Marstiller, 963 F.3d 1167 (11th Cir. 2020), cert. granted sub nom., Gallardo v. Dudek, 141 S. Ct. 2884 (2021)

Background

Planning for long-term health care needs is a recommended part of estate planning for many people.  This is particularly true for farm and ranch (and other small) businesses where the desire is to transition the business into subsequent generations of the family.  Without a plan in place, spending $100,000 annually on a long-term care bill could cause a business succession plan or family estate planning goals to not be met as desired.  Medicaid planning is part of long-term care planning. 

Medicaid is the joint federal/state program that is the primary public assistance available to help pay for long-term care – if the beneficiary has little to no “available” assets.  In addition, once a state provides Medicaid benefits to a beneficiary, the state can seek reimbursement (“recovery”) from the beneficiary’s estate upon death to a certain extent for benefits paid during life.  That is designed to protect, at least in part, the taxpaying public.  A state may also obtain reimbursement from third parties for Medicaid expenses paid to injured beneficiaries.  But, to what extent?  That’s the issue that is presently before the U.S. Supreme Court.

In Gallardo, the plaintiff was severely injured in 2008 after being hit by a pickup truck when she got off a school bus.  She still remains in a persistent vegetative state.  The state (Florida) Medicaid program (e.g., Florida taxpayers) paid $862,688.77 for her medical care.  Her parents sued the truck driver and the school district which resulted in a settlement of $800,000.  Of that amount, $35,367.52 was designated as being for past medical expenses.  None of it was designated as being for future medical expenses.  The state Medicaid agency neither participated in or agreed to the settlement terms, but 42 U.S.C. §1396k(a)(1)(A) requires the state Medicaid program to be reimbursed from any third party because Medicaid is to be a “payor of last resort” for medically necessary goods and services provided to a recipient.  Indeed, state law provides for a superior lien with respect to third-party benefits regardless of whether the Medicaid beneficiary has been made whole or other creditors have been paid.  Fla. Stat. §409.910(1).  But, the state’s recovery is not to be in excess of the amount of medical assistance paid by Medicaid.  42 U.S.C. §1396a(a)(25)(H).  Under Florida’s formula, in the event of a beneficiary’s tort recovery, the state gets 50 percent of the recovery (after fees and costs) up to the total amount provided in medical assistance by Medicaid.  Thus, the state asserted a lien for $862,688.77 on the tort action and any future settlement – even though the settlement specified that $35,367.52 was for past medical expenses.  During an administrative hearing, the state claimed entitlement to the amounts it paid to the beneficiary from the portion of the settlement representing compensation for the plaintiff’s future medical expenses.  The plaintiff sued for a declaration that, under federal law, the state couldn’t be reimbursed from any part of the settlement other than that representing compensation for past medical expenses - $35,367.52.  The trial court granted the plaintiff’s motion for summary judgment, finding that state law was preempted by federal law.   The state Medicaid agency appealed. 

Note:  During the pendency of the appeal, the Florida Supreme Court held in a different case that state federal law authorizes the state to be reimbursed out of personal injury settlements only from the portion representing past medical expenses.  Giraldo v. Agency for Health Care Administration, 248 So. 3d 53 (Fla. 2018). 

The appellate court reversed, determining that federal law does not preempt state law permitting a state Medicaid agency to seek reimbursement from portions of a settlement that represent all future medical care (as well as past), and that the parties’ allocation to past and future medical care didn’t bind the state agency.  This was particularly the case, the appellate court noted, because the parties to the settlement did not seek the state Medicaid agency’s input on the settlement allocation.  Indeed, the appellate court determined that federal Medicaid law merely bars a state from attaching its lien against any part of a settlement that is not designated as payments for medical care (to the extent of Medicaid benefits provided).  The appellate court also upheld the state’s reimbursement formula. 

Conclusion

The U.S. Supreme Court agreed to hear the case, and oral argument was held in early January of 2022.  It will be interesting to see how the Court decides the case.  Certainly, however the Court decides will potentially “tee-up” the issue for state legislatures to address how their respective state Medicaid recovery statutes are worded and what policy is desired when third-party payments to Medicaid beneficiaries are involved.

Missed Tax Deadline

Boechler, P.C. v. Commissioner, 967 F.3d 760 (8th Cir. 2000), cert. granted, 142 S. Ct. 55 (2021)

Background

In 2015, the IRS notified the plaintiff (a law firm) about the failure to file employee tax withholding forms.  The plaintiff didn’t respond, and the IRS imposed a 10 percent intentional disregard penalty of $19,250.  The plaintiff challenged the penalty in a Collection Due Process (CDP) hearing, which resulted in the penalty being imposed, with interest.  On July 28, 2017, the IRS Office of Appeals mailed its CDP hearing determination to sustain the proposed levy on the plaintiff’s property to collect the penalty plus interest.  That plaintiff received the notice on July 31, 2017, which informed the plaintiff that the deadline for submitting a petition for another CDP hearing was 30 days from the date of determination – August 28, 2017.  As an alternative, the plaintiff could petition the Tax Court to review the determination of the IRS Office of Appeals.  But, again, the statutory time frame for seeking Tax Court review involved filing a petition with the Tax Court within 30 days of the determination.  I.R.C. §6330(d)(1).  The plaintiff filed its petition with the Tax Court on August 29, 2017 – one day late.  Accordingly, the IRS moved to dismiss the plaintiff’s petition on the grounds that the Tax Court lacked jurisdiction.  The plaintiff, however, claimed that the statute was not jurisdictional (even though the statute says “(and the Tax Court shall have jurisdiction with respect to such matter).”  Instead, the plaintiff claimed that the filing deadline was subject to “equitable tolling” and that the 30-day deadline should be computed from the date the notice was received.  The Tax Court disagreed with the plaintiff and issued an order dismissing the case for lack of jurisdiction – I.R.C. §6330(d)(1) was jurisdictional. 

Note: When equitable tolling is applied, a court has the discretion to ignore a statue of limitations and allow a claim if the plaintiff did not or could not discover the “injury” until after the expiration of the limitations period, despite due diligence on the plaintiff’s part.   

Appellate Decision

The plaintiff appealed.  The appellate court pointed out that a statutory time limit is generally jurisdictional when the Congress clearly states that it is and noted that the Ninth Circuit had recently held that the statute was jurisdictional.  Duggan v. Comr., 879 F.3d 1029 (9th Cir. 2018).  The appellate court went on to state that the “statutory text of §6330(d)(1) is a rare instance where Congress clearly expressed its intent to make the filing deadline jurisdictional.”   On the plaintiff’s claim that pegging the 30-day timeframe to the date of determination was a Due Process or Equal Protection violation, the appellate court disagreed.  The appellate court, on this issue, noted that the plaintiff bore the burden to establish that the filing deadline is arbitrary and irrational.  Ultimately, the appellate court determined that the IRS had a rational basis for starting the clock on the 30-day timeframe from the date of determination because it streamlines and simplifies enforcement of the tax code.  Measuring the 30 days from the date of receipt, the appellate court pointed out, would cause the IRS to be unable to levy at the statutory uniform time and, using the determination date as the measuring stick safeguards against a taxpayer refusing to accept delivery of the notice as well as supports efficient tax enforcement.   

U.S. Supreme Court

The U.S. Supreme Court, on September 30, 2021, agreed to hear the case. Both the plaintiff and the IRS are focused on test for equitable tolling set forth in United States v. Kwai Fun Wong, 575 U.S. 402 (2015).  That case involved 28 U.S.C. §2401(b), a statute that establishes the timeframe for bring a tort claim against the United States.  There a slim 5-4 majority held that a rebuttable presumption of equitable tolling applied.  The presumption can be rebutted if the statute shows that the Congress “plainly” gave the time limits “jurisdictional consequences.”  In that instance, time limits would be jurisdictional and not subject to equitable tolling.   

The beef comes down to how to read the statute.  The statute at issue, I.R.C. §6330(d)(1) states in full:

“(1) PETITION FOR REVIEW BY TAX COURT

The person may, within 30 days of a determination under this section, petition the Tax Court for review of such determination (and the Tax Court shall have jurisdiction with respect to such matter).”

The IRS asserts that “such matter” refers to the petition that has been filed with the Tax Court that meets the 30-day deadline.  This is the view that the appellate court adopted as did the Ninth Circuit in Duggan.  However, the plaintiff claims that “such matter” refers to “such determination” and, in turn, “determination under this section” with no additional jurisdictional requirement involving timely filing.  According to this view, the Tax Court’s jurisdiction is not limited to IRS determinations for which a petition is filed with the Tax Court within 30 days.  As such, equitable tolling can apply.  Indeed, this is the view that the D.C. Circuit utilized in Myers v. Commissioner, 928 F.3d 1025 (D.C. Cir. 2019) in a case involving a whistleblower tax statute that is similarly worded. 

Conclusion

It will be interesting to see how the Court interprets the statute.  Clearly, based on the facts, equitable tolling should not apply.  The plaintiff negligently didn’t respond to the notice, negligently missed the filing deadline and then came up with a creative argument to try to bail itself out of a bad result created by that negligence.  No colorable argument can be made that the plaintiff was confused about the deadline.  Clearly, if the Court allows for equitable tolling in this case, given the facts of the case, there will be an increase in cases that argue for equitable tolling to be applied. 

However, the Congress did create an unclear antecedent in the statue.  Maybe that’s not as bad as a dangling participle, but the poor drafting has landed a case in the Supreme Court’s lap. 

This concludes my journey through the “Almost Top 10” of 2021.  Now back to “regular programming.”

February 3, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, February 1, 2022

The “Almost Top 10” of 2021 (Part 6)

Overview

I continue my journey through the big developments of 2021 that didn’t make my “Top 10” list.  In Part 6 today, I look at another development that will likely continue to be in the news with implications for farmers and ranchers in 2022 – California’s Proposition 12.

Another 2021 ag law development that wasn’t quite top big enough to make my 10 biggest developments from 2021 – it’s the topic of today’s post.

California’s Proposition 12 Upheld as Constitutional

National Pork Producers Council, et al. v. Ross, 6 F.4th 1021 (9th Cir. 2021), pet. for cert. filed No. 21-468 (Sept. 27, 2021)

Background

In a huge blow to pork producers (and consumers of pork products) nationwide, the U.S. Court of Appeals for the Ninth Circuit has upheld California’s Proposition 12.  Proposition 12 requires any pork sold in California to be raised in accordance with California’s housing requirements for hogs.  This means that any U.S. hog producer, starting January 1, 2022, had to upgrade existing facilities to satisfy California’s requirements if desiring to market pork products in California. 

Note:  Most of the provisions of Proposition 12 went into effect in December of 2018.  However, a requirement that breeding pigs be confined in a structure with at least 24 square feet of space went into effect on January 1, 2022. 

In the fall of 2018, California voters passed Proposition 12.  Proposition 12 bans the sale of whole pork meat (no matter where produced) from animals confined in a manner inconsistent with California’s regulatory standards.  Proposition 12 established minimum requirements on farmers to provide more space for egg-laying hens, breeding pigs, and calves raised for veal. Specifically, the law requires that covered animals be housed in confinement systems that comply with specific standards for freedom of movement, cage-free design and minimum floor space. The law identifies covered animals to include veal calves, breeding pigs and egg-laying hens.

Proposition 12 prohibit a farm owner or operator from knowingly causing any covered animal to be confined in a “cruel manner,” and prohibits a business owner or operator from knowingly engaging in the sale within the state of shell eggs, liquid eggs, whole pork meat or whole veal meat, as defined, from animals housed in a “cruel manner.”  That phrase, “cruel manner” is defined as confining the animal in a manner that prevents the animal from lying down, standing up, fully extending its limbs (without touching the side of the enclosure) or turning around freely (without impediment and without touching a side of the enclosure).  In addition, the law added detailed confinement space standards for farms subject to the law, such as confining a breeding pig with less than 24 square feet of usable floorspace per pig. 

Note:   The alleged reason for the law was to protect the health and safety of California consumers and decrease the risk of foodborne illness and the negative fiscal impact on California. 

The restrictions of Proposition 12 do not apply during medical research; examination, testing, individual treatment or operation for veterinary purposes; transportation; rodeo exhibitions, state or county fair exhibitions, 4-H programs and similar exhibitions; slaughter; to a breeding pig for five days before the expected farrowing date and any day the breeding pig is nursing piglets; and during temporary periods of animal husbandry. 

Note:  The California Department of Food and Agriculture and the State Department of Public Health were to develop rules and regulations to implement Proposition 12 by September 1, 2019.  That deadline was missed.  Proposed rules were released in December of 2021. 

In late 2019, several national farm organizations challenged Proposition 12 and sought a declaratory judgment that the law was unconstitutional under the dormant Commerce Clause.  The plaintiffs also sought a permanent injunction preventing Proposition 12 from taking effect.  The plaintiffs claimed that Proposition 12 impermissibly regulated out-of-state conduct by compelling non-California producers to change their operations to meet California’s standards.  The plaintiffs also alleged that Proposition 12 imposed excessive burdens on interstate commerce without advancing any legitimate local interest by significantly increasing operation costs without any connection to human health or foodborne illness.  The trial court dismissed the plaintiffs’ complaint. 

On appeal, the plaintiffs focused their argument on the allegation that Proposition 12 has an impermissible extraterritorial effect of regulating prices in other states and, as such, is per se unconstitutional.  This was a tactical mistake by the plaintiffs’ attorneys.  The appellate court noted that existing Supreme Court precedent on the extraterritorial principle applied only to state laws that are “price control or price affirmation statutes.”  Thus, the extraterritorial principle does not apply to a state law that does not dictate the price of a product and does not tie the price of its in-state products to out-of-state prices.  Because Proposition 12 was neither a price control nor a price-affirmation statute (it didn’t dictate the price of pork products or tie the price of pork products sold in California to out-of-state prices) the law didn’t have the extraterritorial effect of regulating prices in other states. 

The appellate court likewise rejected the plaintiffs’ claim that Proposition 12 has an impermissible indirect “practical effect” on how pork is produced and sold outside California.  Id.  Upstream effects (e.g., higher production costs in other states) the appellate court concluded, do not violate the dormant Commerce Clause.   The appellate court pointed out that a state law is not impermissibly extraterritorial unless it regulates conduct that is wholly out of state.  Id.  Because Proposition 12 applied to California and non-California pork production the higher cost of production was not an impermissible effect on interstate commerce.

The appellate court also concluded that inconsistent regulation from state-to-state was permissible because the plaintiffs had failed to show a compelling need for national uniformity in regulation at the state level.  Id.  In addition, the appellate court noted that the plaintiffs had not alleged that Proposition 12 had a discriminatory effect on interstate commerce. 

Simply put, the appellate court rejected the plaintiffs’ challenge to Proposition 12 because a law that increases compliance costs (projected at a 9.2 percent increase in production costs that would e passed on to consumers) is not a substantial burden on interstate commerce in violation of the dormant Commerce Clause. 

Note:  There is another case proceeding in the federal district court for the Eastern District of California.  Iowa Pork Producers Association v. Bonta, No. 1:21-cv-01663-NONE-EPG, 2021 U.S. Dist. LEXIS 246123 (E.D. Cal. Dec. 27, 2021).  The plaintiff sought to prevent enforcement of Proposition 12 as of January 1, 2022, by means of temporary injunctive relief but failed.  The plaintiff claimed that the law was unconstitutionally vague because implementing regulations had not yet been developed.  The case was filed on November 9, 2021, more than three years after Proposition 12 was approved by voters, moved to federal court on November 16 with a motion for a hearing to be set on December 17.  The court also noted that the plaintiff had filed an identical suit in Iowa state court in May of 2021 which was removed to federal court and dismissed for lack of personal jurisdiction.  Then, for unexplained reasons, the plaintiff waited 10 weeks to file this identical case in a California county court which was removed to federal court six weeks before Proposition 12 would take effect.  The court expressed its irritation with the conduct of plaintiff’s attorneys and changed the motion to one for a restraining order, noting that the “urgency” of the matter was the fault of the plaintiff’s attorneys.  The court noted that the matter had been one of “urgency” for the plaintiff for more than seven months at the time of filing of the case.  The court ruled that the motion for preliminary injunction would remain pending until a hearing on January 27, 2022. 

On to the Supreme Court?

During the summer of 2021, the U.S. Supreme Court declined to review a decision of the Ninth Circuit involving Proposition 12.  North American Meat Institute v. Bonta, 141 S. Ct. 2854 (2021).  Will the Court now take up the decision of the Ninth Circuit this time around?  It remains to be seen.  Unfortunately, the Supreme Court has been careless in applying the anti-discrimination test as part of the Dormant Commerce Clause, and in many of the cases, neither of the two requirements for finding a violation (interstate competition or harm to the national economy) is ever mentioned.  See, e.g., Hughes v. Oklahoma, 441 U.S. 322 (1979). The reason interstate competition goes unstated is obvious – in most cases the in-state and out-of-state actors compete in the same market.  But, the reason that the second requirement, harm to the national economy, goes unstated is because the Court simply assumes the issue away.

Conclusion

The dormant Commerce Clause is something to watch for in court opinions involving agriculture.  As states enact legislation designed to protect the economic interests of agricultural producers in their states, those opposed to such laws could challenge them on dormant Commerce Clause grounds.  But, such cases must be plead carefully to show an impermissible regulation of extraterritorial conduct. 

In the present case, practically doubling the cost of creating hog barns to comply with the California standards was not enough, nor was the interconnected nature of the pork industry.  California gets to call the shots concerning the manner of U.S. pork production for pork marketed in the state.  This, in spite of overarching federal food, health and safety regulations that address California’s purported rationale for Proposition 12.

The dormant commerce clause is one of those legal theories “floating” around out there that can have a real impact in the lives of farmers, ranchers and consumers, and how economic activity is conducted.   Stay tuned for more developments on this issue in 2022.

February 1, 2022 in Regulatory Law | Permalink | Comments (0)

Thursday, January 27, 2022

The “Almost Top 10” of 2021 (Part 5)

Overview

I continue my journey through the big developments of 2021 that didn’t make my “Top 10” list.  In Part 5 today, I look at two more developments – FDA rule changes to water qualify testing for ag water, and a Missouri food labeling law that was upheld as constitutional by a federal appellate court.

More not quite top 10 developments from 2021 – it’s the topic of today’s post.

FDA Proposes Tightening of Water Quality Testing

FDA Notice of Proposed Rulemaking, 86 FR 69120 (Dec. 6, 2021)

On December 6, 2021, the Food and Drug Administration (FDA) published proposed amendments to the agricultural water regulations contained in the Produce Safety Rule (PSR).  The ag water regulations cover groundwater and numerous surface water sources including ponds, rivers, creeks, as wells as municipal and other public water supplies.   According to the FDA, the proposed rule is designed to make pre-harvest testing of water more practical and less complex while simultaneously protecting public health.  FDA says the proposed rule is designed to be flexible to more easily adapt to future developments in water quality science.  According to the FDA, the new rule would replace the current PSR with systems-based preharvest ag water assessments designed to identify conditions that are reasonably likely to "introduce known or reasonably foreseeable hazards into or onto produce or food contact surfaces, and to determine whether corrective or mitigation measures are needed to minimize the risks associated with preharvest agricultural water."

The PSR is a rule that is part of the implementation of the Food Safety Modernization Act (FSMA), enacted in 2011 as an amendment to the Federal Food, Drug, and Cosmetic Act (FFDCA). The FSMA amended the FFDCA to require the FDA to establish minimum standards for the production and harvesting of certain fruits and vegetables that are raw ag commodities for which the Secretary determines that the minimum standards will minimize the risk of serious adverse health consequences or death. Accordingly, the FDA published a the proposed PSR in 2015 to apply to “covered produce” that are regularly consumed raw. Farmers of covered produce must ensure that there is no detectable E. coli in 100 milliliters of water used to irrigate the covered produce. “Very small producers” (those selling less than $250,000 of covered produce annually over the last three years) were to be in compliance by January 26, 2022. “Small producers (those selling annually between $250,000 and $500,000 of covered produce) had to comply by January 26, 2021. All other producers had to be in compliance by January 25, 2020.  Based on producer feedback, the FDA issued a proposed rule in 2017 extending the compliance dates to January 26, 2024; January 26, 2023, and January 26, 2022, respectively.

The December 6, 2021, proposed rule would amend the ag water requirements for farmers growing covered produce other than sprouts, and would require growers to annually prepare a pre-harvest written ag water assessment and notification anytime a significant change occurs to the grower’s ag water system that introduces a contamination risk. A grower must identify conditions that are reasonably likely to introduce known or reasonably foreseeable hazards into or onto covered produce. The proposal specifies five factors for consideration when composing an ag water assessment – 1) whether the water is ground water or surface water and whether the water is in an open or closed system; 2) the type of irrigation system used; 3) the characteristics of the crop(s) at issue; 4) environmental conditions (e.g., heavy rain or extreme weather events); and 5) the results of any testing the farmer conducted.

Three exemptions from conducting an ag water assessment are provided – 1) if requirements are met for water used on sprouts and in harvesting, packing and holding; 2) if the only water used is from a public water system or public water supply; and 3) if the water used on covered produce is treated according to requirements contained in the proposed rule. The FDA also stated that it anticipates publishing another proposed rule extending the compliance dates. The comment period on the proposed rule runs until April 5, 2022. If finalized, the new rule would replace the pre-harvest microbial quality criteria and testing requirements of the PSR. 

Food Labeling Law Upheld

Turtle Islands Foods, SPC v. Thompson, 992 F.3d 694 (8th Cir. 2021)

In recent years, food labeling issues have been in the courts.  It is an important issue to many ag producers because of the connection to marketing of ag products and the ability to properly market those products to consumers and ensure that consumers have full knowledge of the content of what they are purchasing.  In 2021, a Missouri food labeling law was challenged on constitutional grounds and upheld.

Missouri law (Mo. Rev. Stat. Sec. 265.282(7)) criminalizes the misrepresentations of a product as meat that is not derived from the harvested production of livestock or poultry.  Violations are a Class A misdemeanor that are penalized by up to a year in prison plus a fine not to exceed $1,000. The law is specifically directed at Missouri businesses that market their products that are plant-based or cell-cultured as “meat-based” and sell them as “alternative” protein sources (which implies that the products contain real meat).  The plaintiff, a maker of a vegetarian turkey substitute (Tofurkey), challenged the law as an unconstitutional violation of free speech, due process and the Dormant Commerce Clause and sought a preliminary injunction preventing the state from enforcing the law. The state submitted evidence showing how the plaintiff could comply with the law by labeling their products as “plant-based,” “veggie,” “lab grown,” or something similar.

The trial court denied the plaintiff’s request for an injunction on the basis that the law only barred a company from misleading consumers into believing that a product is meat from livestock when it is not. The trial court also determined that the plaintiff had failed to prove an irreparable injury by risk of prosecution because its packaging already contained the necessary disclaimers.

On further review, the appellate court affirmed. The appellate court noted that the plaintiff admitted that its products were labeled in such a way to clearly indicate that the products did not contain meat from slaughtered animals and denoted that they were plant-based, vegan or vegetarian. The appellate court noted that, on remand at the trial court, facts could be discovered that could possibly lead to a different result on appeal. 

January 27, 2022 in Regulatory Law | Permalink | Comments (0)

Tuesday, January 25, 2022

The “Almost Top Ten” (Part 4) – Tax Developments

Overview

Today’s article is the fourth in a series discussing what I view of significant developments in 2021 that weren’t quite big enough to make my “Top Ten” list.  This time I discuss for tax four tax developments that occurred in 2021 that weren’t quite big enough to make the “Top Ten.”

More significant developments of 2021 in ag law and tax – it’s the topic of today’s post.

Estate Tax Closing Letter Doesn’t Preclude Later Exam of Form 706

C.C.A. 202142010 (Apr. 1, 2021)

IRS Letter 627, an estate tax return closing letter, is issued to an estate and specifies the amount of the net estate tax, the state death tax credit or deduction, and any generation transfer tax for which an estate is liable. The position of the IRS, however, is that the letter is not a formal closing agreement.  Thus, the issuance of the letter does not bar the IRS from reopening or reexamining the estate tax return to determine estate tax liability if:  (1) there is evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact; (2) there is a clearly defined, substantial error based on an established IRS position; or (3) another circumstance indicating that a failure to reopen the case would be a serious administrative omission. Thus, when the IRS issues Letter 627 after accepting the return as filed, the issuance does not constitute an examination and IRS may later examine Form 706 associated with the estate that received the letter. 

IRS Supervisor Review - “Immediate Supervisor” is Person Who Actually Supervised Exam

Sand Investment Co., LLC v. Comr., 157 T.C. No. 11 (2021)

Under the Internal Revenue Code (Code), an IRS examining agent must obtain written supervisory approval to the agent’s determination to assess a penalty on any asserted tax deficiency. Under I.R.C. §6751(b)(1), the approval must be from the agent’s “immediate supervisor” before the penalty determination if “officially communicated” to the taxpayer. In a partnership audit case under the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), supervisory approval generally must be obtained before the Final Partnership Administrative Adjustment (FPAA) is issued to the partnership. See, e.g., Palmolive Building Investors, LLC v. Comr., 152 T.C. 75 (2019). If an examiner obtains written supervisory approval before the FPAA was issues, the partnership must establish that the approval was untimely. See, e.g., Frost v. Comr., 154 T.C. 23 (2020). 

In this case, the IRS opened a TEFRA examination of the petitioner’s 2015 return. The IRS auditor’s review was supervised by a team manager. While the audit was ongoing, the agent was promoted and transferred to a different team, but continued handling the audit still under the supervision of the former team manager. Ultimately, the agent asserted an accuracy-related penalty against the petitioner and the former team manager signed the approval form. The next day, the auditor sent the petitioner several documents indicating that a penalty might be imposed. Two days later the new team manager also signed the auditor’s penalty approval form. The petitioner challenged the imposition of penalties because the new team manager hadn’t approved the penalty assessment before the auditor sent the penalty determination to the petitioner. The Tax Court held that the supervisor who actually oversaw the agent’s audit of the petitioner was the “immediate supervisor” for purposes of the written supervisory approval requirement of I.R.C. §6751(b)(1). There was no evidence that the new team manager had any authority to supervise the agent’s audit of the petitioner. 

Meal Portion of Per Diem Allowance Eligible to be Treated As Attributed to a Restaurant. 

IRS Notice 2021-63, 2021-49 IRB 835

Under I.R.C. §274(n)(1) and Treas. Reg. §1.274-12, a deduction of any expense for food or beverages generally is limited to 50 percent of the amount otherwise deductible (i.e., as an ordinary and necessary business expense that is not lavish or extravagant under the circumstances). However, the Consolidated Appropriations Act, 2021, provides that that the full cost of such an expense is deductible if incurred after Dec. 31, 2020, and before Jan. 1, 2023, for food or beverages "provided by a restaurant." Meals obtained from a grocery or convenience store do not qualify.  The IRS, with this notice, specified that a taxpayer may treat the meal portion of a per diem rate or allowance paid or incurred after Dec. 31, 2020, and before Jan. 1, 2023, for meals purchased while traveling away from home as being attributable to food or beverages provided by a restaurant. 

Note:   The Notice is effective for expenses incurred by an employer, self-employed individual or employees described in I.R.C. §62(a)(2)(B) through (E) after December 31, 2020, and before January 1, 2023.

Credit Card Reward Dollars May Be Taxable

Anikeev, et ux. v. Comr., T.C. Memo. 2021-23

The petitioners, husband and wife, spent over $6 million on their “Blue Cash” American Express credit cards (“Blue Card”) from 2013 to 2014.  They used their Blue Cards to accumulate as many reward points as possible, which they did by using the cards to buy Visa gift cards, money orders or prepaid debit card reloads that they later used to pay the credit card bill. The credit card earned then five percent cash back on certain purchases after spending in $6,500 in a single calendar year. Before purchases were sufficient for them to reach the five percent level, the card earned one percent cash back on certain purchases. Rewards were issued in the form of “rewards dollars” that could be redeemed for gift cards and statement credits.

In 2013, the petitioners charged over $1.2 million for the purchase of Visa gift cards, reloadable debit cards and money orders.  In 2014 they charged over $5.2 million primarily for the purchase of Visa gift cards.  They then used the Visa gift cards to buy money orders which they used to pay the American Express bills. 

They redeemed $36,200 in rewards dollars from the card as statement credits in 2013 and $277,275 in 2014. The petitioners did not report these amounts as income for either year. The IRS audited and took the position that the earnings should have been reported as “other income.” The petitioners claimed that when a payment is made by a seller to a customer, it’s generally seen as a “price adjustment to the basis of the property” – the “rebate rule.” Rev. Rul. 79-96, 1976-1 C.B. 23.  Under this rule, a purchase incentive is not treated as income. Instead, the incentive is treated as a reduction of the purchase price (and associated reduction of basis) of what is purchased with the rewards or points. Thus, points and cashback earned on spending are viewed as a price adjustment. The petitioners, citing this rule, pointed out that the “manner of purchase of something…does not constitute an accession of wealth. The IRS, conversely, asserted that the rewards were taxable upon receipt because the petitioners did not purchase goods or services for which a rebate or purchase price adjustment could be applied.  Instead, the IRS claimed that the petitioners purchased cash equivalents – Visa gift cards; reloadable debit cards; and money orders.  See, e.g., Tech. Adv. Memo. 200437030 (Apr. 30, 2004).  As cash equivalents, the rewards paid to the petitioners as statement credits were an accession to wealth and, thus, gross income under I.R.C. §61. 

The Tax Court agreed that gift cards were a “product” – they couldn’t be redeemed for cash and were not eligible for deposit into a bank account.  Likewise, the Tax Court determined that that Visa gift cards provided a service to the petitioners via a product stating that, “[p]roviding a substitute for a credit card is a service via a product which is commonly sold via displays at drug stores and grocery stores.”  Thus, the portion of their reward dollars associated with gift card purchases weren't taxable under the “rebate rule.”  However, the Tax Court held that the petitioners’ direct purchases of money orders and reloads of cash into the debit cards using their credit card was different in that the petitioners were buying “cash equivalents” rather than a rebate on a purchase. They were not a product subject to a price adjustment and were not used to obtain a product or service. Because there was no product or service obtained in connection with direct money order purchases and cash reloads, the reward dollars associated with those purchases were for cash infusions.

The Tax Court also noted that the petitioners’ practice would most often have been ignored if it had not been for the petitioners’ “manipulation” of the rewards program using cash equivalents. Thus, the longstanding IRS rule of not taxing credit card points didn’t apply. Thus, the Tax Court held that reward points become taxable when massive amounts of cash equivalents are purchased to generate wealth – buying money orders and funding prepaid debit cards with a credit card for cash back, and then immediately paying the credit card bill.

Note:   The Tax Court also stated that it would like to see some reform in this area providing guidance on the issue of credit card rewards and the profiting from buying cash equivalents with a credit card. 

January 25, 2022 in Estate Planning, Income Tax | Permalink | Comments (0)