Tuesday, October 19, 2021
Operating a small business means, in part, paying business taxes. But, business taxes for many small businesses are different than those that are taken out of an employee’s paycheck. Under current law, there can be an advantage for many small businesses, particularly those engaged in professional services, to operate in the form of an S corporation. But, that advantage could be eliminated under a proposal that is under consideration in the Congress.
S corporation tax treatment and a current legislative proposal – it’s the topic of today’s post.
S Corporation Tax Treatment
Many small businesses are subject to the Self-Employment Contributions Act (SECA), and self-employment tax must be paid. But S corporation shareholders are not subject to SECA tax because the S corporation is treated as separate from the shareholders – its activities are not attributed to its shareholders. An S corporation must pay its owner-employees “reasonable compensation” for services rendered to the corporation. That compensation is subject to Federal Insurance Contributions Act (FICA) tax. But any non-wage distributions to S corporation shareholders are not subject to either FICA or SECA taxes. Therein lies the “rub.” Salary that is too low in relation to the services rendered results in the avoidance of payroll taxes. So, when shareholder-employees take flow-through distributions from the corporation instead of a salary, the distributions are not subject to payroll taxes (i.e., the employer and employee portions of FICA taxes and the employer Federal Unemployment Tax Act (FUTA) tax.
Note: FICA requires employers to withhold a set percentage of each employee’s paycheck to cover the Social Security tax, Medicare tax and other insurance costs. Employer’s must also equally match those withholdings, with the total amount being 15.3 percent of each employee’s net earnings. Under SECA, a small business owner is deemed to be both the employer and the employee and is, therefore, responsible for the full 15.3 percent “self-employment tax” that is paid out of net business earnings
In accordance with Rev. Rul. 59-221, S corporation flow-through income is taxed at the individual level and is (normally) not subject to self-employment tax. Also, in addition to avoiding FICA and FUTA tax via S corporation distributions, the 0.9% Medicare tax imposed by I.R.C. §3101(b)(2) for high-wage earners (but not on employers) is also avoided by taking income from an S corporation in the form of distributions. These are the tax incentives for S corporation shareholder-employees to take less salary relative to distributions from the corporation. With the Social Security wage base set at $142,800 for 2011, setting a shareholder-employee’s compensation beneath that amount with the balance of compensation consisting of dividends can produce significant tax savings.
Note: It is currently projected that the Social Security wage base will be $146,700 for 2022.
Who’s an “Employee”?
Most S corporations, particularly those that involve agricultural businesses, have shareholders that perform substantial services for the corporation as officers and otherwise. In fact, the services don’t have to be substantial. Indeed, under a Treasury Regulation, the provision of more than minor services for remuneration makes the shareholder an “employee.” Once, “employee” status is achieved, the IRS views either a low or non-existent salary to a shareholder who is also an officer/employee as an attempt to evade payroll taxes and, if a court determines that the IRS is correct, the penalty is 100 percent of the taxes owed. Of course, the burden is on the corporation to establish that the salary amount under question is reasonable.
Before 2005, the court cases involved S corporation owners who received all of their compensation in form of dividends. Most of the pre-2005 cases involved reclassifications on an all-or-nothing basis. In 2005, the IRS issued a study entitled, “S Corporation Reporting Compliance.” Now the courts’ focus is on the reasonableness of the compensation in relation to the services provided to the S corporation. That means each situation is fact-dependent and is based on the type of business the S corporation is engaged in and the amount and value of the services rendered.
So what are the factors that the IRS examines to determine if reasonable compensation has been paid? Here’s a list of some of the primary ones:
- The employee’s qualifications;
- the nature, extent, and scope of the employee’s work;
- the size and complexities of the business; a comparison of salaries paid;
- the prevailing general economic conditions;
- comparison of salaries with distributions to shareholders;
- the prevailing rates of compensation paid in similar businesses;
- the taxpayer’s salary policy for all employees; and
- in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.
According to the IRS, the key to establishing reasonable compensation is determining what the shareholder/employee did for the S corporation. That means that the IRS looks to the source of the S corporation’s gross receipts. If they came from services of non-shareholder employees, or capital and equipment, then they should not be associated with the shareholder/employee’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation. Alternatively, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder/employee’s direct generation of gross receipts, the shareholder/employee should also be compensated for administrative work performed for the other income-producing employees or assets. As applied in the ag context, for example, this means that reasonable compensation for a shareholder/employee in a crop farming operation could differ from that of a shareholder-employee in a livestock operation.
For those interested in digging into the issue further, I suggest reading the following cases:
- Watson v. Comr., 668 F.3d 1008 (8th Cir. 2012)
- Sean McAlary Ltd., Inc. v. Comr., T.C. Sum. Op. 2013-62
- Glass Blocks Unlimited v. Comr., T.C. Memo. 2013-180
- Scott Singer Installations, Inc. v. Comr., T.C. Memo. 2016-161
Each of these cases provides insight into the common issues associated with the reasonable compensation issue. The last two also address distributions and loan repayments in the context of reasonable compensation of unprofitable S corporations with one case being a taxpayer victory and the other a taxpayer loss.
A current proposal, effective for tax years beginning after December 31, 2021, that would change the tax rules applicable to S corporations is being considered as part of the massive spending bills that are currently before the Congress. The proposal is an attempt to ensure that all of the pass-through business income that an individual receives that has more than $400,000 of adjusted gross income for the tax year is subject to the 3.8 percent Medicare tax – either through the tax on net investment income (I.R.C. §1411) or through the SECA tax. This outcome would be accomplished by the legislation amending the definition of “net investment income” so that it includes an individual’s gross income and gain from a pass-through business that is not otherwise subject to employment taxes. That means it would apply to S corporation shareholders who are active in the corporation’s business, but don’t receive a “sufficient” level of compensation. The proposal would also apply SECA tax to the distributive share of the business income that an S corporation shareholder receives who materially participates in the entity’s business
Note: The proposal would also apply SECA tax (above a threshold amount) to the distributive shares of partners in limited partnerships and limited liability company (LLC) members that provide services to the entity and materially participate.
If the legislative proposal is enacted into law, it would significantly change the taxation of pass-through entities and owners that have AGI above the $400,000 threshold. The technique of reducing employment tax by managing compensation levels withing the boundaries set by the IRS and the courts would no longer be a viable strategy. Also, if enacted, the proposal could incentivize the revocation of the S election in favor of C corporate status. But, that move depends, at least in part, on where the C corporate tax rate turns out to be - that’s under consideration in the Congress also.
Thursday, October 14, 2021
Rural landowners often receive payment from utility companies, oil pipeline companies, wind energy companies and others for rights-of-way or easements over their property. The rights acquired might include the right to lay pipeline, construct aerogenerators and associated roads, electric lines and similar access rights. Payments may also be received for the placement of a “negative” easement on adjacent property so that the neighboring landowner is restricted from utilizing their property in a manner that might decrease the value of nearby land.
Tax issues with easement payment – it’s the topic of today’s post.
Characterizing the Transaction
The receipt of easement payments raises several tax issues. The payments may trigger income recognition or could be offset partially or completely by the recipient’s income tax basis in the land that the easement impacts. Also, a sale of part of the land could be involved. In addition, a separate payment for crop damage could be involved.
A sale or exchange triggers gain or loss for income tax purposes. I.R.C. §1001. Is the grant of an easement a taxable event? It depends. In essence, a landowner’s grant of an easement amounts to a sale of the land if after the easement grant the taxpayer has virtually no property right left except bare legal title to the land. For instance, in one case, the grant of an easement to flood the taxpayer’s land was held to be a sale. Scales v. Comr., 10 B.T.A. 1024 (1928), acq., 1928-2 C.B. 35. In another situation, the IRS ruled that the grant of an easement for air rights over property adjoining an air base with the result that the property was rendered useless was a sale. Rev. Rul. 54-575, 1954-2 C.B. 145. The grant of a perpetual easement on a part of unimproved land to the state for a highway, as well as the grant of a permanent right-of-way easement for use as a highway have also been held to be a sale. Rev. Rul. 72-255, 1972-1 C.B. 221; Wickersham v. Comr., T.C. Memo. 2011-178. Also, the IRS has determined that the grant of a perpetual conservation easement on property in exchange for “mitigation banking credits” was held to be a sale or exchange. Priv. Ltr. Rul. 201222004 (Nov. 29, 2011). Under the facts of the ruling, the taxpayer acquired a ranch for development purposes, but did not develop it due to the presence of two endangered species. The taxpayer negotiated a Mitigation Bank Agreement with a government agency pursuant to which the taxpayer would grant a perpetual conservation easement to the government in return for mitigation banking credits to allow the development of other, similarly situated, land. The IRS determined that the transaction constituted a sale or exchange.
If the payments for the grant of an easement are, in effect, rents for land use the characterization of the payments in the hands of the landowner is ordinary income. For example, in Gilbertz v. United States, 574 F. Supp. 177 (D. Wyo. 1983), aff’d., and rev’d. by, 808 F.2d 1374 (10th Cir. 1987), the taxpayers, a married couple, raised cattle on their 6,480-acre ranch. They held title to the surface rights and a fractional interest in the minerals. The federal government reserved most of the mineral rights. In 1976 and 1977, the taxpayers negotiated more than 50 contracts with oil and gas lessees and pipeline companies to receive payments for anticipated drilling activities on the ranch. The taxpayers reported the payments as non-taxable recovery of basis in the entire ranch with any excess amount reported as capital gain. The IRS disagreed, asserting that the payments taxable as ordinary income. The taxpayers paid the asserted deficiency and sued for a refund.
The trial court dissected the types of payments involved concluding that the “Release and Damage Payments” were not rents taxable as ordinary income. The payments from pipeline companies for rights-of-ways and damage to the land involved a sale or exchange and were taxable as capital gain – the pipeline companies had obtained a perpetual right-of-way. On further review, the appellate court held that the “Release and Damage Payments” were not a return of capital to the taxpayers that qualified for capital gain treatment to the extent the amount received exceeded their basis in the land. However, the appellate court affirmed the trial court’s holding that the amounts received from the pipeline companies were properly characterized as the sale of a capital asset and constituted a recovery of basis with any excess taxable as capital gain.
Limited Easements. The grant of a limited easement is treated as the sale of a portion of the rights in the land impacted by the easement, with the proceeds received first applied to reduce the basis in the land affected. Thus, if the grant of an easement deprives the taxpayer of practically all of the beneficial interest in the land, except for the retention of mere legal title, the transaction is considered to be a sale of the land that the easement covers. That means that gain or loss is computed in the same manner as in the case of a sale of the land itself under I.R.C. §1221 or §1231. In addition, only the basis of the land that is allocable to that portion is reduced by the amount received for the grant of the easement. Any excess amount received is treated as capital gain. The allocation of basis does not require proration based on acreage. Instead, basis allocation is to be “equitably apportioned” based likely on fair market value or assessed value at the time the easement is acquired.
In rare situations where the entire property is impacted by the easement, the entire basis of the property can be used to offset the amount received for the easement. This might be the situation where severance damage payments are received. These types of payments may be made when the easement bisects a landowner’s property with the result that the property not subject to the easement can no longer be put to its highest and best use. This is more likely with commercial property and agricultural land that has the potential to be developed. Severance damages may be paid to compensate the landowner for the resulting lower value for the non-eased property. If severance damages exceed the landowner’s basis in the property not subject to the easement, gain is recognized.
Types of Payments
Damage payments. As noted above, an initial payment made to a landowner for acquisition of an easement could result in income to the landowner or a reduction of the landowner’s basis in the land, or both. That means that a lump sum payment for the right to lay a pipeline across a farm may result in income, a reduction in basis of all or part of the land or both. An amount for actual, current damage to the property caused by construction activities on the property subject to the easement may be able to be offset by basis in the affected property. Examples of this type of payment would be payments for damage to the property caused by environmental contamination and soil compaction. A payment for damage to growing crops, however, is treated as a sale of the crop reported on line 2 of Schedule F (landlord or tenant) or line 1 of Form 4835 for a non-material participation crop-share landlord. Any payment for future property damage (e.g., liquidated damages), however, is generally treated as rent.
Severance damages. Under I.R.C. §1033, it is possible for the landowner to defer gain resulting from the payment of severance damages by using the severance damages to restore the property that the easement impacts or by investing the damages in a timely manner in other qualified property. There is no requirement that the landowner apply the severance damages to the portion of the property subject to the easement. Also, if the easement so impacts the remainder of the property where the pre-easement use of the property is not possible, the sale of the remainder of the property and use of the sale proceeds (plus the severance damages) to acquire other qualified property can be structured as a deferral transaction under I.R.C. §1033.
Temporary easements. Some easements may involve an additional temporary easement to allow the holder to have space for access, equipment and material storage while conduction construction activities on the property subject to the easement. A separate designation for a temporary easement for these purposes will generate rental income for allocated amounts. As an alternative, it may be advisable to include the temporary space in the perpetual easement which is then reduced after a set amount of time. Under this approach, it is possible to apply the payment attributable to the temporary easement to the tract subject to the permanent easement. Alternatively, it may be possible, based on the facts, to classify any payments for a temporary easement as damage payments.
Negative easements. A landowner may make a payment to an adjacent or nearby landowner to acquire a negative easement over that other landowner’s tract. A negative easement is a use restriction placed on the tract to prevent the owner from specified uses of the tract that might diminish the value of the payor’s land. For instance, a landowner may fear that their property would lose market value if a pipeline, high-power transmission line or wind aerogenerator were to be placed on adjacent property. Thus, the landowner might seek a negative easement over that adjacent property to prevent that landowner from granting an easement to a utility company for that type of activity from being conducted on the adjacent property. The IRS has reached the conclusion that a negative easement payment is rental income in the hands of the recipient. F.S.A. 20152102F (Feb. 25, 2015). It is not income derived from the taxpayer’s trade or business. In addition, the IRS position taken in the FSA could have application to situations involving the government’s use of a taxpayer’s property to enhance wildlife and conservation.
A right of use that is not an easement generates ordinary income to the landowner and is, potentially, net investment income subject to an additional 3.8 percent tax. Thus, transactions that are a lease or a license generate rental income with no basis offset. For example, when a landowner grants surface rights for oil and gas exploration, the transaction is most likely a lease. Easements for pipelines, roads, surface sites and similar interests that are for a definite term of years are leases. Likewise, if the easement is for “as long as oil and gas is produced in paying quantities,” it is lease.
The IRS has ruled that periodic payments that farmers received under a “lease” agreement that allowed a steel company to discharge fumes without any liability for damage were rent. In Rev. Rul. 60-170, 1960-1 C.B. 357, the payments from the steel company were to compensate the farmers for damages to livestock, crops, trees and other vegetation because of chemical fumes and gases from a nearby plant. The IRS determined that the payments were rent and, as such, were not subject to self-employment tax.
Some other points on lease payments should be made. A lease is characterized by periodic payments. A lease is also indicated when failure to make a payment triggers default procedures and potential forfeiture. In addition, lease payments are not subject to self-employment tax in the hands of the recipient regardless of the landowner’s participation in the activity. Accordingly, the annual lease payment income would be reported on Schedule E (Form 1040), with the landowner likely having few or no deductible rental expenses.
Proposed easement acquisitions can be contentious for many landowners. Often, landowners may not willingly grant a pipeline company or a wind energy company, for example, the right to use the landowners’ property. In those situations, eminent domain procedures under state law may be invoked which involves a condemnation of the property. The power of eminent domain is the right of the state government (it’s called the “taking power” for the federal government) to acquire private property for public use, subject to the constitutional requirement that “just compensation” be paid. While eminent domain is a power of the government, often developers of pipelines and certain other types of energy companies are often delegated the authority to condemn private property. The condemnation award (the constitutionally required “just compensation”) paid is treated as a sale for tax purposes.
Note: The IRS view is that a condemnation award is solely for the property taken. But, if the condemnation award clearly exceeds the fair market value of the property taken, a court may entertain arguments about the various components of the award. Thus, it’s important for a landowner to preserve any evidence that might support allocating the award to various types of damages.
Involuntary conversion. While a condemnation award that a landowner receives is treated as a sale for tax purposes, it can qualify for non-recognition treatment under the gain deferral rules for involuntary conversions contained in I.R.C. §1033. Rev. Rul. 76-69, 1976-1 C.B. 219; Rev. Rul. 54-575, 1954-2 C.B. 145. I.R.C. §1033 allows a taxpayer to elect to defer gain realized from a condemnation (and sales made under threat of condemnation) by reinvesting the proceeds in qualifying property within three years. See, e.g., Rev. Rul. 72-433, 1972-2 C.B. 470
The election to defer gain under I.R.C. §1033 is made by simply showing details on the return about the involuntary conversion but not reporting the condemnation gain realized on the return for the tax year the award is received. A disclosure that the taxpayer is deferring gain under I.R.C. §1033, but not disclosing details is treated as a deemed election.
Note: If the taxpayer designates qualified replacement real estate on a return within the required period and purchases the property at the anticipated price within three years of the end of the gain year, a valid election is complete. If the purchase price of the replacement property is lower than anticipated, the resulting gain should be reported by amending the return for the election year. If qualified replacement property within the required three-year period, the return for the year of the election must be amended to report the gain.
Rural landowners are facing easement issues not infrequently. Oil and gas pipelines, wind energy towers, and high voltage power lines are examples of the type of structures that are associated with easements across agricultural land. Seeking good tax counsel can help produce the best tax result possible in dealing with the various types of payments that might be received.
Monday, October 11, 2021
It’s been a while since I highlighted a few recent cases for the blog. Today is that day. Recently, the court have decided cases about a packing plant’s potential liability exposure to employee claims about the virus; a legal challenge to the beef checkoff; C corporation distributions; and whether a trade or business existed in a rather unique setting.
Caselaw update – it’s the topic of today’s post.
Meat-Packing Plant Employees Can’t Sue Over Virus Claims
Fields v. Tyson Foods, Inc., No. 6:20-cv-00475, 2021 U.S. Dist. LEXIS 181083 (E.D. Tex. Sept. 22, 2021).
The plaintiffs were defendant’s employees. They sued for negligence and gross negligence, alleging that the defendant failed to take adequate safety measures, such as not providing personal protective equipment and not implementing social-distancing guidelines, which caused them to contract COVID-19. The plaintiffs argued that the defendant failed to satisfy a duty of care to keep its premises in a reasonably safe condition, and that it failed to exercise ordinary care to reduce or eliminate the risk of employees being exposed to COVID-19. The defendant filed a motion to dismiss for a failure to state a claim upon which relief can be granted. The defendant argued that the Poultry Products Inspection Act (PPIA) as promulgated by the Food Safety and Inspection Service (FSIS) of the Department of Agriculture contained an express-preemption clause that foreclosed the plaintiffs’ claims. Additionally, the defendant argued that the recently passed Pandemic Liability Protection Act (PLPA) provided the defendant retroactive protection against damages lawsuits that alleged exposure to COVID-19. The trial court agreed and noted that the PPIA’s express-preemption clause overrode state requirements that are different than the regulations. The trial court noted that although the plaintiffs argued that the defendant failed to impose adequate safety measures to reduce the spread of COVID-19 in its facility, the FSIS promulgated a number of regulations under the PPIA that directly addressed the spread of disease. The trial court held that the duty of care alleged by the plaintiffs’ negligence claim would require the defendant to utilize additional equipment, therefore the plaintiffs’ claims were preempted by federal law. The trial court next addressed the PLPA, which generally shields corporations from liability if an individual suffers injury or death as a result of exposure to COVID-19. The trial court noted that the plaintiffs needed to allege that the defendant either knowingly failed to warn them or remedy some condition at the facility that the defendant knew would expose the plaintiffs to COVID- 19, or that the defendant knowingly contravened government-promulgated COVID-19 guidance. Further, the plaintiffs must allege reliable scientific evidence that shows that the defendant’s conduct was the cause-in-fact of the plaintiffs’ contracting COVID-19. The trial court noted that the plaintiffs failed to provide any reliable scientific evidence that showed that the defendant was the cause-in-fact of the plaintiffs’ contracting COVID-19. Because the plaintiffs merely made conclusory statements that they contracted COVID-19 due to unsafe working conditions, without alleging how or when they contracted COVID-19, the trial court held the plaintiffs’ complaint failed to satisfy the PLPA. Upon granting the defendant’s motion to dismiss, the trial court noted that even if the plaintiffs amended their complaint to satisfy the causation prong, the PPIA preemption clause would still foreclose the plaintiffs’ claims.
Lawsuit Challenging Changes to Beef Checkoff Continues
Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. United States Department of Agriculture, et al., NO. 20-2552 (RDM), 2021 U.S. DIST. LEXIS 187182 (D. D.C. Sept. 29, 2021).
The plaintiff, a cattle grower association, sued the United States Department of Agriculture (USDA) claiming that the USDA made substantive changes to the Beef Checkoff Program in violation of the Administrative Procedure Act (APA) by entering into memorandums of understanding (MOUs) with various state beef councils. The plaintiff asserted that such amendments should have been subject to public notice-and-comment rulemaking. The MOUs gave the USDA more oversight authority over how the state beef councils could use the funds received from the checkoff. In other litigation, the USDA has been claiming oversight authority (even though not exercised) over state beef councils to argue that the beef checkoff is government speech rather than private speech in order to defeat First Amendment claims. In the present litigation, the USDA motioned to dismiss the case for lack of standing. The court denied the USDA’s motion on the basis that the plaintiff, on the face of its claim, had established sufficient elements of associational standing – that at least one of the plaintiff’s members had suffered a diminished return on investment as a result of the MOUs. The court did not address the factual question of the plaintiff’s standing. The USDA’s had also asserted a defense of claim preclusion but the court postponed examining that issue until additional evidence was submitted allowing the court to fully address the issue of jurisdiction.
Lack of Documentation Leads to Receipt of Constructive Dividends
Combs v. Comr., No. 20-70262, 2021 U.S. App. LEXIS 28875 (9th Cir. Sept. 23, 2021), aff’g., T.C. Memo. 2019-96.
The petitioner was the sole shareholder of a C corporation in which he housed his motivational speaking business. The fees he earned were paid to the corporation. The corporation paid him a small salary which he instructed the corporation not to report as income to him. In addition, he also paid many personal expenses from a corporate account. The IRS claimed that the distributions from the corporation to the petitioner constituted dividends that the petitioner should have included in gross income. The Tax Court noted that if the corporation has sufficient earnings and profits that the distribution is a dividend to the shareholder receiving the distribution, but that if the distribution exceeds the corporation’s earnings and profits, the excess is generally a nontaxable return of capital to the extent of the shareholder’s basis in the corporation with any remaining amount taxed to the shareholder as gain from the sale or exchange of property. The Tax Court noted that the petitioner’s records did not distinguish personal living expenses from legitimate business expenses and did not provide any way for the court to estimate or determine if any of the expenses at issue were ordinary and necessary business expenses. Thus, the court upheld the IRS determination that the petitioner received and failed to report constructive dividends. The appellate court affirmed noting that there was ample evidence to support the Tax Court’s constructive dividend finding and that the petitioner had failed to rebut any of that evidence.
Suing Ex-Wife Not a Trade or Business
Ray v. Comr., No. 20-6004, 2021 U.S. App. LEXIS 27614 (5th Cir. Sept. 14, 2021).
The petitioner divorced his wife in 1977 and then sued her in state court in 1998 over debts she owed associated with two real estate purchases and credit cards, as well as penalties she owed the petitioner for not providing him with financial statements in a timely manner. During the pendency of the lawsuit in 2020, he sued her two more times in state court and sued her attorneys in federal court. The federal litigation involved losses from trading agreements the petitioner entered into with her involving a futures and options trading method she created. Ultimately, she owed the petitioner about $384,000 for trading losses incurred with funds he deposited into a commodities brokerage account. The petitioner deducted $267,000 in legal fees on his 2014 return and the IRS rejected the deduction, tacking on an accuracy-related penalty. In 2019, the Tax Court disallowed the legal expenses under I.R.C. §162(a), but allowed a deduction for legal costs incurred that were associated with trading agreement losses as production of income expenses under I.R.C. §212(1). The Tax Court also upheld the accuracy-related penalties. On appeal the appellate court largely affirmed the Tax Court, find that the petitioner didn’t prove that his lawsuit to recover the trading agreement losses was related to his work with a trade or business. Also, the appellate court upheld the Tax Court finding that the petitioner didn’t have a profit motive in suing his ex-wife which was required for a deduction under I.R.C. §212(1). However, the appellate court held that the Tax Court erred in concluding that the petitioner lacked some justification for claiming deductions under I.R.C. §162(a) for legal fees relating to the trading agreement losses. As such, the appellate court remanded the penalty issue to the Tax Court.
Expect challenges to the beef checkoff to continue. Many livestock ranchers and farmers that also have cattle and pay the checkoff have been irritated about the use of their checkoff dollars and the conduct of state beef councils for many years. Also, the constructive dividend issue is a big one. Compensation arrangements for corporate officers/shareholders must be structured properly to avoid the constructive dividend issue. The IRS does examine that issue. In addition, the trade or business issue often arises in the context of agricultural activities – particularly when rental arrangements are involved. Remember, under IRS rules a cash lease is not a farming trade or business – it’s a rental activity. That can have implications in numerous settings. But, I have never seen the argument come up before the Ray case in the context of suing an ex-spouse! That’s an interesting twist.
Friday, October 8, 2021
Note: This article is an update to my blog article of May 4, 2020 that can be accessed here: https://lawprofessors.typepad.com/agriculturallaw/2020/05/farm-bankruptcy-stripping-claw-back-and-the-tax-collecting-authorities.html
As originally enacted, Chapter 12 did not create a separate tax entity for Chapter 12 bankruptcy estates for purposes of federal income taxation. That shortcoming precludes debtor avoidance of potential income tax liability on disposition of assets as may be possible for individuals who file Chapter 7 or 11 bankruptcy. But, an amendment to Chapter 12 enacted 19 years after Chapter 12 was established made an important change. As modified, tax debt associated with the sale of an asset used in farming can be treated as unsecured debt that is not entitled to priority and ultimately discharged. Without this modification, a farmer faced with selling assets to come up with funds to satisfy creditors could trigger substantial tax liability that would impair the chance to reorganize the farming business under Chapter 12. Such a farmer could be forced into liquidation.
If taxes can be treated as unsecured debt how are taxes that the debtor has already paid to be treated? Can those previously paid or withheld taxes be pulled back into the bankruptcy estate where they are “stripped” of their priority?
Chapter 12 bankruptcy and priority “stripping” of taxes – it’s the topic of today’s post.
2005 Modified Tax Provision
The 2005 Bankruptcy Code allows a Chapter 12 debtor to treat claims arising out of “claims
owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge. 11 U.S.C. §1222(a)(2)(A). The amendment attempted to address a major problem faced by many family farmers filing Chapter 12 bankruptcy where the sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general unsecured creditors. Even though the priority tax claims could be paid in full in deferred payments under prior law, in many instances the debtor did not have enough funds to allow payment of the priority tax claims in full even in deferred payments. That was the core problem that the 2005 provision was attempting to address.
Nothing in the 2005 legislation specified when the property can be disposed of to have the associated taxes be eligible for unsecured claim status. Of course, to confirm a Chapter 12 plan the taxing agencies must receive at least as large an amount as they would have received had the claim been a pre-petition unsecured claim. On this issue, the United States Court of Appeals for the Eighth Circuit has ruled that a debtor’s pre-petition sale of slaughter hogs came within the scope of the provision, and that the provision changes the character of the taxes from priority status to unsecured such that, upon discharge, the unpaid portion of the tax is discharged along with interest and penalties. In re Knudsen, et al. v. Internal Revenue Service, 581 F.3d 696 (8th Cir. 2009). The court also held the statute applies to post-petition taxes and that those taxes can be treated as an administrative expense. Such taxes can be discharged in full if provided for in the Chapter 12 plan and the debtor receives a discharge. Upon the filing of a Chapter 12, a separate taxpaying entity apart from the debtor is not created.
That is an important point in the context of the 2005 amendment. The debtor remains responsible for tax taxes triggered in the context of Chapter 12. The amendment, however, allows non-priority treatment for claims entitled to priority under 11 U.S.C. §507(a)(2). That provision covers administrative expenses that are allowed by 11 U.S.C. §503(b)(B) which includes any tax that the bankruptcy estate incurs. Pre-petition taxes are covered by 11 U.S.C. §507(a)(8). But, post-petition taxes, to be covered by the amendment, must be incurred by the bankruptcy estate such as is the case with administrative expenses. Indeed, the IRS position is that post-petition taxes are not "incurred by the estate" as is required for a tax to be characterized as an administrative expense in accordance with 11 U.S.C. § 503 (b)(1)(B)(i), and that post-petition taxes constitute a liability of the debtor rather than the estate. See ILM 200113027 (Mar. 30, 2001). The U.S. Circuit Courts of Appeal for the Ninth and Tenth Circuits agreed with the IRS position, as did the U.S. Supreme Court. Hall v. United States, 132 S. Ct. 1882 (2012).
H.R. 2266, signed into law on October 26, 2017, contains the Family Farmer Bankruptcy Act (Act). The Act adds 11 U.S.C. §1232 which specifies that, “Any unsecured claim of a governmental unit against the debtor or the estate that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor's discharge under section 1228, as a result of the sale, transfer, exchange, or other disposition of any property used in the debtor's farming operation”… is to be treated as an unsecured claim that arises before the bankruptcy petition was filed that is not entitled to priority under 11 U.S.C. §507 and is deemed to be provided for under a plan, and discharged in accordance with 11 U.S.C. §1228. The provision amends 11 U.S.C. §1222(a)(2)(A) to effectively override the U.S. Supreme Court decision in Hall. As noted above, in Hall the U.S. Supreme Court held that tax triggered by the post-petition sale of farm assets was not discharged under 11 U.S.C. §1222(a)(2)(A). The Court held that because a Chapter 12 bankruptcy estate cannot incur taxes by virtue of 26 U.S.C. §1399, taxes were not “incurred by the estate” under 11 U.S.C. §503(b) which barred post-petition taxes from being treated as non-priority. The 2017 legislation overrides that result. The provision was effective for all pending Chapter 12 cases with unconfirmed plans and all new Chapter 12 cases as of October 26, 2017.
The 2005 provision also makes no mention of how the amount of priority and non-priority tax claims is to be computed. Operationally, if a Chapter 12 bankruptcy filer has liquidated assets used in the farming operation within the tax year of filing or liquidates assets used in the farming operation after Chapter 12 filing as part of the Chapter 12 plan, and gain or depreciation recapture income or both are triggered, the plan should provide that there are will be no payments to unsecured creditors until the amount of the tax owed to governmental bodies for the sale of assets used in the farming operation is ascertained. The dischargeable tax claims are then added to the pre-petition unsecured claims to determine the percentage distribution to be made to the holders of pre-petition unsecured claims as well as the claims of the governmental units that are being treated as unsecured creditors not entitled to priority. That approach assures that all claims that are deemed to be unsecured claims would be treated equitably.
Methods of computation. To accurately determine the extent of the priority tax claim under the non-priority provision, it is necessary to directly relate the priority tax treatment to the income derived from sources that either satisfy the non-priority provision or do not satisfy it. There are two basic approaches for computing the priority and general dischargeable unsecured tax claims – the proportional method or the marginal allocation method. The proportional method (which is the IRS approach) divides the debtor’s ordinary farming income by the debtor’s total income and then multiplies the total tax claim by the resulting fraction. That result is then subtracted from the debtor’s total tax liability with the balance treated as the non-priority part of the tax obligation. Conversely, under the marginal approach, the debtor prepares a pro-forma tax return that omits the income from the sale of farm assets. The resulting tax liability from the pro forma return is then subtracted from the total tax due on the debtor’s actual return. The difference is the tax associated with the sale of farm assets that is entitled to non-priority treatment.
A shortfall of the IRS’ proportional method is that it merely divides the debtor’s tax obligation by applying the ratio of the debtor’s priority tax claim to the debtor’s total income and then divides the total tax claim. That mechanical computation does not consider any deductions and/or credits that impact the debtor’s final tax liability, and which are often phased out based on income. Instead, the proportional method simply treats every dollar of income the same. The result is that the proportional method, as applied to many debtors, significantly increases the debtor’s adjusted gross income and the priority non-dischargeable tax obligation. The proportional method makes no attempt to measure the type of income, or what income “causes” any particular portion of the tax claim.
The marginal approach was adopted by Eighth Circuit in the Knudsen case as well as the Bankruptcy Court in In re Ficken, 430 B.R. 663 (Bankr. D. Colo. 2009). The appropriate tax allocation method was not at issue in either of the cases on appeal. The Kansas bankruptcy court also rejected the IRS approach in favor of the marginal method. The most recent court decision on the issue has, like earlier cases, rejected the proportional method in favor of the marginal method. In re Keith, No. 10-12997, 2013 Bankr. LEXIS 2802 (Bankr. D. Kan. Jul. 8, 2013).
What About Withheld Tax?
Under the 2005 amendment (and the 2017 legislation) taxes triggered by the sale, exchange, etc., of assets used in farming can be stripped of there priority status in a Chapter 12 farm bankruptcy. However, the debtor’s method for computing the taxes not entitled to priority involves utilization of the debtor’s total tax claim. That means that taxes that have already been withheld or paid through estimated payments should be refunded to the debtor’s bankruptcy estate, where it becomes subject to the priority/non-priority computation, rather than being offset against the debtor’s overall tax debt (with none it subject to non-priority treatment). Of course, the IRS and state taxing authorities object to this treatment.
Iowa bankruptcy case. The issue of how to handle withheld taxes was at issue in a recent case. In In re DeVries, No. 19-0018, 2020 U.S. Bankr. LEXIS 1154 (Bankr. N.D. Iowa Apr. 28, 2020), the debtors, a married couple, filed an initial Chapter 12 reorganization plan that the bankruptcy court held to be not confirmable. The debtors filed an amended plan that required the IRS and the Iowa Department of Revenue (IDOR) to refund to the debtors’ bankruptcy estate withheld income taxes. The taxing authorities objected, claiming that the withheld amounts had already been applied against the debtor’s tax debt as 11 U.S.C. §553(a) allowed. The debtors claimed that the 2017 legislation barred tax debt arising from the sale of assets used in farming from being offset against previously collected tax. Instead, the debtors argued, the withheld taxes should be returned to the bankruptcy estate. If withheld taxes weren’t returned to the bankruptcy estate, the debtors argued, similarly situated debtors would be treated differently.
The debtors sold a significant amount of farmland and farming machinery in 2017, triggering almost a $1 million of capital gain income and increasing their 2017 tax liability significantly. The tax liability was offset to a degree by income tax withholding from the wife’s off-farm job. Their amended Chapter 12 plan called for a refund to the estate of withheld federal and state income taxes. In the fall of 2019, the debtors submitted pro forma state and federal tax returns as well as their traditional tax returns for 2017 to the bankruptcy court in conjunction with the confirmation of their amended Chapter 12 plan. The pro-forma returns showed what the debtors’ tax liability would have been without the sale of the farmland and farm equipment. The pro-forma returns also showed, but for the capital gain, the debtors would have been entitled to a full tax refund of the taxes already withheld from the wife’s off-farm job.
The court was faced with the issue of whether 11 U.S.C. §1232(a) entitled the bankruptcy estate to a refund of the withheld tax. The IRS and IDOR claimed that 11 U.S.C. §553(a) preserved priority position for tax debt that arose before the bankruptcy petition was filed. The court disagreed, noting that 11 U.S.C. §1232(a) deals specifically with how governmental claims involving pre-petition tax debt are to be treated – as unsecured, non-priority obligations. But the court noted that 11 U.S.C. §1232(a) does not specifically address “clawing-back” previously withheld tax. It merely referred to “qualifying tax debt” and said it was to be treated as unsecured and not entitled to priority. Referencing the legislative history behind both the 2005 and 2017 amendments, the court noted that the purpose of the priority-stripping provision was to help farmers have a better chance at reorganization by de-prioritizing taxes, including capital gain taxes. The court pointed to statements that Sen. Charles Grassley made to that effect. The court also noted that the 2017 amendment was for the purpose of strengthening (and clarifying) the original 2005 de-prioritization provision by overturning the result in Hall to allow for de-prioritization of taxes arising from both pre and post-petitions sales of assets used in farming. Accordingly, the court concluded that 11 U.S.C. §1232(a) overrode a creditor’s set-off rights under 11 U.S.C. §553(a) in the context of Chapter 12. The debtors’ bankruptcy estate was entitled to a refund of the withheld income taxes.
On appeal, the bankruptcy appellate panel for the Eighth Circuit reversed. In re DeVries, 621 B.R. 445 (8th Cir. B.A.P. 2020). The appellate panel determined that 11 U.S.C. §1232(a) is a priority-stripping provision and not a tax provision and only addresses the priority of a claim and does not establish any right to or amount of a refund. As such, nothing in the statue authorized a debtor’s Chapter 12 plan to require a taxing authority to disgorge, refund or turn-over pre-petition withholdings for the benefit of the bankruptcy estate. The statutory term “claim,” the court reasoned, cannot be read to include withheld tax as of the petition date. Accordingly, the statute was clear and legislative history purporting to support the debtor’s position was rejected.
Indiana bankruptcy case. In re Richards, 616 B.R. 879 (Bankr. S.D. Ind. 2020) was decided the day after DeVries. In re Richards involved debtors, a married farm couple, who filed Chapter 12 bankruptcy in 2018 after suffering losses from negative weather events and commodity market price declines during 2013 through 2015. The primary lender refused to renew the loan which forced liquidation of the farm’s assets in the spring of 2016. During 2016, the debtors sold substantially all of the farm equipment, vehicles and other personal property assets as well as grain inventory. The proceeds were paid to the primary lender as well as other lenders with purchase money security interests in relevant assets. After filing Chapter 12, the debtors sold additional farmland. The asset sales triggered substantial income tax obligations for 2016, 2017 and 2018 tax years. The debtors Chapter 12 plan made no mention concerning whether off-farm earnings, tax withholdings or payments the debtors voluntarily made to the IRS, or a claim or refund would remain property of the bankruptcy estate after Plan confirmation. The plan did, however, divide the debtors federal tax obligations into 1) tax liabilities for income arising from the sale, transfer, exchange or other disposition of any property used in the debtors’ farming operation “Section 1232 Income”; and 2) tax liabilities arising from other income sources – “Traditional income.” Tax liabilities associated with Traditional Income would retain priority status, but taxes associated with Section 1232 Income would be de-prioritized (regardless of when the liability was incurred) and treated as general unsecured claims that would be discharged upon Plan completion if not paid in full. The debtors would pay directly the tax liability associated with Traditional Income incurred after the Chapter 12 filing date. Under the Plan, unsecured claims would be paid on a “pro rata” basis using the “marginal method” along with other general unsecured claims. The Section 1232 taxes would be computed by excluding the taxable income from the disposition of assets used in farming from the tax return utilizing a pro forma tax return.
The Plan was silent concerning how the Debtors’ withholding payments and credits for each tax year were to be applied or allocated between any particular tax year’s income tax return and the corresponding pro forma return. The IRS filed a proof of claim for the 2016 and 2017 tax years in the amount of $288,675.43. The debtors objected to the IRS’s claim, but did seek to reclassify $5,681 of the IRS claim as general unsecured priority status. The IRS failed to respond, and the court granted the debtors approximately $280,000 in tax relief for 2016 and 2017. The debtors then submitted their 2018 federal and state returns showing a tax liability of $58,380 and their pro forma return for 2018 excluding the income from the sale of farm assets which showed a tax liability of $3,399.
The debtors, due to withholding and estimated tax, inadvertently paid $9,813 to the IRS during 2018. The claimed $6,414 was an overpayment and listed that amount on the Pro Forma return as a refund. The IRS amended its proof of claim and asserted a general unsecured claim of $42,200 for the 2018 tax year (excluding penalties and interest). The IRS claimed that none of the debtors’ tax liability qualified for non-priority treatment under 11 U.S.C. §1232, and that it had a general unsecured claim for $42, 220 for the 2018 tax year. To reach that amount, the IRS allocated tax withholdings and credits of $9,813 to the assessed tax due on the debtors’ pro forma return which reduced that amount to zero, and then allocated the remaining $6,414 of withholdings, payments and credits to the outstanding tax liability of $48,634. IRS later added $6,347 of net investment income tax that the debtors had reported on their return but IRS had excluded due to a processing error. The debtors objected to the IRS’s claim and asserted it should not be increased by neither the $6,414 overpayment or the $6,347 of net investment income tax. The debtors sought to adjust the IRS claim to $54,981 and have the court issue a refund to them of $6,414 or reduce distributions to the IRS until the refund obligation had been satisfied. The IRS objected on the basis that the court lacked jurisdiction to compel the issuance of a refund or credit of an overpayment, and that the debtors were not entitled to the refund or credit of the overpayment shown on the pro forma return as a matter of law.
The court sustained the debtors’ objection to the extent the 2018 refund was applied to the IRS’s claim in a manner other than provided for under the confirmed plan. Specifically, the court held that the IRS has exercised a setoff that was not permitted under 11 U.S.C. §553 which violated the plan’s bar against any creditor taking any action “to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan.” But, the court held that it lacked jurisdiction to compel the issuance of a refund or credit of an overpayment and that the debtors were not entitled to the refund or credit of overpayment as a matter of law. This was because, the court determined, the refund was not “property of the estate” under 11 U.S.C. § §542 and 541(a).
Note: While the Indiana bankruptcy court claimed it lacked authority to force the IRS to issue a refund based on a “property of the estate” argument, that argument leads to a conclusion that is counter to the intent and purpose of I.R.C. §1232. How is 11 U.S.C. §1232 to be operative if a court says it can’t enforce it? Certainly, filing a Notice of intent concerning the priority stripping of 11 U.S.C. §1232 taxes with the court asserting the debtors’ right to receive the tax refund would have teed-up the issue more quickly, one wonders whether a judge intent on negating the impact of 11 U.S.C. §1232 would have decided differently.
Later, the court held that the overpayment reflected on the pro forma return was “property of the estate” and withdrew its prior analysis of 11 U.S.C. §§542 and 505(a)(2)(B). Thus, the court allowed the IRS’s 2018 general unsecured tax claim in the amount of $54,981 and ordered the Trustee to pay distributions to the debtors until the overpayments had been paid to the debtors.
The IRS appealed, claiming that the bankruptcy court erred in allowing the IRS’s proof of claim in the amount of $54,981 rather than $48,567, and ordering the IRS to issue the debtors a refund or credit of any overpayment in the amount of $6,414. Specifically, the IRS asserted that 11 U.S.C. §1232 did not provide the debtors any right to an “overpayment” or “refund” because it only applies to “claims” - tax liability after crediting payments and withholdings. The IRS based its position on DeVries. However, the appellate court in In re Richards, No. 1:20-cv-027030SEB-MG, 2021 U.S. App. LEXIS 188154 (7th Cir. Sept. 30, 2021), noted distinctions with the facts of DeVries. Here, the sale of property at issue occurred post-petition and involved a claim objection after the Plan had already been confirmed. The appellate court noted that the IRS did not object to the terms of the Plan, and under 11. U.S.C. §1232 the debtors were entitled to deprioritize all post-petition Sec. 1232 liabilities, not just a portion. The application of the marginal method resulted in a tax liability of $54,981 to be paid in accordance with Sec. 1232. The non-Sec. 1232 tax liability was $3,399. The debtors inadvertently paid $9,813 to the IRS and were entitled to a refund of $6,414 which the IRS could not apply against the Sec. 1232 liabilities in calculating its proof of claim.
The appellate court also determined that the refund amount was “property of the estate” under 11 U.S.C. §1207(a)(2). The appellate court noted that the debtors’ off-farm earnings became property of the estate at the time the Plan was confirmed and became subject to the terms and payment requirements of the Plan. The Plan directed the use of the off-farm earnings during the life of the Plan and specifically provided that off-farm earnings could not be used to pay tax liabilities associated with the sale of farm assets used in farming – the Sec. 1232 liabilities. Thus, the appellate court concluded what the debtors’ position was consistent with In re Heath, 115 F.3d 521 (7th Cir. 1997) because the $6,414 refund was part of a payment made from off-farm earnings necessary to fund the Plan’s payment obligations.
Devries and Richards are important cases for practitioners helping farmers in financial distress. 11 U.S.C. §1232 is a powerful tool that can assist making a farm reorganization more feasible. The Indiana case is a bit strange. In that case, the debtors were also due a refund for 2016. A pro-forma return for that year showed a refund of $1,300. Thus, the issue of a refund being due for pre-petition taxes could have been asserted just as it was in the Iowa case. Another oddity about the Indiana case is that the 2018 pro-forma (and regular) return was submitted to the IRS in March of 2019. Under 11 U.S.C. §1232, the “governmental body” has 180 days to file its proof of claim after the pro forma tax return was filed. The IRS timely filed tis proof of claim and later filed an amended proof of claim which was identical to the original proof of claim. The IRS filed an untimely proof of claim in one of the other jointly administered cases.
Procedurally, in the Indiana case, a Notice regarding the use of 11 U.S.C. §1232 should have been filed with the court to clarify the dates of Notice to the IRS (and other governmental bodies) of the amount of the priority non-dischargeable taxes and 11 U.S.C. §1232 taxes to be discharged under the plan. That is when the issue of the refund would have been raised with the IRS. However, there was no Notice of the filing of the pro-forma return with the court.
Note: Going forward, Chapter 12 reorganization plans should provide that if a pro-forma return shows that the debtor is owed a refund the governmental bodies will pay it.
It is also important to remember that if the debtor does not receive a Chapter 12 discharge, the taxing bodies are free to pursue the debtor as if no bankruptcy had been filed, assessing and collecting the tax as well as all penalties and interest allowed by law including any refunds the taxing bodies are forced to make based on § 1232. Competent bankruptcy counsel that appreciates tax law is a must.
Tuesday, October 5, 2021
A corporate buy-sell agreement funded with life insurance is fairly common in farm and ranch settings where there is a desire to keep the business in the family for subsequent generations and there are both on-farm and off-farm heirs. When a controlling shareholder dies, it can be a good way to get the control of the business in the hands of the on-farm heirs and income into the hands of the off-farm heirs. But, how does corporate-owned life insurance impact the value of the company and the value of the decedent’s gross estate?
The impact of corporate-owned life insurance on value – it’s the topic of today’s post.
Valuation is where the “action” is when it come to federal estate tax. The rule for valuing property for federal estate (and gift) tax purposes is the “willing buyer-willing-seller” test. Treas. Reg. §25.2512-1. Whatever price the parties arrive at is deemed to be the property’s fair market value. Id. But, how is a corporation to be valued when it will receive insurance proceeds upon the death of a shareholder and the proceeds will be offset by a corporate obligation to redeem the decedent’s stock? Will the proceeds of an insurance policy owned by a corporation and payable to the corporation be taken into account in determining the corporation’s net worth? Under the Treasury Regulations, the proceeds do not add to corporate net worth to the extent that they are otherwise reflected in a determination of net worth, prospective earning power, and dividend-paying capacity. Treas. Reg. §20.2031-2(f). This means that, for the stockholders that have various degrees of control, the insurance proceeds may be reflected in the pro-rata determination of stock value. The same is true for proceeds payable to a third party for a valid business purpose that results in a net increase in the corporate net worth. See Treas. Reg. §20.2042-1(c)(6).
A related question is what the impact is on the decedent’s estate that has stock redeemed? Does state law matter?
The Blount Case
The issue of corporate valuation when life insurance proceeds are payable to the corporation upon a shareholder’s death for the purpose of funding a stock redemption pursuant to a buy-sell agreement came up in Estate of Blount v. Comr., T.C. Memo. 2004-116. In Blount, the decedent owned 83.2 percent of a construction company. There was only one other shareholder, and the two shareholders entered into a buy-sell agreement in 1981 with the corporation. Under the agreement, the stock could only be sold with shareholder consent. Upon a shareholder’s death, the agreement specified that the corporation would buy the stock at a price that the shareholders had agreed upon or, if there was no agreement, at a price based on the corporation’s book value.
In the early 1990s, the corporation bought insurance policies for the sole purpose of ensuring that the business could redeem stock and continue in business. The policies provided about $3 million, respectively, for the stock redemption. The corporation was valued annually, and a January 1995 valuation pegged it at $7.9 million.
The first shareholder died in early 1996 at a time when he owned 46 percent of outstanding corporate shares. The corporation received about $3 million in insurance proceeds and paid slightly less than that to redeem the shareholder’s stock based on the prior year’s book value. The decedent was diagnosed with cancer in late 1996. The 1981 buy-sell agreement was amended about a month later locking the redemption price at the January 1996 value of the corporation. The decedent died in the fall of 1987. The corporation paid his estate about $4 million in accordance with the 1996 agreement. The decedent’s estate tax return reported the $4 million as the value of the shares. Upon audit, the IRS asserted that the stock was worth about twice that amount based on the corporation being worth about $9.5 million (including the insurance proceeds to the other corporate assets).
Based on numerous expert valuations, the Tax Court started with a base corporate valuation of $6.75 million. After adding the $3.1 million of insurance paid to the corporation as a non-operating asset upon the decedent’s death, the corporation was worth $9.85 million. Given the decedent’s ownership percentage of 83.2 percent, the value of the decedent’s stock for estate tax purposes was $8.2 million. But the Tax Court limited the stock value to slightly less than $8 million which was the amount that the IRS had determined in its original notice of deficiency. In making its valuation determination, the Tax Court disregarded the buy-sell agreement on the basis that it had been modified and, therefore, didn’t meet the requirement to be binding during life. In addition, the Tax Court reasoned that the agreement could be disregarded under I.R.C. §2703 because it was entered into by related parties that didn’t engage in arm’s-length negotiation. Because the Tax Court disregarded the buy-sell agreement, the issue of whether the corporation’s obligation to redeem the decedent’s stock offset the proceeds was not in issue.
The appellate court affirmed the Tax Court’s decision that the buy-sell agreement couldn’t establish the value of the corporate stock for estate tax purposes primarily because the decedent owned 83.2 percent of the stock and could have changed the agreement at any time, but reversed on the issue of whether the insurance proceeds should be included in the corporation’s value as non-operating assets. Estate of Blount v. Comr., 428 F.3d 1338 (11th Cir. 2005). The appellate court determined that the proceeds had already been taken into account in determining the corporation’s net worth. The buy-sell agreement was still an enforceable liability against the company under state law even though it didn’t set the value of the company for tax purposes. The appellate court noted that the insurance proceeds were offset dollar-for-dollar by the corporation’s obligation to satisfy its contractual obligation with the decedent’s estate. The appellate court grounded this last point in Treas. Reg. §20.2031-2(f)(2), which it held precluded the inclusion of life insurance proceeds in corporate value when the proceeds are used for a redemption obligation.
Note: The Ninth Circuit also reached the same conclusion in Cartwright v. Comr., 183 F.3d 1034 (9th Cir. 1999). In Cartwright, the court deducted the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout.
Essential facts. In Connelly v. United States, No. 4:19-cv-01410-SRC, 2021 U.S. Dist. LEXIS 179745 (E.D. Mo. Sept. 21, 2021), two brothers were the only shareholders of a closely-held family roofing and siding materials business. They entered into a stock purchase agreement that required the company to buy back shares of the first brother to die. The company then purchased about $3.5 million in life insurance coverage to ensure it had enough cash to redeem the stock. The brother holding the majority of the company’s shares (77.18 percent) died on October 1, 2013. The company received $3.5 million in insurance proceeds. The surviving brother chose not to buy his shares, so the company used a portion of the proceeds to buy the deceased brother’s shares from his estate for $3 million pursuant to a Sale and Purchase Agreement. Under the agreement the estate received $3 million and the decedent’s son received a three-year option to buy company stock from the surviving brother. In the event that the surviving brother sold the company within 10 years, the brother and decedent’s son would split evenly any gains from the sale.
The estate valued the decedent’s stock at $3 million and included that amount in the taxable estate. Upon audit the IRS asserted that the fair market value of the decedent’s corporate stock should have factored-in the $3 million in life-insurance proceeds used to redeem the shares which, in turn, resulted in a higher value of the decedent’s stock than was reported. The IRS assessed over $1 million in additional estate tax. The estate paid the deficiency and filed a refund claim in federal district court.
The buy-sell agreement. The court noted that a stock-purchase agreement is respected when determining the fair market value of stock for estate tax purposes upon satisfying the requirements of I.R.C. §2703(b). Those requirements are that the agreement must: 1) be a bona fide business arrangement; 2) not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in the money’s worth; and 3) have terms that are comparable to similar arrangements entered in an arms’ length transaction. The court also noted several judicially-created requirements – 1) the offering price must be fixed and determinable under the agreement; 2) the agreement must be legally binding on the parties both during life and after death; and 3) the restrictive agreement must have been entered into for a bona fide business reason and must not be a substitute for a testamentary disposition for less than full-and-adequate consideration.
The IRS expert claimed that the insurance proceeds should be included in the company’s value as a non-operating asset, and that allowing the redemption obligation to offset the insurance proceeds undervalued the company’s equity and the decedent’s equity interest in the company, and would create a windfall for a potential buyer that a willing seller would not accept. The IRS expert concluded that the fair market value of the company was $6.86 million rather than $3.86 million. The IRS also took the position that the stock purchase agreement didn’t meet the requirements in the Code and regulations to control the value of the company.
The estate claimed that the company sold the decedent’s shares at fair market value and that the shares had been properly valued. Thus, the $3 million in life insurance proceeds were properly excluded from the decedent’s estate based on the appellate opinion in Blount. The estate claimed that the stock purchase agreement provided a sufficient basis for the court to accept the estate’s valuation as the proper estate-tax value of the decedent’s shares. On that point, the IRS claimed that the stock purchase agreement was not a bona fide business arrangement and, as such, didn’t control the value of the decedent’s stock. The IRS position was that the stated estate planning objectives of the stock purchase of continued family ownership of the company were insufficient to make it a bona fide business arrangement, particularly because the brothers did not follow it by disregarding the pricing mechanisms contained in it.
The court passed on the bona fide business arrangement issue because it determined that the estate had failed to show that the stock purchase agreement was not a device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration. The process that the surviving brother and the estate used in selecting the redemption price bolstered the court’s conclusion that the stock purchase agreement was a testamentary device. They also did not obtain an outside appraisal or professional advice on setting the redemption price, thereby disregarding the appraisal requirement set forth in the agreement. The court also noted that the agreement didn’t provide for a minority interest discount for the surviving brother’s shares or a lack of control premium for the decedent’s shares with the result that the decedent’s shares were undervalued. This also, according to the court, demonstrated that the stock purchase agreement was a testamentary device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration and was not comparable to similar agreements negotiated at arms’ length.
Inclusion of life insurance proceeds in corporate value. On the issue of whether the life insurance proceeds should be included in corporate value, the court rejected the appellate court’s approach in Blount, finding it to be analytically flawed. The court concluded that the appellate court in Blount had misread Treas. Reg. §20.2031-2(f)(2), and that the regulation specifically requires consideration to be given to non-operating assets including life insurance proceeds, “to the extent such nonoperating assets have not been taken into account in the determination of net worth.” The court concluded that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been “taken into account in the determination of a company’s net worth.” The court concluded that, “by its plain terms, the regulation means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company’s stock…. And…a redemption obligation is not the same as an ordinary corporate liability.” There is a difference, the court noted, between a redemption obligation that simply buys shares of stock, and one that also compensates for a shareholder’s past work. One that only buys stock is not an ordinary corporate liability – it doesn’t change the value of the corporation as a whole before the shares are redeemed. It involves a change in the ownership structure with a shareholder essentially “cashing out.”
The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds. The insurance proceeds were not offset by the company’s redemption obligation and, accordingly, the company’s fair market value and the decedent’s shares included all of the insurance proceeds, and the IRS position was upheld.
The Connelly opinion is appealable to the Eighth Circuit, which would not be bound to follow either the Ninth or Eleventh Circuits on the corporate valuation issue. The opinion does provide some “food for thought” when using life insurance to fund stock buyouts in closely-held business settings. That will be an even bigger concern if the federal estate tax exemption declines in the future.
Thursday, September 30, 2021
Extended Livestock Replacement Period Applies in Areas of Extended Drought – IRS Updated Drought Areas
Each year, by the end of September, the IRS provides guidance on the extension of the replacement period under I.R.C. §1033(e)(2)(B) for livestock sold on account of drought, flood or other weather-related condition. The extended replacement period allows taxpayers additional time to replace the involuntarily converted livestock with like-kind replacement animals without triggering gain on the sale. The IRS recently issued its 2021 guidance on the issue.
With Notice 2021-55, 2021-41, I.R.B., the IRS issued its annual Notice specifying those areas that are eligible for an extension of the replacement period for livestock that farmers and ranchers must sell because of severe weather conditions (drought, flood or other weather-related conditions). For livestock owners in the listed areas that were anticipating that their replacement period would expire at the end of 2021 now have at least until the end of 2022 to replace the involuntarily converted livestock.
Involuntary Conversion Rules
I.R.C. §1033(e) provides that a taxpayer does not recognize gain when property is involuntarily converted and replaced with property that is similar or related in service or use. Under I.R.C. §1033(e)(1), the sale or exchange of livestock that a taxpayer holds for draft, dairy or breeding purposes in an amount exceeding the number of livestock that the taxpayer would normally sell under the taxpayer’s usual business practice, is treated as a non-taxable involuntary conversion if the sale of the livestock is solely on account of drought, flood or other weather-related conditions. The weather-related conditions must result in the area being designated as eligible for assistance by the federal government. For purposes of this rule, poultry does not count as “livestock.”
The livestock must be replaced with "like-kind" livestock. I.R.C. §1033(a)(1). Normally, the replacement period is four years from the close of the first tax year in which any part of the gain from the conversion is realized. I.R.C. §1033(e)(2)(A). But the Treasury Secretary has discretion to extend the replacement period on a regional basis for “such additional time as the Secretary deems appropriate” if the weather-related conditions that resulted in the federal designation continue for more than three years. I.R.C. §1033(e)(2)(B).
If the involuntary conversion of livestock is on account of drought and the taxpayer’s replacement period is determined under I.R.C. §1033(e)(2)(A), the extended replacement period under I.R.C. §1033(e)(2)(B) and Notice 2006-82, 2006-2 C.B. 529 is until the end of the taxpayer’s first taxable year after the first drought-free year for the applicable region. That is defined as the first 12-month period that ends on August 31 in or after the last of the taxpayer’s four-year replacement period, and does not include any weekly period for which exceptional, extreme or severe drought is reported for any location in the applicable region. The “applicable region” is the county (and all contiguous counties) that experienced the drought conditions on account of which the livestock was sold or exchanged
Note: If an area is designated as not having a drought-free year, the extended replacement period applies.
Thus, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2021 (or, for a fiscal-year taxpayer, at the end of the first tax year that includes August 31, 2021), the replacement period extends until the end of the taxpayer’s first taxable year ending after a drought-free year for the applicable region.
Determining Eligible Locations
One way to determine if a taxpayer is in an area that has experienced exceptional, extreme or severe drought is to refer to the U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center The U.S. Drought Monitor maps are archived at https://droughtmonitor.unl.edu/Maps/MapArchive.aspx
Another way is to wait for the IRS to publish its list of counties, which it is required to issue by the end of September each year.
In accordance with the 2021 IRS Notice on the matter, the following is a list of the counties for which the 12-month period ending August 31, 2021, is not a drought-free year:
Counties of Apache, Cochise, Coconino, Gila, Graham, Greenlee, La Paz, Maricopa, Mohave, Navajo, Pima, Pinal, Santa Cruz, Yavapai, and Yuma.
Counties of Benton, Carroll, Madison, and Washington.
Counties of Alameda, Alpine, Amador, Butte, Calaveras, Colusa, Contra Costa, Del Norte, El Dorado, Fresno, Glenn, Humboldt, Imperial, Inyo, Kern, Kings, Lake, Lassen, Los Angeles, Madera, Marin, Mariposa, Mendocino, Merced, Modoc, Mono, Monterey, Napa, Nevada, Orange, Placer, Plumas, Riverside, Sacramento, San Benito, San Bernardino, San Diego, San Francisco, San Joaquin, San Luis Obispo, San Mateo, Santa Barbara, Santa Clara, Santa Cruz, Shasta, Sierra, Siskiyou, Solano, Sonoma, Stanislaus, Sutter, Tehama, Trinity, Tulare, Tuolumne, Ventura, Yolo, and Yuba.
Counties of Adams, Alamosa, Arapahoe, Archuleta, Baca, Bent, Boulder, Broomfield, Chaffee, Cheyenne, Clear Creek, Conejos, Costilla, Crowley, Custer, Delta, Denver, Dolores, Douglas, Eagle, Elbert, El Paso, Fremont, Garfield, Gilpin, Grand, Gunnison, Hinsdale, Huerfano, Jackson, Jefferson, Kiowa, Kit Carson, Lake, La Plata, Larimer, Las Animas, Lincoln, Logan, Mesa, Mineral, Moffat, Montezuma, Montrose, Morgan, Otero, Ouray, Park, Phillips, Pitkin, Prowers, Pueblo, Rio Blanco, Rio Grande, Routt, Saguache, San Juan, San Miguel, Sedgwick, Summit, Teller, Washington, Weld, and Yuma.
Counties of Hartford, Litchfield, Middlesex, New Haven, New London, Tolland, and Windham.
Counties of Hawaii, Honolulu, Kalawao, Kauai, and Maui.
Counties of Ada, Adams, Bannock, Bear Lake, Benewah, Bingham, Blaine, Boise, Bonner, Bonneville, Boundary, Butte, Camas, Canyon, Caribou, Cassia, Clark, Clearwater, Custer, Elmore, Franklin, Fremont, Gem, Gooding, Idaho, Jefferson, Jerome, Kootenai, Latah, Lemhi, Lewis, Lincoln, Minidoka, Nez Perce, Oneida, Owyhee, Payette, Power, Shoshone, Teton, Twin Falls, Valley, and Washington.
Counties of Boone, Christian, Cook, DeKalb, De Witt, DuPage, Jo Daviess, Kane, Lake, Logan, McHenry, Macon, Menard, Ogle, Piatt, Sangamon, Stephenson, and Winnebago.
Counties of Adair, Adams, Allamakee, Audubon, Benton, Black Hawk, Boone, Bremer, Buchanan, Buena Vista, Butler, Calhoun, Carroll, Cass, Cerro Gordo, Cherokee, Chickasaw, Clay, Clayton, Crawford, Dallas, Delaware, Dickinson, Dubuque, Emmet, Fayette, Floyd, Franklin, Fremont, Greene, Grundy, Guthrie, Hamilton, Hancock, Hardin, Harrison, Howard, Humboldt, Ida, Iowa, Jasper, Johnson, Keokuk, Kossuth, Linn, Lyon, Madison, Mahaska, Marshall, Mills, Mitchell, Monona, Montgomery, O'Brien, Osceola, Page, Palo Alto, Plymouth, Pocahontas, Polk, Pottawattamie, Poweshiek, Sac, Shelby, Sioux, Story, Tama, Warren, Webster, Winnebago, Winneshiek, Woodbury, Worth, and Wright.
Counties of Brown, Cheyenne, Clark, Clay, Cloud, Comanche, Decatur, Dickinson, Geary, Gove, Graham, Grant, Greeley, Hamilton, Jackson, Jewell, Kearny, Lincoln, Logan, Marshall, Meade, Mitchell, Morton, Nemaha, Norton, Ottawa, Phillips, Pottawatomie, Rawlins, Republic, Riley, Scott, Seward, Sheridan, Sherman, Smith, Stanton, Stevens, Thomas, Wabaunsee, Wallace, Washington, and Wichita.
Counties of Androscoggin, Aroostook, Cumberland, Franklin, Hancock, Kennebec, Knox, Lincoln, Oxford, Penobscot, Piscataquis, Sagadahoc, Somerset, Waldo, Washington, and York.
Counties of Barnstable, Berkshire, Bristol, Dukes, Essex, Franklin, Hampden, Hampshire, Middlesex, Nantucket, Norfolk, Plymouth, Suffolk, and Worcester.
County of Alcona, Allegan, Arenac, Barry, Bay, Benzie, Berrien, Branch, Calhoun, Cass, Clinton, Eaton, Genesee, Gladwin, Grand Traverse, Gratiot, Hillsdale, Huron, Ingham, Ionia, Iosco, Isabella, Jackson, Kalamazoo, Kent, Lapeer, Leelanau, Livingston, Manistee, Mason, Mecosta, Midland, Montcalm, Muskegon, Newaygo, Ogemaw, Ottawa, Saginaw, Saint Clair, Saint Joseph, Sanilac, Shiawassee, Tuscola, Van Buren, Washtenaw, and Wexford.
County of Aitkin, Anoka, Becker, Beltrami, Benton, Big Stone, Blue Earth, Brown, Carlton, Carver, Cass, Chippewa, Chisago, Clay, Clearwater, Cook, Cottonwood, Crow Wing, Dakota, Douglas, Faribault, Fillmore, Freeborn, Goodhue, Grant, Hennepin, Houston, Hubbard, Isanti, Itasca, Jackson, Kanabec, Kandiyohi, Kittson, Koochiching, Lac qui Parle, Lake, Lake of the Woods, Le Sueur, Lincoln, Lyon, McLeod, Mahnomen, Marshall, Martin, Meeker, Mille Lacs, Morrison, Mower, Murray, Nicollet, Nobles, Norman, Otter Tail, Pennington, Pine, Pipestone, Polk, Pope, Ramsey, Red Lake, Redwood, Renville, Rice, Rock, Roseau, Saint Louis, Scott, Sherburne, Sibley, Stearns, Steele, Stevens, Swift, Todd, Traverse, Wadena, Waseca, Washington, Watonwan, Wilkin, Wright, and Yellow Medicine.
Counties of Grenada, Leflore, Quitman, Tallahatchie, and Yalobusha.
Counties of Atchison, Barry, Barton, Cedar, Christian, Dade, Douglas, Greene, Holt, Jasper, Lawrence, McDonald, Newton, Polk, Stone, Taney, Vernon, and Webster.
Counties of Beaverhead, Big Horn, Blaine, Broadwater, Carbon, Carter, Cascade, Chouteau, Custer, Daniels, Dawson, Deer Lodge, Fallon, Fergus, Flathead, Gallatin, Garfield, Glacier, Golden Valley, Granite, Hill, Jefferson, Judith Basin, Lake, Lewis and Clark, Liberty, Lincoln, McCone, Madison, Meagher, Mineral, Missoula, Musselshell, Park, Petroleum, Phillips, Pondera, Powder River, Powell, Prairie, Ravalli, Richland, Roosevelt, Rosebud, Sanders, Sheridan, Silver Bow, Stillwater, Sweet Grass, Teton, Toole, Treasure, Valley, Wheatland, Wibaux, and Yellowstone.
Counties of Adams, Antelope, Arthur, Banner, Box Butte, Boyd, Buffalo, Burt, Butler, Cass, Cedar, Chase, Cherry, Cheyenne, Clay, Colfax, Cuming, Custer, Dakota, Dawes, Dawson, Deuel, Dixon, Dodge, Douglas, Dundy, Franklin, Frontier, Furnas, Gage, Garden, Garfield, Gosper, Grant, Greeley, Hall, Hamilton, Harlan, Hayes, Hitchcock, Holt, Howard, Jefferson, Johnson, Kearney, Keith, Keya Paha, Kimball, Knox, Lancaster, Lincoln, McPherson, Madison, Merrick, Morrill, Nance, Nemaha, Nuckolls, Otoe, Pawnee, Perkins, Phelps, Pierce, Platte, Red Willow, Richardson, Rock, Saline, Sarpy, Saunders, Scotts Bluff, Sheridan, Sherman, Sioux, Stanton, Thayer, Thurston, Valley, Washington, Wayne, Webster, and Wheeler.
City of Carson City. Counties of Churchill, Clark, Douglas, Elko, Esmeralda, Eureka, Humboldt, Lander, Lincoln, Lyon, Mineral, Nye, Pershing, Storey, Washoe, and White Pine.
Counties of Belknap, Carroll, Cheshire, Coos, Grafton, Hillsborough, Merrimack, Rockingham, Strafford, and Sullivan.
Counties of Bernalillo, Catron, Chaves, Cibola, Colfax, Curry, DeBaca, Dona Ana, Eddy, Grant, Guadalupe, Harding, Hidalgo, Lea, Lincoln, Los Alamos, Luna, McKinley, Mora, Otero, Quay, Rio Arriba, Roosevelt, Sandoval, San Juan, San Miguel, Santa Fe, Sierra, Socorro, Taos, Torrance, Union, and Valencia.
Counties of Allegany, Cattaraugus, Hamilton, Herkimer, Jefferson, Lewis, Oneida, Saint Lawrence, and Suffolk.
Counties of Bladen, Brunswick, Columbus, Duplin, New Hanover, Onslow, Pender, Robeson, Sampson, and Scotland.
Counties of Adams, Barnes, Benson, Billings, Bottineau, Bowman, Burke, Burleigh, Cass, Cavalier, Dickey, Divide, Dunn, Eddy, Emmons, Foster, Golden Valley, Grand Forks, Grant, Griggs, Hettinger, Kidder, LaMoure, Logan, McHenry, McIntosh, McKenzie, McLean, Mercer, Morton, Mountrail, Nelson, Oliver, Pembina, Pierce, Ramsey, Ransom, Renville, Richland, Rolette, Sargent, Sheridan, Sioux, Slope, Stark, Steele, Stutsman, Towner, Traill, Walsh, Ward, Wells, and Williams.
Counties of Atoka, Beaver, Beckham, Blaine, Bryan, Caddo, Canadian, Carter, Choctaw, Cimarron, Coal, Custer, Dewey, Ellis, Grady, Greer, Harmon, Harper, Jackson, Jefferson, Johnston, Kiowa, Love, Major, Marshall, Murray, Roger Mills, Texas, Tillman, Washita, Woods, and Woodward.
Counties of Baker, Benton, Clackamas, Clatsop, Columbia, Coos, Crook, Curry, Deschutes, Douglas, Gilliam, Grant, Harney, Hood River, Jackson, Jefferson, Josephine, Klamath, Lake, Lane, Lincoln, Linn, Malheur, Marion, Morrow, Multnomah, Polk, Sherman, Tillamook, Umatilla, Union, Wallowa, Wasco, Washington, Wheeler, and Yamhill.
Counties of Blair, Cambria, Cameron, Centre, Clearfield, Clinton, Huntingdon, Lycoming, McKean, Potter, Tioga, and Union.
Counties of Bristol, Kent, Newport, Providence, and Washington.
Counties of Calhoun, Chesterfield, Clarendon, Darlington, Dillon, Florence, Georgetown, Horry, Kershaw, Lee, Lexington, Marion, Marlboro, Orangeburg, Richland, Sumter, and Williamsburg.
Counties of Aurora, Beadle, Bennett, Bon Homme, Brookings, Brown, Brule, Buffalo, Butte, Campbell, Charles Mix, Clark, Clay, Codington, Corson, Custer, Davison, Day, Deuel, Dewey, Douglas, Edmunds, Fall River, Faulk, Grant, Gregory, Haakon, Hamlin, Hand, Hanson, Harding, Hughes, Hutchinson, Hyde, Jackson, Jerauld, Jones, Kingsbury, Lake, Lawrence, Lincoln, Lyman, McCook, McPherson, Marshall, Meade, Mellette, Miner, Minnehaha, Moody, Oglala Lakota, Pennington, Perkins, Potter, Roberts, Sanborn, Spink, Stanley, Sully, Todd, Tripp, Turner, Union, Walworth, Yankton, and Ziebach.
Counties of Andrews, Angelina, Aransas, Armstrong, Atascosa, Austin, Bailey, Bandera, Bastrop, Baylor, Bee, Bell, Bexar, Blanco, Borden, Bosque, Brazoria, Brazos, Brewster, Briscoe, Brooks, Brown, Burleson, Burnet, Caldwell, Calhoun, Callahan, Cameron, Carson, Castro, Cherokee, Childress, Clay, Cochran, Coke, Coleman, Collin, Collingsworth, Colorado, Comal, Comanche, Concho, Cooke, Coryell, Cottle, Crane, Crockett, Crosby, Culberson, Dallam, Dallas, Dawson, Deaf Smith, Denton, DeWitt, Dickens, Dimmit, Donley, Duval, Eastland, Ector, Edwards, Ellis, El Paso, Erath, Falls, Fayette, Fisher, Floyd, Foard, Frio, Gaines, Galveston, Garza, Gillespie, Glasscock, Goliad, Gonzales, Gray, Grayson, Grimes, Guadalupe, Hale, Hall, Hamilton, Hardeman, Hardin, Harris, Hartley, Haskell, Hays, Hemphill, Henderson, Hidalgo, Hill, Hockley, Houston, Howard, Hudspeth, Hunt, Hutchinson, Irion, Jack, Jackson, Jeff Davis, Jim Hogg, Jim Wells, Johnson, Jones, Karnes, Kaufman, Kendall, Kenedy, Kent, Kerr, Kimble, King, Kinney, Kleberg, Knox, Lamb, Lampasas, La Salle, Lavaca, Lee, Leon, Liberty, Lipscomb, Live Oak, Llano, Loving, Lubbock, Lynn, McCulloch, McLennan, McMullen, Madison, Martin, Mason, Matagorda, Maverick, Medina, Menard, Midland, Milam, Mills, Mitchell, Montague, Montgomery, Motley, Nacogdoches, Navarro, Nolan, Nueces, Ochiltree, Oldham, Parker, Parmer, Pecos, Polk, Potter, Presidio, Randall, Reagan, Real, Reeves, Refugio, Roberts, Robertson, Rockwall, Runnels, San Jacinto, San Patricio, San Saba, Schleicher, Scurry, Somervell, Starr, Stephens, Sterling, Stonewall, Sutton, Swisher, Tarrant, Taylor, Terrell, Terry, Throckmorton, Tom Green, Travis, Trinity, Tyler, Upton, Uvalde, Val Verde, Victoria, Walker, Ward, Washington, Webb, Wheeler, Wilbarger, Willacy, Williamson, Wilson, Winkler, Wise, Yoakum, Young, Zapata, and Zavala.
Counties of Beaver, Box Elder, Cache, Carbon, Daggett, Davis, Duchesne, Emery, Garfield, Grand, Iron, Juab, Kane, Millard, Morgan, Piute, Rich, Salt Lake, San Juan, Sanpete, Sevier, Summit, Tooele, Uintah, Utah, Wasatch, Washington, Wayne, and Weber.
Counties of Addison, Caledonia, Essex, Orange, Orleans, Rutland, Washington, Windham, and Windsor.
Counties of Adams, Asotin, Benton, Chelan, Clark, Columbia, Cowlitz, Douglas, Ferry, Franklin, Garfield, Grant, Island, Kittitas, Klickitat, Lincoln, Okanogan, Pend Oreille, San Juan, Skagit, Skamania, Spokane, Stevens, Wahkiakum, Walla Walla, Whatcom, Whitman, and Yakima.
Counties of Burnett, Crawford, Dane, Dodge, Grant, Green, Jefferson, Kenosha, La Crosse, Lafayette, Milwaukee, Monroe, Ozaukee, Pierce, Polk, Racine, Richland, Rock, Saint Croix, Vernon, Walworth, Washington, and Waukesha.
Counties of Albany, Big Horn, Campbell, Carbon, Converse, Crook, Fremont, Goshen, Hot Springs, Johnson, Laramie, Lincoln, Natrona, Niobrara, Park, Platte, Sheridan, Sublette, Sweetwater, Teton, Uinta, Washakie, and Weston.
Monday, September 27, 2021
I receive many requests for my seminar schedule, particularly during the fall season when I am doing training events for tax practitioners. Today’s post provides a listing (as of today) for my events for the rest of the year.
September 29, 2021 (LaHarpe, Kansas)
This is not a tax event, but a breakfast meeting from 8:00 a.m. – 9:30 a.m. for local landowners impacted or potentially impacted by the Southwest Power Pool Blackberry Line from Wolf Creek Nuclear plant to Blackberry (south of Pittsburg). I will be discussing real estate principles concerning easements.
October 8, 2021 (Laramie, Wyoming)
This event is for attorneys and CPAs and other tax professionals. I will be providing an up-to-date discussion and analysis of the current status of proposed tax legislation. I will also be addressing some other estate and tax planning topics of present importance. You can learn more about this event and register at the following link: https://www.washburnlaw.edu/employers/cle/farmranchplanning.html
Kansas State University (KSU) Tax Institutes (October 25 – December 14)
The KSU Tax Institutes are two-day Institutes at six locations across the state of Kansas and two, two-day webinars. This fall I will be team-teaching Day 1 with Paul Neiffer at Garden City, Kansas and Hays, Kansas. I will also be team teaching Day 2 at those locations with Ross Hirst, retired IRS. The three of us will also be teaching Webinar No. 1. The Garden City Institute is on October 25-26. The Hays Institute is on October 27 and 28. Webinar No. 1 is on November 3-4.
The remaining Institutes will be taught on Day 1 by Prof. Edward A. Morse of Creighton University School of Law and Daniel Waters of Lamson Dugan & Murray in Omaha, Nebraska. Prof. Morse is also a CPA and is an excellent presenter on tax topics for CPAs and other tax professionals. He teaches various tax classes at the law school and also operates a farm east of Omaha in Iowa. Daniel has an extensive tax and estate/business planning practice. Ross Hirst and I will team teach Day 2 at each of these locations.
The dates for these five Institutes are: Salina, Kansas on November 8-9; Lawrence, Kansas November 9-10; Wichita, Kansas on November 22-23; Pittsburg, Kansas on December 8-9; and Webinar No. 2 on December 13-14.
You can learn more about the KSU Tax Institutes and the topics that we will be covering, and registration information at the following link: https://agmanager.info/events/kansas-income-tax-institute
December 16-17 (San Angelo, Texas)
At this two-day conference, I will be focusing on critical income tax and estate/business planning issues. This event is sponsored by the San Angelo Chapter of the Texas Society of CPAs.
I also have other in-house training events scheduled this fall for various CPA firms.
I look forward to seeing you in-person at one of the events this fall. If you can’t attend in-person, some of the events are online, as noted. Also, thanks to those listening to the daily two-minute syndicated radio program that airs across the country. Air plays were up about 30 percent in August compared to July.
Friday, September 24, 2021
Earlier this week the U.S. House Ways and Means Committee released the legislative text (Amendment in the Nature of a Substitute to the Committee Print Offered by Mr. Neal of Massachusetts) that includes proposed tax changes to be included in the budget reconciliation bill – the massive “porkulus” spending bill to accompany the infrastructure bill that is a separate piece of legislation. While there are likely still many permutations remaining, and it’s still possible that the entire spending bills could go down flames, if the current proposals move forward as is what can be done to prepare for their impact?
I will be covering the most recent developments at my October 8 conference in Laramie, Wyoming. You may attend either in person or online. I will provide at that event the then present status of tax proposals and what planning steps should be undertaken in advance of possible changes in the tax laws. You can learn more about that conference and register here: https://www.washburnlaw.edu/employers/cle/farmranchplanning.html
Tax provisions in the committees and associated planning steps – it’s the topic of today’s post.
Income Tax Rates
As of today, the proposal continues to be to raise the top marginal income tax rate (federal) to 42.6 percent. For married persons filing jointly, that rate would kick-in at a modified adjusted gross income (MAGI) exceeding $5 million. The new 39.6 percent bracket would apply to married persons filing jointly with MAGI of approximately $450,000 up to that $5 million mark. For single persons the 39.6 percent rate would apply at taxable income above $400,000. This rate would also apply to trusts and estates with taxable income exceeding $12,500 ($100,000 for the 42.6 percent rate). Of course, applicable state and local taxes get added on.
This higher rate would apply to tax years beginning after 2021, which means there is some time to do some tax planning associated with trusts. Depending on the type of trust and the language of the trust it might be possible to trigger income in 2021 at a lower rate. A call to your tax and estate planning professionals might be in order, particularly if you recently changed the beneficiary of a retirement plan to a trust. Some did that in light of another recent law change that eliminated “stretch” IRAs. If the higher rate actually becomes law, it would be better in many situations to have the retirement funds distributed directly to a beneficiary rather than via a trust. Sec. 138201.
Corporate Tax Rates
Presently, the corporate tax rate is a flat 21 percent. The proposal graduates the corporate rate structure as follows: 18 percent on corporate taxable income up to $400,000; 21 percent on taxable income between $400,000 and $5 million; and 26.5 percent on taxable income over $5 million but under not exceeding $10 million. An additional tax is added to the 26.5 percent rate for corporations with taxable income in excess of $10 million. Sec. 138101
Qualified Small Business Stock
I.R.C. §1202 stock gain exclusion provisions of 75 percent and 100 percent would be inapplicable to taxpayers with adjusted gross income (AGI) at or above $400,000. The 50 percent exclusion would remain. Sec. 138150.
Capital Gain Rates
The initial proposal to raise capital gain rates to the (newer) top marginal income tax rate of 39.6 percent appears to be dead. It looks more likely that what will move forward is a 25 percent rate. The current legislation says that the higher rate would apply to gains triggered “after date of introduction.” If have no clue what that means, other than it is sometime before 2022. Perhaps it means September 13, 2021, the date the legislative text was released.
Thankfully, it appears that the “deemed realization” rules are no longer included in the proposed legislation. That would have made death a capital gain triggering event rather than waiting for an heir to sell inherited property. Also, for now, the “stepped-up” basis at death rule (or adjustment to fair market value at death) is retained. Sec. 138202.
Net Investment Income Tax
Obamacare added a 3.8 percent tax on passive sources of income under I.R.C. §1411. The current proposal is to tack this additional tax onto all trade or business income on a joint return exceeding $500,000 ($400,000 single). It does not apply to any earnings that are subject to FICA tax. The effect of this is to make the tax apply to distributions from S corporations, limited liability companies and partnerships with profits above the threshold. This provision specifies that it applies to tax years beginning after 2021. Sec. 138203.
Qualified Business Income Deduction (QBID)
As I noted in a post last week, the current proposal is to limit the 20 percent QBID to a maximum deduction of $500,000 for married filing joint filers ($400,000 for single filers). For trusts and estates, the maximum QBID would be $10,000. So, businesses operating inside trust that could generate a sizable QBID would no longer be a good idea from a tax standpoint. The legislation says nothing about limiting the amount of the deduction passed through to a patron of an agricultural or horticultural cooperative. So, a farmers QBID would be limited to $500,000, but any amount passing through from a cooperative would not be. This provision also would be effective for tax years beginning after 2021. Sec. 138204.
Excess Business Losses
The proposal would permanently disallow excess business losses for noncorporate taxpayers. Sec. 138205.
The proposed legislation contains contribution limits to Individual Retirement Accounts (IRAs). The limitations start to apply on retirement plan balances in excess of $10 million as of the end of the prior tax year and where the account owner’s MAGI exceeds $450,000 on a joint return. The limitation applies to regular IRAs, Roth IRAs and defined contribution plans. In addition, owners of account balances exceeding the $10 million threshold will be required to withdraw more from the account on an annual basis than will account owners with balances not exceeding the threshold. That excess amount as a minimum distribution for the following year would be 50 percent of the amount by which the individual’s prior-year aggregate traditional IRA, Roth IRA and defined contribution account balance exceeds the $10 million limit. A different minimum distribution calculation is specified for combined account balances of an owner exceeding $20 million. Secs. 138301 and 138302.
IRAs would also be barred from holding investments in nonregistered securities. For IRA accounts that hold nonregistered securities after 2021, such investments would be deemed to be distributed over a two-year transition period.
Another provision changes the existing threshold prohibiting investment by an IRA in an entity in which the IRA owner owns at least a 50 percent ownership interest to a 10 percent ownership interest for investments that are not traded on an established securities market.
Roth conversions would be eliminated for married taxpayers filing jointly with taxable income exceeding $450,000 ($400,000 single). Sec. 138311.
Exemption Equivalent of the Unified Credit
I have written in prior articles about the proposal to “decouple” the estate and gift tax systems. They are presently “coupled” but if the proposed changes make it into law, the systems will be decoupled. There will be a credit to offset estate tax, and a separate credit to offset gift tax. Under current law, the coupled estate and gift tax credit rises with inflation through 2025. Beginning in 2026 it is scheduled to drop so that its exemption equivalent is $5 million in 2011 dollars. The present proposal fast-forwards the 2026 law to 2022. In other words, the exemption equivalent of the unified credit would be $5 million adjusted for inflation since 2011 – approximately $6.2 million. Thus, for higher-wealth persons, it might be wise to start using some of the higher exemption by the end of 2021. Strategies might include the formation of a “self-settled” trust (in some states); a special power of appointment trust; or a spousal lifetime access trust. Sec. 138207.
Special Use Valuation
Under current law, as I have noted in other posts, farm and ranch land (and other non-farm business property) can be valued at death for federal estate tax purposes at its use value rather than fair market value. I.R.C. §2032A. For deaths in 2021, the maximum value reduction possible is $1,190,000. Under the current proposal the maximum reduction in value would be $12 million. Sec. 138208.
I have written previously on proposals that would essentially end dynasty trusts and intentionally defective grantor trusts as well as grantor retained annuity trusts, qualified personal residence trusts and even irrevocable life insurance trusts. The provisions attacking these traditional planning methods remain.
Eliminating valuation discounting as a planning tool was a target of the Obama-Biden administration. After the valuation regulations largely eliminating such discounts was removed by the Trump Administration, the restrictions on valuation discounting are now back. This time the restrictions would be statutory and would eliminate discounts on non-business assets. Passive assets are non-business assets. That could mean that farm and ranch land under a cash lease is a passive, non-business asset in the landlord’s hands. Likewise, the value of marketable securities would not be eligible for a valuation discount.
The draft legislation ends the employer credit for wages paid to employees during family and medical leave for tax years beginning after 2023. Sec. 138506.
An S corporation could reorganize as a partnership tax-free. The S corporation that qualifies is one that was an S corporation as of May 13, 1996. Sec. 138509.
The Work Opportunity Tax Credit would be increased to 50 percent for the first $10,000 of wages for all groups except youth employees. This provision would apply for persons hired before 2023. Sec. 138513.
A new payroll tax credit for compensation of “local news journalists” is created. The tax credit applies against employment taxes for each calendar quarter up to $12,500. The credit is 50 percent for each of the first four calendar quarters (total of $25,000) and then 30 percent thereafter. An “eligible local newspaper publisher” is one having substantially all gross receipts derived from publishing a local newspaper. “Local newspaper” means any print or digital publication if the content is original and derives from primary sources relating to news and current events. The publisher must not employ more than 750 employees during the calendar quarter during which a credit is allowed. A “local news journalist” is a person providing at least 100 hours of service during the calendar quarter. Sec. 138517.
I will provide the latest up-to-date discussion of pending tax legislation and possible year-end planning steps at the conference in Laramie, WY on October 8. Again, attendance may either be in person or online.
Monday, September 20, 2021
According to the U.S. Financial Education Foundation, it is estimated that over 40 million lawsuits are filed annually. Thus, for some persons, including farmers and ranchers, an important aspect of estate and business planning is asset protection. The goal of asset protection planning is to protect property from claims of creditors by restructuring asset ownership to limit liability risk in the event of a lawsuit. Done correctly the restructuring creates a degree of separation between the assets and their owner to properly shelter them from creditors.
A significant key to asset protection planning is timing. Once a lawsuit has been filed or is a substantial certainty to be filed with an anticipated adverse outcome for a client, it’s too late to start utilizing legal strategies to shelter assets from potential creditors. Civil and criminal liability is possible for all parties involved as well as malpractice liability for related ethical violations. A recent case illustrates the point.
Considerations when engaging in asset protection – it’s the topic of today’s post.
The Attempt To Shield an Iowa Farm From Creditors – Recent Case
Facts of the case. A recent federal court case from Iowa illustrates the serious problems that can result for parties and their professional counsel that engage in asset protection if not done properly. Kruse v. Repp, No. 4:19-cv-00106-SMR-SBJ, 2021 U.S. Dist. LEXIS 114013 (S.D. Iowa Jun. 15, 2021), involves three interrelated lawsuits. The plaintiff was injured in an automobile accident, which left her in need of 24-hour care likely for the rest of her life. The accident was Weller’s fault and, due to his experience as an insurance agent, he knew he would face a large claim for the plaintiff’s injuries. Weller told family members he feared losing the family farm as a result of the impending lawsuit. After determining his liability exposure exceeded his insurance coverage, he sought legal counsel to help him shelter the assets from a potential claim. Based on the initial legal advice he received, less than two months after the accident Weller transferred the farm and other assets into a revocable trust and made several cash transfers to family members exceeding $100,000. He notified the defendant bank that he had recently been found at-fault in a major motor vehicle accident and that he faced liability exposure that exceeded his insurance coverage. However, the bank began working with him to weaken the appearance of his financial condition.
After leaving his previous attorney when settlement negotiations broke down, Weller met the defendant attorney (Repp) two months before the personal injury trial was set to begin. Repp holds himself out having a practice focusing on estate planning and that he “counsels and advises clients with respect to the management of their wealth to minimize estate and inheritance taxes through the use of asset protection trusts.” Weller later testified at trial that he told Repp of his previous attempts to shield himself from judgment by transferring his assets to a revocable trust and making cash "gifts." To this end, Weller testified he went to Repp specifically because Repp holds himself out as an "asset protection attorney." Repp told Weller that his previous attorney had given bad legal advice and that the cash gifts were inappropriate transfers of wealth. Repp then created an LLC and had Weller transfer the farm to the LLC by quitclaim deed to protect it from the anticipated personal injury judgment. The deed was accompanied with a trustee’s affidavit that Repp prepared and notarized stating that the Trust was conveying the real estate "free and clear of any adverse claim." This transaction was completed approximately one month before trial in the personal injury case was scheduled to begin.
State court judgment. The plaintiff was awarded approximately $2,557,100 million in damages in the personal injury lawsuit. Judgment was entered on May 1, 2015. In early 2016, Repp helped Weller prepare a financial statement reporting the value of the farmland as an LLC asset. The bank helped Weller refinance mortgages on the farm, which listed the farm as Weller’s personal asset, and issued promissory notes that were secured by the mortgage. This led to the plaintiff suing Weller on March 3,2016, for fraudulent transfers intended to shield Weller’s assets from the personal injury judgment. The state trial court determined that the LLC was formed with the intent to shield Weller’s assets from the plaintiff levying her judgment lien against his real estate. The state trial court, on March 13, 2018, found in the plaintiff’s favor and held that all assets of the LLC remained available to the plaintiff for satisfaction of the judgment.
Claims for personal liability and removal to federal court. The plaintiff sued the bank and Repp in early 2019, alleging that they both knowingly participated in Weller’s fraudulent attempts to shield his assets from the plaintiff’s judgment. Specifically, the plaintiff claimed that fraudulent transfers had been made under state law; that the defendants conducted or otherwise participated in the conduct of a racketeering enterprise with the purpose of defrauding the plaintiff; and that the defendants tortiously interfered with her ability to collect the personal injury award. The defendants removed the case to federal court and claimed that the undisputed facts entitled them to judgment as a matter of law on various claims. The federal court largely denied the defendants’ claims in early 2020, and the case proceeded.
Under the fraudulent transfer state law claim, the defendants argued that the plaintiff could not prove that they knew of Weller’s fraudulent intent or that they helped in his scheme to shield his assets from the plaintiff’s judgment. The court strongly disagreed pointing to Weller’s disclosures to the bank that he was at fault in a major motor vehicle accident and the bank’s subsequent dealings. The trial court also noted that the bank allowed Weller to inconsistently classify the farm as both a personal and LLC asset. The court determined a factfinder could reasonably infer that the bank had knowledge of Weller’s intent to defraud the plaintiff. The bank argued that the plaintiff did not show prejudice by reason of priority in interest. The court noted that the bank’s argument was based on a false premise, and that prejudice may be shown if a debtor encumbers property to create the appearance of over-securitization. Thus, the court determined that because critical questions existed concerning the effect of Weller’s refinancing with the bank, summary judgment under the fraudulent transfer claim was precluded.
RICO claim. The Racketeering Influenced and Corrupt Organizations Act (RICO) provides for criminal penalties and a civil cause of action for acts performed as part of an ongoing criminal organization. 18 U.S.C. §§1861-1868. Under RICO, a person who has committed "at least two acts of racketeering activity" within a 10-year period can be charged with “racketeering” if the acts are related in a specified manner to an "enterprise." Those found guilty of racketeering can be fined up to $25,000 and sentenced to 20 years in prison per racketeering count. 18 U.S.C. §924; §1963. In addition, the racketeer must forfeit all ill-gotten gains and interest in any business gained through a pattern of "racketeering activity."
RICO also permits a private individual "damaged in his business or property" by a "racketeer" to file a civil suit. The plaintiff must prove the existence of an "enterprise." There must be one of four specified relationships between the defendant(s) and the enterprise: (1) either the defendant(s) invested the proceeds of the pattern of racketeering activity into the enterprise; (2) the defendant(s) acquired or maintained an interest in, or control of, the enterprise through the pattern of racketeering activity; (3) the defendant(s) conducted or participated in the affairs of the enterprise "through" the pattern of racketeering activity; or (4) the defendant(s) conspired to do one of the first three. 18 U.S.C. §1962(a)-(d). In essence, the enterprise is either the 'prize,' 'instrument,' 'victim,' or 'perpetrator' of the racketeers. See National Organization for Women v. Scheidler, 510 U.S. 249 (1994). RICO also allows for the recovery of damages that are triple the amount of the actual or compensatory damages.
Repp claimed that there was no common purpose among himself and Weller to constitute an associated in-fact enterprise, and if there was, that the enterprise required a common purpose that is fraudulent, illicit, or unlawful. He asserted that these elements did not exist. The court disagreed, expressing disbelief at the assertions, and noted that RICO liability is extended to those who play some role in directing the group to further its shared goals, unlawful or not, so long as those goals are carried out through a pattern of criminal behavior.
The court stated as follows:
“They nevertheless prepared legal documents transferring his [Weller’s] property to a corporate form that posed significant barriers to any recovery by Kruse, assisted Weller in the creation of financial statements that painted an inaccurate picture of Weller's finances, and defended the legality of the conveyances in court. In both cases, the facts are sufficient for a reasonable jury to find Defendants tacitly agreed to participate in Weller's scheme to defraud Kruse and conspired to further the purpose of a RICO enterprise.”
Thus, the court determined that sufficient evidence existed for a fact-finder to possibly infer that Weller, Repp and the bank shared an unlawful purpose to shield Weller’s assets from the plaintiff’s looming judgment.
The court further stated:
“…Repp changed the course of the effort to defraud Kruse and "joined in a collaborative undertaking with the objective of releasing [Weller] from the financial encumbrance visited upon him by [Kruse]'s judgment."… Reversing the mechanisms put in place by Weller's prior attorney, Repp organized Weller Farms, filed a trustee's affidavit that ignored Kruse's unliquidated tort claim, directed Weller to execute a quit claim deed conveying his real estate to the entity, and assisted Weller in preparing financial statements that embedded multiple "ambiguities" that devalued Weller's financial picture during settlement negotiations. [Repp} then defended the transactions in the fraudulent transfer action, devising a legal strategy in an attempt to persuade the state court to validate the transactions. In essence, Repp agreed Weller's previous efforts were inappropriate. All of his advice that followed was consistent with the expertise in asset protection that Repp, not Weller, possessed.”
The defendants also claimed that there was no pattern of racketeering activity and that they had not directed the conduct of the enterprise’s affairs. The court disagreed, noting that the evidence of three years’ worth of communications led to a reasonable inference that a pattern of racketeering existed. Repp also asserted that he provided nothing more than ordinary legal services such that his conduct played no part in directing the affairs of Weller or the LLC. The court again disagreed and determined that factual issues remained concerning whether Repp played some part in directing the affairs of Weller’s fraudulent scheme.
The court lastly noted that for liability to arise from a RICO conspiracy, the plaintiff only needs to establish a tacit understanding between the defendants for conspirators to be liable for the acts of their co-conspirators. The defendants argued they did not know the full extent of Weller’s fraudulent scheme and were mere scriveners of information provided by him. The court disagreed, stating as follows:
“They claim he was a mere scrivener of information provided by Weller and intended only to assist Weller in setting up a farming entity by which to bring his son into the family business. That characterization, in light of the circumstances surrounding his [Repp’s] relationship with Weller, present genuine factual issues and credibility determinations on whether Repp played "some part" in directing the affairs of Weller's fraudulent scheme and require a jury to resolve.”
The trial court determined there was a genuine issue of material fact as to whether the defendants knew of or were willfully blind to the scope of the RICO enterprise. Therefore, the trial court denied summary judgment on the RICO charges and determined the defendants’ position was a question for the jury.
Tortious interference with economic expectancy. On the common law tortious interference claim, the defendants argued that the Iowa Supreme Court had not yet recognized tortious interference with an economic expectancy as a cause of action. The Second Restatement of Torts describes this action as, “one who intentionally deprives another of his legally protected property interest or causes injury to the interest.” Second Restatement of Torts §871. A party that does this is subject to liability if the party’s conduct is generally culpable and not justifiable under the circumstances. The court determined that although the Iowa Supreme Court had not yet considered this issue, it would likely recognize this tort as a prima facie tort in the context of fraudulent financial practices.
Repp argued that the plaintiff failed to show that his predominant intent in forming the LLC was to injure the plaintiff’s property interest. However, the court noted that the majority rule governing a prima facie tort does not require that the defendant be motivated predominantly to injure the plaintiff. The court pointed out that the facts led to a reasonable inference that Repp knew the transfer of Weller’s assets to the LLC would interfere with the plaintiff’s collection efforts. The bank made a similar argument, which the court rejected, resulting in summary judgment on the tortious interference claim being denied. Thus, the jury will need to determine whether the defendants were more than mere scriveners, and thus subject to tort liability.
Note: It’s important to remember that the case was positioned on a motion for summary judgment. That’s a fairly low hurdle for the plaintiff to clear, especially when the evidence on such a motion is viewed in the light most favorably to the non-moving party (the plaintiff in the Iowa case).
The asset protection legal field is fraught with ethical “landmines” for attorneys. I asked Prof. Shawn Leisinger, Associate Dean for Centers and External Programs at Washburn University School of Law to comment on some of the possible ethical issues involved in the Iowa case. Shawn teaches ethics at the law school and also sometimes makes ethics presentations at my events around the country. The following comments are his.
It is fairly well settled that attorneys generally, and certainly attorneys who specialize in taxation issues, may advise clients in the area of “tax avoidance” but must not have that same advice go over the line into “tax evasion.” This concept frames the ethical guidelines that attorneys must consider when they work with their clients on asset ownership structuring, whether for tax or liability purposes. In the Iowa case, a fairly common business entity formation asset protection tactic arguably stepped over the line that falls in that gray area between avoidance and evasion.
While each state has its own version of ethical rules that the attorneys licensed their must follow, these rules generally incorporate or adapt what are known as the Model Rules of Professional Conduct promulgated by the American Bar Association. In the case at hand a number of these rules would warrant consideration but we only touch on a few of those that apply most directly here.
MRPC Rule 2.1: Advisor. Under this rule, attorneys are deemed to be counselors who are advised, “In representing a client, a lawyer shall exercise professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client’s situation.” This rule is arguably permissive and would suggest that Repp should have had a candid conversation with the client about the steps being taken to protect the client’s assets and the risks and realities of those steps. We are not privy to the private conversations that occurred in this case, however.
MRPC Rule 8.4: Misconduct. This rule sets forth the specific definitions of attorney misconduct that in turn warrant and could support attorney discipline under the rules. The rule provides, “It is professional misconduct for a lawyer to: … (b) commit a criminal act that reflects adversely on the lawyer’s honesty, trustworthiness or fitness as a lawyer in other respects; (c) engage in conduct involving dishonesty, fraud, deceit or misrepresentation; (d) engage in conduct that is prejudicial to the administration of justice; …”.
While the “criminal act” under (b) might seem a higher bar to hit in the asset planning realm, as one reads the facts of the Iowa case it is fairly easy to conclude that the multiple steps taken by and with multiple parties to try to shelter the assets noted, and the continuing interaction with the bankers and others involved in the property transfers, hit either the disjunctive “dishonesty” or “misrepresentation” standards in section (c). I note section (d) as well due to the fact that in many of these kinds of cases a court may well conclude that the catch-all of “acts prejudicial to the administration of justice” certainly must define the actions if one might argue the other provisions do not fit.
From an ethical perspective one should also know that attorneys have an obligation to report unethical conduct of other attorneys under the rules. Rule 8.3 provides, “A lawyer who knows that another lawyer has committed a violation of the Rule of Professional Conduct that raises a substantial question as to that lawyer’s honesty, trustworthiness or fitness as a lawyer in other respects, shall inform the appropriate professional authority”.
An important point to remember is that the ethical perspective on these cases is largely fact specific and subject to argument and interpretation of when and how that gray line may have been crossed.
To put the Iowa case in perspective and provide further guidance for others engaged in asset protection strategies, I asked Timothy P. O’Sullivan, a partner in Foulston Siefkin LLP, a law firm in Wichita, Kansas to comment. Among other things, Tim is a Fellow in the American College of Trust and Estate Counsel and is an adjunct professor of law at Washburn University School of Law. The following comments are his.
This Iowa decision puts into stark relief the personal and professional exposure asset protection attorneys may have when advising clients of estate planning techniques to protect their assets from creditor claims. Most estate planning attorneys whose practice extends into this area have given thought, but often not enough, to the possibility that they can be held in violation of attorney professional conduct rules by participating in or structuring a transaction that is a fraudulent conveyance by their clients, as well as risk possible personal liability for damages by an aggrieved creditor. Although there does not appear to be more than a modicum of cases to date imposing such liability against assisting third parties, such exposure is nonetheless present. The exposure may derive from a state’s version of the Uniform Fraudulent Transfer Act, which has been enacted in the vast majority of states, which otherwise would not have included a remedy against a third party involved in the transaction.
As noted in the Iowa case, other potential legal authority for imposing personal liability rests more solidly and broadly under the federal RICO Act as an alleged “civil conspiracy,” or (as the court also noted) an actionable tort by an aggrieved creditor under the Second Restatement of Torts for assisting in the fraudulent act. These principles extend well beyond applicable state law.
The potential liability of estate planning professionals generally requires not only that the creditor incur damages as a result, but also actual knowledge as to the principal purpose of the estate planning device used, and that the client had a debt (which need not be liquidated) the satisfaction of which would be avoided, delayed, or hindered by the implementation of a specific asset protection plan. The plan could be as simple as gifting assets away or it could be a plan to make the claim more arduous or unlikely to be satisfied, such as putting exposed non-exempt assets in an LLC or restructuring debt to the detriment of a claim by a creditor. All three of these strategies were present in the Iowa case. As noted by the court, there is no defense against the personal liability of an attorney that the attorney was a mere scrivener of his client’s plan if the attorney is assisting in implementing a strategy that the attorney knows to be fraudulent.
For professionals engaging in asset protection strategies, there can be no more important prophylactic measure against professional liability exposure than gaining sufficient knowledge of the client, the client’s assets and liabilities, and most importantly, determining ab initio whether the client is seeking advice as protection against a specific currently existing, or problematic current creditor. Perhaps the client is simply desiring to protect against potential future creditors in general due to the nature of the client’s assets or personal, business or professional activities. If so, asset protection planning is entirely appropriate. But, determining the client’s purposes up-front is a must.
The use of detailed salient client questionnaires and requisite financial statements that gather complete and relevant legal and financial information from clients is most desirable. Checking clients’ references and gleaning knowledge of a client’s background can also serve as valuable indicia in determining a client’s honesty and intent in seeking asset protection advice. In all events, the attorney’s engagement letter should make it clear that the attorney is relying on the accuracy of the client’s disclosures and submitted information in recommending or implementing any asset protection plan and further clearly stating that the attorney will not participate, or continue to represent the client, in any plan that might constitute a fraudulent transfer.
Although the Iowa case involved a decision that denied summary judgment in favor of the defendants, the court’s analysis of the legal underpinnings make it quite evident as to the third-party liability exposure of the defendants, including not only the debtor’s attorneys involved in setting up the LLC, but also the debtor’s bank in favorably restructuring the debtor’s debt to the creditors’ disadvantage, should the factual assertions of the plaintiffs be proven at trial.
Saturday, September 18, 2021
The Tax writing committees in the Congress are busy trying to figure out ways to pick your pocket through the tax Code to pay for the massive spending legislation that is currently proposed and being debated. If and when any legislative proposals become law, important planning steps will be necessary for many farm and ranch families. But, all hinges on just exactly what changes become law. It’s difficult, if not impossible, to plan for changes that are unknown. That’s particularly the case if tax changes are done on a retroactive basis.
In today’s post, I highlight where the areas of change might occur by referring you to a lengthy article resulting from interviews with farm media in recent days. Also, I invite you to attend either in-person or online, my upcoming 4-hour seminar on the tax landscape on October 8. The in-person presentation will be at the University of Wyoming College of Law in Laramie. The event will also be simulcast over the web. I will provide the most up-to-date information of where legislative proposals are at as of that time and the prospects for passage, and planning steps that need to be taken.
The current tax landscape and the upcoming October 8 seminar – it’s the topic of today’s post.
In the article in which I am quoted that is linked below, I attach percentages (as of September 17, 2021) as to likelihood of whether particular current tax Code provisions would change. The areas that I address include the following:
- The federal estate tax exemption
- “Stepped-up” basis at death
- Income tax rates
- The deduction for state and local taxes
- A cap on itemized deductions
- The capital gains tax rate(s)
As for the stepped-up basis issue and the possible elimination of modification of the rule, the Congress has tried this approach before. The long-standing rule has been that the basis of property that is included in a decedent’s estate for tax purposes gets a basis equal to the fair market value of the property in the hands of the heir(s). I.R.C. §1014. But, for property that is gifted, the donee generally receives an income tax basis equal to the donor’s basis at the time of the gift. This is known as a “carryover basis.” The Tax Reform Act of 1976 expanded carryover basis to include dispositions at death. Pub. L. No. 94-455, Sec. 2005, 90 Stat. 1872 (1976). Section 2005(a)(1) of that law retained the old step-up/step-down (fair market value basis) rule of I.R.C. Sec. 1014 in the case of a decedent dying before January 1, 1977. The Revenue Act of 1978 delayed the effective date of I.R.C. Sec. 1023 (the new carryover basis rule) to decedents dying after 1979, and the non-application date of I.R.C. Sec. 1014 (the old step-up basis rule), to estates of decedents dying before January 1, 1980. Pub. L. No. 95-600, Sec. 515, 82 Stat. 2884. The new carryover basis rule of I.R.C. §1023 was repealed by Pub. L. No. 96-223, Sec. 401, 94 Stat. 229 (1980). This amendment was made effective for decedents dying after 1976. The date on this repeal amendment is April. 2, 1980.
As of this writing, it appears that the Congress will not change the existing fair market value basis at death rule. The chairman of the House Ways and Means committee has indicated that the votes are not there to change the rule. That’s good news for farmers and ranchers and tax practitioners – the administrative burden of changing to a carryover over basis would be extensive.
Corporate Tax and I.R.C. §199A
Corporate tax. Presently, the proposal is to increase the corporate tax to 26.5 percent on income exceeding $5 million from its current 21 percent rate. That would amount to a 25.5 percent rate increase at the federal level that corporations would, depending on the competitive structure of their market, pass through to consumers in the form of higher prices. On top of the 26.5 percent rate would be any state-level corporate tax. The current federal corporate income tax rate puts the United States near the middle of the pack in comparison with its Organisation for Economic Co-operation and Development peer countries. The proposed change would give the U.S. one of the highest corporate tax rates of the OECD countries. The result would be a drop in investment in U.S. companies and cause some firms to locate outside the U.S., taking jobs with them. Also, if the corporate rate is increased, it’s not likely that the various tax deductions and other favorable corporate tax provisions that the Tax Cuts and Jobs Act removed, would not be restored.
Qualified Business Income Deduction (QBID). The QBID of I.R.C. §199A, under the current House proposal, the QBID would be limited to a $500,000 deduction (joint), $400,000 (single) and $250,000 (MFS). It would be capped at $10,000 for a trust or an estate. For farmers that are patrons of qualified cooperatives the amount passed through from the cooperative would not be limited. The QBID is presently 20 percent of business income. There is “talk” on the Senate side of eliminating the QBID, but retaining any amount passed through to a patron from a cooperative. Either proposal, if enacted, would result in a significant tax increase for many farmers.
For discussion of the other major tax proposals, you can read my comments in the article linked here: https://www.farmprogress.com/farm-life/farm-busting-tax-changes-possible-unlikely
As mentioned above, I will be addressing the legislative tax proposals and providing possible planning steps at a seminar to be held at the University of Wyoming College of Law in Laramie on October 8, 2021. You may attend either in person or online. For more information the October 8 event, you may click here: https://www.washburnlaw.edu/employers/cle/farmranchplanning.html
The future of tax policy for agriculture is of critical importance at the present time. Make sure you are staying up with the developments.
Wednesday, September 15, 2021
In the Part One of this series, I discussed the basics rules governing gifts made during life and the present interest annual exclusion. In Part Two, I expanded the present interest gifting discussion to gifts of entity interests and how to qualify the gifts for present interest exclusions. In today’s Part Three the attention turns to how to report gifts of interests in a partnership for tax purposes.
The tax reporting of gifted partnership interests – it’s the topic of today’s post.
Basic Rules Applied
Often no issues. From an income tax standpoint, the donee does not recognize income (or loss) on the value of gifted property. The gift, however, can trigger gift tax if the amount of the gift exceeds the present interest annual exclusion (presently $15,000 per donee, per year) or is not of a present interest of any amount. In that situation, Form 709 must be filed by April 15 of the year following the year in which the taxable gift was made. But, as noted in Part One, gift tax is often not due because the tax can be offset by unified credit. But remember, even if the credit is used to fully offset gift tax, Form 709 must be filed to show the amount of the taxable gift and the offsetting credit reducing the taxable amount to zero.
Valuing gifts for tax purposes. If gift tax is imposed, it is calculated on the fair market value (FMV) of the gifted property less the amount of debt (if any) from which the donor is relieved. Applying those principles in the partnership context, the fair market value of a partnership interest would need to be determined, as well as the donor’s share of any partnership liabilities. If the gifted partnership interest relieves the donor of more debt than the donor has income tax basis in the partnership interest, the excess is treated as an amount realized in a deemed sale transaction. In that event, the donor must recognize gain. Treas. Reg. §1.1001-2(a).
Gain Recognition on Gift of a Partnership Interest
For gifted partnership interests, gain recognition is common when the donor has a negative tax basis capital account. A partner’s tax basis capital account balance generally equals the amount of cash and tax basis of property that the partner contributes to the partnership, increased by allocations of taxable income to the partner, decreased by allocations of taxable loss to the partner, and decreased by the amount of cash or the tax basis of property distributed by the partnership to the partner. If the result of all of these adjustments is a negative amount, the partner has a negative tax basis capital account and is more likely to have gain recognition upon the gift of a partnership interest.
Note: For tax years ending on or after 2020 partnerships must report each partner’s capital account on a tax basis. For prior years, a partnership could report partner capital accounts on some other basis (such as GAAP) which limited the ability of the IRS to identify potentially taxable situations.
Depending on whether the “hot asset” rules of I.R.C. §751 apply, some of the gain could be taxed at ordinary income rates. IRC §751 requires recognition of gain from "hot assets" as ordinary income. Under §751(b), "hot assets" include unrealized receivables, substantially appreciated inventory and depreciation recapture. Any amount of capital gain triggered by the gifted partnership interest will be either short-term or long-term under the normal rules.
Frank has structured his farming operation as a general partnership. Assume that his tax basis capital account is negative $200,000 and his share of partnership liabilities is $300,000, and the FMV of his interest in the partnership assets is $400,000. For succession planning purposes, Frank wants to gift his partnership interest to his son, Fred. Frank needs to know both the gift tax and income tax consequences of gifting his partnership interest to Fred.
The amount of the taxable gift is the difference in the FMV of Frank’s share of the partnership assets and his share of partnership debt he is being relieved of. Thus, the amount of the gift is $100,000. Assuming that the gift qualifies for the present interest annual exclusion (see Part 2 of this series), the taxable gift would be $85,000. That amount could be fully offset by the estate and gift tax unified credit (assuming Frank has enough currently remaining) resulting in no gift tax liability. Form 709 would need to be filed by April 15 of the year following the year of the gift.
On the income tax side of things, the gift of the partnership interest relieved Frank of his share of partnership liabilities of $300,000. From that amount Frank subtracts the adjusted basis of his partnership interest – that’s Frank’s tax basis capital account value of negative $200,000 plus his share of partnership liabilities of $300,000. Thus, from the debt relief of $300,000, Frank subtracts $100,000. The result is that Frank has $200,000 of gain associated with a deemed sale of the partnership interest.
The amount of gain that Frank recognizes on the gift of the partnership interest is added to Frank’s basis in his interest for determining Fred’s basis. Fred then has a basis equal to the amount realized (the amount of debt relief) in the deemed sale. Treas. Reg. §1.1015-4(a). Fred’s tax basis capital account begins at zero, representing Frank’s negative capital account of $200,000 plus $200,000 gain recognized by Frank. Another way of looking at this is the tax basis of Frank’s share of the partnership assets was $100,000, plus Frank recognized gain of $200,000, reduced by Frank’s share of the partnership debt assumed by Fred of $300,000.
Note: One exception to the general rule of carryover basis is if the donor’s pays any gift tax on the gift. See I.R.C. §§742 and 1015.
Note: If the FMV of a partnership interest is less than the partner's basis at the time of the gift, for purposes of determining the donee's loss on a subsequent disposition, the donee's basis in the interest is the FMV of the partnership interest at the time of the gift. I.R.C. §1015(a).
Basis adjustment. If a gifting partner recognizes gain on the deemed sale of the partnership interest and the partnership had an I.R.C. §754 election in place, the partnership will need to adjust the basis of its assets to reflect the amount of the gain.
Transfer to family members. If a partnership interest is purchased by a family member, the transfer is subject to the family partnership rules of I.R.C. §704(e)(2). For this purpose, a “family member” is defined as the donor’s spouse, ancestors and lineal descendants and any trusts for the primary benefit of such persons. If the rules are triggered, the transfers is treated as if it was created by gift from the seller, and the fair market value of the purchased interest is considered to be donated capital. This rule is designed to bar the shifting of income and property appreciation from higher-bracket taxpayers to lower-bracket taxpayers by requiring income produced by capital to be taxed to the true owner of that capital. The rule is also designed to ensure that services are taxed to the person performing the services. If the IRS deems the rules to have been violated it may reallocate income between partners (or determined that a partner is not really a partner) for income tax purposes.
Valuation discounts. As noted in Part 2, gifts of partnership interests to family members are often subject to valuation discounts to reflect lack of marketability or minority interest. Thus, careful structuring of partnerships and transferring of partnership interests involving family members must be cautiously and carefully undertaken to avoid IRS objection.
Transitioning the farming or ranching business to the next generation is difficult from a technical perspective. But those difficulties should not prevent farm and ranch families from doing appropriate planning to ensure that a succession plan is in place to help assist the future economic success of the family business.
Monday, September 13, 2021
In Part One of this series, I discussed some of the basics with respect to gifting pre-death to facilitate estate planning and/or business succession. Also covered in Part One was a gifting technique utilizing what is known as the “Crummey demand power” as a means of moving property into trusts for minors and qualifying the gifts for the present interest annual exclusion. In Part Two, the commentary continues with the use of the Crummey gifting technique with respect to entity interests.
Gifting interests in closely-held entities – it’s the topic of today’s article.
Using Crummey-Type Demand Powers in the Entity Context – Significant Cases
Crummey-type demand powers may also be relevant in the context of gifted interests in closely-held entities. From a present-interest gifting standpoint, the issue is whether there are substantial restrictions on the transferred interests such that the donee does not have a present beneficial interest in the gifted property. If so, the present interest annual exclusion is not available for the gifted interests. The courts have set forth markers that provide guidance.
The Hackl case. In Hackl v. Comr., 118 T.C. 279 (2002), the taxpayer purchased two tree farms (consisting of about 10,000 acres) worth approximately $4.5 million. He contributed the farms along with another $8 million in cash and securities to Treeco, LLC (“Treeco”), and had an investment goal of long-term growth (the trees were largely unmerchantable timber). The actual tree farming activities were conducted via a separate entity. The taxpayer and his wife initially owned all of Treeco’s interests, with the taxpayer serving as Treeco’s manager. Under the LLC operating agreement, the manager could serve for life (or until he resigned, was removed or became incapacitated) and could also dissolve the LLC. The operating agreement also specified that the manager controlled any financial distributions and members needed the manager’s approval to withdraw from the company or sell their shares. As for cash distributions, the operating agreement specified that the taxpayer, as manager, “may direct that the Available Cash, if any, be distributed to the members pro rata in accordance with their respective percentage interests.” No member could transfer their respective interest unless the taxpayer gave prior approval. If a member made an unauthorized transfer of shares, the transferee would only receive the economic rights associated with the shares – no membership or voting rights transferred. In addition, before dissolution, no member could withdraw their respective capital contribution, unless the taxpayer approved otherwise. It also took an 80 percent majority to amend Treeco’s articles of organization and operating agreement and dissolve Treeco after the taxpayer ceased being the manager.
Upon Treeco’s creation, the taxpayer and his wife began transferring voting and nonvoting shares of Treeco to their eight children, the spouses of their children and a trust established for their 25 minor grandchildren. Eventually, a majority of Treeco’s voting shares were held by the children and their spouses. The taxpayer and his wife elected split-gift treatment, and reported the transfers as present interest gifts covered by the annual exclusion ($10,000 per donee, per year at the time). However, the IRS disallowed all of the annual exclusions, taking the position that the transfers involved gifts of future interests. The taxpayer claimed that the gifts were present interests because all legal rights in the gifted property were given up, but IRS viewed the gifted interests as still being subject to substantial restrictions that did not provide the donees with a substantial present economic benefit. As a result, the IRS position was that the gifts were future interests’ ineligible for the exclusion.
The Tax Court agreed with the IRS that the transfers were gifts of future interests that were not eligible for annual exclusions. The Tax Court determined that the proper standard for determining present interest gift qualification was established in Fondren, 324 U.S. 18 (1945), where the key question was whether the transferee received an immediate “substantial present economic benefit” from the gift. To answer that question, Treeco’s operating agreement became the focus of attention. On that point, the Tax Court noted that Treeco’s operating agreement required the donees to get the taxpayer’s permission before transferring their interests and gave the taxpayer the retained power to either make or not make cash distributions to the donees. In addition, the donees couldn’t withdraw their capital accounts or redeem their interests without the taxpayer’s approval, and none of them, acting alone, could dissolve Treeco. Based on those restrictions, the Tax Court determined that the donees did not realize any present economic benefit from the gifted interests. Instead, the restrictive nature of Treeco’s operating agreement “forclosed the ability of the donees presently to access any substantial economic or financial benefit that might be represented by the units.” Thus, the gifts, while outright, were not gifts of present interests. See also Treas. Reg. §25.2503-3. On appeal, the U.S. Court of Appeals for the Seventh Circuit agreed. Hackl v. Comr., 335 F.3d 664 (7th Cir. 2003).
The Price and Fisher cases. In 2010, the Tax Court reached the same conclusion in a case that was factually identical to Hackl where the donees lacked the ability to “presently to access any substantial economic or financial benefit that might be represented by the ownership units.” Price v. Comr., T.C. Memo. 2010-2. Likewise, a federal district court reached the same result in Fisher v. United States, No. 1:08-cv-0908-LJM-TAB, 2010 U.S. Dist. LEXIS 23380 (S.D. Ind. Mar. 11, 2010). In Fisher, the taxpayers transferred 4.762 percent membership interests in an LLC to each of their seven children (one-third total interest in the LLC). The LLC’s primary asset was undeveloped land bordering Lake Michigan. The taxpayers claimed present interest annual exclusions for the gifts, but on audit, IRS disagreed on the basis that the gifts were future interests and assessed over a $650,000 gift tax deficiency.
The Fisher court noted that the LLC’s operating agreement specified that any potential of the LLC’s capital proceeds to the taxpayers’ children was subject to numerous contingencies that were completely within the LLC general manager’s discretion. So, consistent with Hackl, the court determined that the right of the children to receive distributions of the LLC’s capital proceeds did not involve a right to a “substantial present economic benefit.” As for the taxpayers’ argument that the children had the unrestricted right to possess, use and enjoy the LLC’s primary asset, the court noted that there was nothing in the LLC’s operating agreement that indicated such rights were transferred to the children when they became owners of the LLC interests. Finally, the court rejected the taxpayers’ argument that the children could unilaterally transfer their LLC interests. The court noted that such transfers could only be made if certain conditions were satisfied – including the LLC’s right of first refusal which was designed to keep the LLC interests within the family. Even if such a transfer stayed within the family, the LLC operating agreement still subjected the transfer to substantial restrictions. The result was that the court upheld the IRS’ determination that the gifts were not present interest gifts, just as the similarly structured transfers in Hackl and Price didn’t qualify as present interest gifts.
The Wimmer case. In Estate of Wimmer v. Comr., T.C. Memo. 2012-157, the decedent and his wife established an FLP to invest in land and stocks. The decedent also established a trust for his grandchildren. The trust was a limited partner of the FLP and was set-up as a Crummey Trust. The trust, as a limited partner, received dividends. The decedent and his wife were limited partners and they made gifts of partial limited partner interests on an annual basis consistent with the present interest gift tax exclusion. The gifts of the limited partner interests were significantly restricted, however, under the FLP agreement.
The IRS claimed that the gifts of limited partner interests were not present interests and, as such, were not excluded from the decedent's gross estate. However, the Tax Court concluded that while the donees of limited partner interests did not receive an unrestricted right to the interests, they did receive the right to the income attributable to those interests. The Tax Court also noted that the estate had the burden of establishing that the FLP would generate income and that some portion of that income would flow to the donees on a consistent basis and that the portion could be ascertained. Importantly, the FLP held dividend-producing, publicly traded stock. Thus, the court determined that the income from the stock flowed steadily and was ascertainable. Accordingly, the limited partners received present interests and the gifted amounts were excluded from decedent's estate. Based on Wimmer, an FLP that makes distributions on at least an annual basis should allow the use of present interest gifting.
If a partnership/LLC places sufficient restrictions on gifted interests or the general partner has unfettered discretion to make or withhold distributions, any gift of an interest in the partnership/LLC may be treated as a gift of a future interest that does not qualify for the annual gift tax exclusion. See, e.g., Tech. Adv. Memo. 9751003 (Aug. 28, 1997). In Hackl, Price and Fisher, there was no question that the donees had the immediate possession of the gifted interests. However, even if such interests have vested, the Tax Court (and the appellate court in Hackl) listed numerous factors that led to the conclusion that the gifted interests were not present interests. Unfortunately, from an estate and business planning perspective, those same factors are typically drafted into operating agreements with the express purpose of generating valuation discounts for estate and gift tax purposes.
So, there’s a trade-off between annual exclusion gifts and valuation discounts. But, Wimmer may provide a way around the corner on that problem if the FLP generates income and it can be established that at least some of that income will consistently flow to the donees in ascertainable amounts. Beyond that, there may be other ways to achieve both present interest status for gifts and valuation discounts for transfer tax purposes. Clearly, from a present interest perspective, the key is to gift equity interests in an entity that give a donee the right to withdraw from the entity, have less restrictions on sale or transfer and make regular distributions to a donee. Structuring to also take valuation discounts upon death could include drafting the entity’s operating agreement to specify that transferred interests are subject to put rights allowing the transferee the ability to force the entity or another transferee to repurchase the transferee’s interests at a particular price, after a specified date or upon the occurrence of a specified event. That seemingly provides the done with a present interest while preserving valuation discounts.
In any event, a combined strategy of present interest gifting of entity interests with valuation discounting requires careful drafting.
Present interest gifting is possible via entity interests. When valuation discounts upon death are also desired, the structuring and drafting becomes complex. In Part Three, I will focus on additional income tax considerations involving income tax basis as well as income tax issues associated with gifting partnership interests.
Friday, September 10, 2021
Proposed legislation that would decrease the federal estate tax exemption and the federal gift tax exemption is raising many concerns among farm and ranch families and associated estate and business planning issues. For farmers and ranchers desirous of keeping the family business intact for the next generation, questions about gifting assets and business interests to the next generation of owners now are commonplace.
Gifting assets before death – Part One of a series - It’s the topic of today’s post.
Federal Estate and Gift Tax - Current Structure
The current federal estate and gift tax system is a “coupled” system. A “unified credit” amount generates and “applicable exclusion” of $11.7 per individual for 2021. That amount can be used to offset taxable gifts during life or offset taxable estate value at death. It’s and “either/or” proposition. Any unused exclusion at the time of death can be “ported” over to the surviving spouse and added to the surviving spouse’s own applicable exclusion amount at death.
However, some gifts are not “taxable” gifts for purposes of using up the unified credit and, in turn, reducing the amount of asset value that can be excluded from federal estate tax at death.
Gifting – The Present Interest Annual Exclusion
Basics. “Present interest” gifts are not “taxable” gifts and do not reduce the donor’s unified credit. The present interest annual exclusion amount is a key component of the federal gift tax. I.R.C. §2503. The exclusion is presently $15,000 per donee, per year. That means that a donor can make gifts of up to $15,000 per year, per donee (in cash or an equivalent amount of property) without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return.
Note: Spouses can elect split gift treatment regardless of which spouse actually owns the gifted property. With such an election, the spouses are treated as owning the property equally, thereby allowing gifts of up to $30,000 per donee. Also, under I.R.C. §2503(e), an unlimited exclusion is allowed for direct payment of certain educational and medical expenses. In effect, such transfers are not deemed to be gifts.
The exclusion “renews” each year and is not limited by the number of potential donees. It is only limited by the amount of the donor’s funds and interest in making gifts. Thus, the exclusion can be a key estate planning tool by facilitating the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both. But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests.
Note: A present interest gift is one that the recipient is free to use, enjoy, and benefit from immediately. A gift of a future interest is one where the recipient doesn't have complete use and enjoyment of it until some future point in time. “Strings” are attached to future interest gifts.
Gifts to minors. I.R.C. §2503(c) specifies that gifts to persons under age 21 at the time of the gift are not future interests if the property and the income from the gift “may be expended by, or for the benefit of, the donee before attaining the age of 21 years, and will to the extent not so expended, pass to the donee on his attaining the age of 21 years, and in the event the donee dies before attaining…age…21…, be payable to the estate of the donee or as he may appoint under a general power of appointment…”. This provision contemplates gifts to minors in trust with a trustee appointed to manage the gifted property on the minor’s behalf. But, to qualify as a present interest, the gift still must be an “outright” gift with no strings attached.
Whether gifts are present interests that qualify for the annual exclusion has been a particular issue in the context of trust gifts that benefit minors. In 1945, the U.S. Supreme Court decided two such cases. In Fondren v. Comr. 324 U.S. 18 (1945) and Comr. v. Disston, 325 U.S. 442 (1945), the donor created a trust that benefitted a minor. In Fondren, the trustee had the discretion to distribute principal and income for the minor’s support, maintenance and education and, in Disston, the trustee had to apply to the minor’s benefit such income “as may be necessary for…education, comfort, and support.” In both cases, the Court determined that the minor was not entitled to any amount of a “specific and identifiable income stream.” So, no present interest was involved. The gifts were determined to be future interests.
What if a transferee has a right to demand the trust property via a right to withdraw the gifted property from the trust? Is that the same as outright ownership such that the gifted property would qualify the donor for an annual exclusion on a per donee basis? In 1951, the U.S. Court of Appeals for the Seventh Circuit said “yes” in a case involving an unlimited timeframe in which the withdrawal right could be exercised without any time limit for exercising the right. Kieckhefer v. Comr., 189 F.2d 118 (7th Cir. 1951). But in 1952 the U.S. Court of Appeals for the Second Circuit said “no” because it wasn’t probable that the minor would need the funds. Stifel v. Comr., 197 F.2d 107 (2d Cir. 1952). In Stifel, the minor’s access to the gifted property was to be evaluated in accordance with how likely it was that the minor would need the funds and whether a guardian had been appointed.
The “breakthrough” case on the issue of gifts to minors and qualification for the present interest annual exclusion came in 1968. In that year, the U.S. Circuit Court of Appeals for the Ninth Circuit, in Crummey v. Comr., 397 F.2d 82 (9th Cir. 1968), allowed present interest annual exclusions for gifts to a trust for minors that were subject to the minor’s right to demand withdrawal for a limited timeframe without any need to determine how likely it was that a particular minor beneficiary would actually need the gifted property. Since the issuance of the Crummey decision, the “Crummey demand power” technique has become widely used to assure availability of annual exclusions while minimizing the donee’s access to the gifted property.
Gifting – The Income Tax Basis Issue
In general, property that is included in a decedent’s estate receives an income tax basis in the hands of the heir equal to the fair market value of the property as of the date of the decedent’s death. I.R.C. §1014(a)(1). However, the rule is different for gifted property. Generally, a donee takes the donor’s income tax basis in gifted property. I.R.C. §1015(a). These different rules are often a significant consideration in estate planning and business transition/succession plans.
With the current federal estate and gift tax exemption at $11.7 million for decedent’s dying in 2021 and gifts made in 2021, gifting assets to minimize or eliminate potential federal estate tax at death is not part of an estate or succession plan for very many. But, if a current proposal to reduce the federal estate tax exemption to $3.5 million and peg the gift tax exemption at the $1 million level would become law, then gifting to avoid estate tax would be back in “vogue.” However, legislation currently under consideration would change the basis rule with respect to inherited property. The proposal is to limit the fair market at death income tax basis rule to $1 million in appreciated value before death, and apply a “carry-over” basis to any excess. An exception would apply to farms and ranches that remain in the family and continue to be used as a farm or ranch for at least 10 years following the decedent’s death. Gifted property would retain the “carry-over” basis rule.
Another proposal would specify death as an income tax triggering event causing tax to be paid on the appreciated value over $1 million, rather than triggering tax on appreciated value when the heir sells the appreciated property. If any of these proposals were to become law, the planning horizon would have to be reevaluated for many individuals and small businesses, particularly farming and ranching operations.
Still another piece of the proposed legislation would limit present interest gifts to $10,000 per donee and $20,000 per donor on an annual (it appears, although this is not entirely clear) basis.
Note: At this time, it remains to be seen whether these proposed changes will become law. There is significant push-back among farm-state legislators from both aisles and small businesses in general.
Even if the rules change surrounding the exemption from federal estate tax and/or the income tax basis rule at death, and/or the timing of taxing appreciation in wealth, gifting of assets during life will still play a role in farm and ranch business/succession planning. A big part of that planning involves taking advantage of the present interest annual exclusion to avoid reducing the available federal estate tax exemption at death.
Wednesday, September 8, 2021
The courts continue to issue opinions involving important tax issues not only farmers and ranchers, but opinions on issues that impact a broader range of taxpayers. In today’s post I highlight a few of the recent developments involving dependency; conservation easements; the ability to deduct NOLs; whether the “Roberts Tax” is a tax; whether losses are passive; and the deductibility of theft losses.
Recent court developments in tax law – it’s the topic of today’s post
Taxpayer Caring for Brother’s Children Entitled to Child-Related Tax Benefits
Griffin v. Comr., T.C. Sum. Op. 2021-26
During the tax year in issue, the petitioner lived with and cared for her mother at the petitioner’s home. She received compensation for caring for her mother through a state agency. For more than one-half of the tax year, the petitioner also cared for her niece and nephews because their father (her brother) was a disabled single parent. The niece and nephews stayed with her overnight from mid-May to mid-August and on weekends during school closures and on holidays. While they were with her, she paid for their food, home utility use and entertainment. On her 2015 return she claimed dependency exemption deductions for the children and child tax credits as well as the earned income tax credit. On audit and during the examination, the brother provided a signed form 8332, but the petitioner did not attach it to her return. The IRS denied the dependency exemptions, the child tax credits and the earned income tax credit. The Tax Court, rejecting the IRS position, noted that the children stayed with the petitioner for more than one-half of the tax year and that the petitioner’s testimony was credible to establish that the children were “qualifying children” for purposes of I.R.C. §152. Because none of them had reached age 17 during the tax year, the petitioner was entitled to a child tax credit for each one. Also, because I.R.C. §32 uses the same definition of “qualifying child” as does I.R.C. §152, the petitioner was entitled to the earned income tax credit.
IRS Provides Deed Language for Conservation Easement Donations
CCA 202130014 (Jun. 16, 2021)
The IRS has noted that a deed language for a donated conservation easement to a qualified charity fails to satisfy the requirements of I.R.C. §170(h) if the deed contains language that subtracts from the donee’s extinguishment proceeds the value of post-donation improvements or the post-donation increase in value of the property attributable to improvements. Such language violates Treas. Reg. §1.170A-14(g)(6)(ii) unless, as provided in Treas. Reg. §1.170A-14(g)(6). The IRS has provided sample language adhering to Treas. Reg. §1.170A-14(g)(6)(ii) that would not cause the issue from arising on audit. The language specifically states that on any subsequent sale, exchange or involuntary conversion of the property subject to the easement, the done is entitled to a portion of the proceeds at least equal to the proportionate value of the perpetual conservation restriction.
NOL Not Available Due to Lack of Documentation
Martin v. Comr., T.C. Memo. 2021-35
The petitioners, a married couple, has NOLs from 1993-1997 (which could be carried back three years and forward 15 years) that were being used to offset income in 2009 and 2010. The petitioners provided their 1993 and 1994 tax returns, but the returns did not include a detailed schedule related to the NOLs. Based on the information provided, the Tax Court determined that the petitioners had, at most, an NOL of $782,584 in 1993 and $666,002 in 1992 or earlier. Consequently, $1,448,586 of the NOL had expired in 2008 and was not available to offset income in 2009 or 2010. Thus, the petitioners had a potential NOL of $257,125 for their 1994 return. The Tax Court pointed out that the petitioners bore the burden of substantiating NOLs by establishing their existence and the carryover amount to the years at issue. That requires a statement be include with the return establishing the amount of the NOL deduction claimed, including a detailed schedule showing how the taxpayer computed the NOL deduction. The petitioners also filed bankruptcy in 1998. The Tax Court determined that the $257,125 NOL for 1994 was zeroed-out in the bankruptcy. The petitioners provided some information from their 1997-2007 returns which seemed to show Schedule C losses for some years, but had no documentation. They claimed that the NOLs should be allowed because they had survived prior audits of their 20072008 and 2011-2012 returns. The Tax Court pointed out that each year stands on its own and the fact that the IRS didn’t challenge an item on a return in a prior year is irrelevant to the current year’s treatment. Due to the lack of documentation the Tax Court denied any NOL deduction for 2009 or 2010.
“Roberts Tax” is Not a Tax
In re Juntoff, No. 20-13035, 2021 Bankr. LEXIS 995 (Bankr. N.D. Ohio Apr. 15, 2021)
The court held that the “shared-responsibility” payment of Obamacare is not an income tax because it is not measured based on income or gross receipts. The court determined that it also was not an excise tax because an individual’s not purchasing minimum essential coverage was not a transaction. Thus, the payment was not on a transaction. Thus, the “Roberts Tax” was not a tax entitled to priority treatment in bankruptcy under 11 U.S.C. §507(a)(8). The court noted it’s disagreement with the holding in In re Szczyporski, No. 2:20-cv-03133, 2021 U.S. Dist. LEXIS 61628 (E.D. Pa. Mar. 31, 2021) on the same issue.
Losses Not Passive and Fully Deductible
Padda v. Comr., T.C. Memo. 2020-154
The petitioner, a married couple, worked full-time as physicians. They also owned and operated a pain management clinic. During 2008-2012, they also opened five restaurants and a brewery with a 50 percent partner in the same general location as their medical practices. Each restaurant and the brewery operated in a separate LLC. For the years 2010-2012, they deducted nonpassive losses of more than $3 million from these businesses. The IRS claimed that the losses were passive and, thus, nondeductible. The petitioners couldn’t substantiate their participation, but did have some records showing trips and time spent at the various locations. They were also able to obtain sworn statements from 12 witnesses about the petitioners’ involvement in the construction and operation on a daily basis over the years. The Tax Court found the witnesses credible. The Tax Court determined that the petitioners had satisfied the material participation requirement of Temp. Treas. Reg. §1,469-5T(a)(4) because their hours in the non-medical activities exceeded the 100 hours required for each one to be considered a significant participation activity and exceeded the 500-hour threshold. The Tax Court therefore rejected the IRS argument that the restaurants and brewery were passive activities. The claimed losses were currently deductible.
No Theft Loss Deduction
Torres v. Comr., T.C. Memo. 2021-66
The petitioner was the president, CEO and sole shareholder of an S corporation that he cofounded with Ruzendall. From about 2010 forward, Ruzendall was no longer a shareholder but continued to manage the S corporation’s books and records. The petitioner became ill in 2016 and was unable to work and relied on others to handle the taxes for the business. Upon a bookkeeper’s advice, Ruzendall was issues a Form 1099-Misc. for 2016 reporting $166,494 in non-employee compensation. In 2018, the petitioner sued Ruzendall for misappropriation of funds, alleging a loss from embezzlement. In 2019, an amended Form 1120-S was filed. The IRS denied a deduction for embezzlement and the alternative claim as a deduction for compensation. The Court looked to the definition of embezzlement under state law. One of the requirements is an intent to defraud. The taxpayer did not offer evidence the woman intended to defraud the company and denied the deduction. The Court also noted that even if a theft loss occurred it was discovered in 2017, not 2016 and, therefore, could only be deducted in the year of discovery. The Court also denied the taxpayer's alternate argument of a deduction for compensation, but on the taxpayer's claim he did not mention the woman was entitled to compensation. The Court denied the alternative argument.
There are so many relevant and key developments practically on a daily basis. I’ll be posting soon on where this fall’s tax update seminars will be held at and when online updates will be occurring.
Sunday, September 5, 2021
The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, §6. As an estate planning device, the partnership is generally conceded to be less complex and less costly to organize and maintain than a corporation. A general partnership is comprised of two or more partners. There is no such thing as a one-person partnership, but there is no maximum number of partners that can be members of any particular general partnership.
Sometimes interesting legal issues arise as to whether a particular organization is, in fact, a partnership. If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch business relationships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
When does a partnership exist – it’s the topic of today’s post.
Informality Creates Questions
If there is no written partnership agreement, one of the questions that may arise is whether a landlord/tenant lease arrangement constitutes a partnership. Unfortunately, the great bulk of farm partnerships are oral. Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). This also tracks the U.S. Supreme Court’s definition of a partnership as the sharing of income and gains from the conduct of a business between two or more persons. Comr. v. Culbertson, 337 U.S. 733(1949). This rule has been loosely codified in I.R.C. §761, which also includes a “joint venture” in the definition of a partnership.
A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's deductions. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income, and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists.
This means that a partnership can exist in certain situations based on the parties’ conduct rather than intent. Does the form of property ownership constitute a partnership? By itself, the answer is generally “no.” See, e.g., Kan. Stat. Ann. §56a-202. Thus, forms of ownership of property (including joint ownership) do not by themselves establish a partnership “even if the co-owners share profits made by the use of the property.” See, e.g., Kan. Stat. Ann. §56a-202(c)(1). Also, if a share of business income is receive in payment of rent, a presumption that the parties would otherwise be in a partnership does not apply. See, e.g., Kan. Stat. Ann. §56a-202(c)(3)(iii).
Tax Code, Tax Court and IRS Views
The United States Tax Court, in Luna v. Comr., 42 T.C. 1067 (1964) set forth eight factors to consider in determining the existence of a partnership for tax purposes. In Luna, the Tax Court considered whether the parties in a business relationship had informally entered into a partnership under the tax Code, allowing them to claim that a payment to one party was intended to buy a partnership interest. To determine whether the parties formed an informal partnership for tax purposes, the Tax Court asked "whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise." The Tax Court listed non-exclusive factors to determine whether the intent necessary to establish a partnership exists.
The eight factors set forth in Luna are:
- The agreement of the parties and their conduct in executing its terms;
- The contributions, if any, which each party has made to the venture;
- The parties' control over income and capital and the right of each to make withdrawals;
- Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income;
- Whether business was conducted in the joint names of the parties;
- Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint ventures;
- Whether separate books of account were maintained for the venture;
- Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise
A recent Tax Court case is instructive on the application of the Luna factors. In White v. Comr., T.C. Memo. 2018-102, the petitioner was approached by his ex-wife, about forming a mortgage company and, along with their respective spouses, they orally agreed to work together in the real estate business in 2010 or 2011. The business was conducted informally, and no tax professionals were consulted. In 2011, the petitioner withdrew funds from his retirement account to support the business. The ex-wife and her new husband did not make similar financial contributions. Each of the “partners” handled various aspects of the business. The petitioner initially used his personal checking account for the business, until business accounts could be opened. Some accounts listed the petitioner as “president” and his wife as treasurer, but other business accounts were designated as “sole proprietorship” with the petitioner’s name on the account. The petitioner controlled the business funds and used business accounts to pay personal expenses and personal accounts to pay business expenses. Records were not kept of the payments. Business funds were also used to pay the ex-wife’s personal expenses.
The Tax Court applied the Luna factors and concluded that the business was not a partnership for tax purposes. The Tax Court determined that all but one of the Luna factors supported a finding that a partnership did not exist. To begin with, the parties must comply with a partnership. There was no equal division of profits; the parties withdrew varying sums from the business; the petitioner claimed personal deductions for business payments; the ex-wife and her new spouse could have received income from sources other than their share of the business income; and there was no explanation for how payments shown on the ex-wife’s return ended up being deposited into the business bank account.
Alternatively, the court concluded that even if a partnership existed, there was no reliable evidence of the partnership's total receipts to support an allocation of income different from the amounts that the IRS had determined by its bank deposits analysis.
When applying the Luna factors to typical farming/ranching arrangements, it is relevant to ask the following:
- Was Form 1065 filed for any of the years at issue (it is required for either a partnership or a joint venture)?
- Did the parties commingle personal and business funds?
- Were any partnership bank accounts established?
- Was there and distinct treatment of income and expense between business and personal expenses?
- How do the parties refer to themselves to the public?
- How do the parties represent themselves to the Farm Service Agency?
- Are the business assets co-owned?
An informal farming arrangement can also be dangerous from an income tax perspective. Often
taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income
and expense among several taxpayers in a more favorable manner or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful, as demonstrated in the following case. See, e.g., Speelman v. Comr., 41 T.C.M. 1085 (1981).
Liability and other Legal Concerns
Why all of the concern about whether an informal farming arrangement could be construed legally as a partnership? Usually, it is the fear of unlimited liability. Partners are jointly and severally liable for the debts of the partnership that arose out of partnership business. It is this fear of unlimited liability that causes parties that have given thought to their business relationship to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
The scenarios are many in which legal issues arise over the question of whether a partnership exists and gives rise to some sort of legal issue. For example, in Farmers Grain Co., Inc. v. Irving 401 N.W.2d 596 (Iowa Ct. App. 1986), the plaintiff extended credit to the defendant who was a tenant under an oral livestock share lease. Upon default of the loan, the defendant filed bankruptcy and the plaintiff tried to bind the landlord to the debt under a partnership theory. The court held that a partnership had not been formed where the landlord did not participate in the operation, no joint bank accounts were established, and gross returns were shared rather than net profits.
In Tarnavsky v. Tarnavsky, 147 F.3d 674 (8th Cir. 1998), the court determined that a partnership did exist where the farming operation was conducted for a profit, the evidence established that the parties involved intended to be partners and business assets were co-owned.
Oral business arrangements can also create unanticipated problems if one of the parties involved in the business dies. In In re Estate of Palmer, 218 Mont. 285, 708 P.2d 242 (1985), the court determined that a partnership existed even though title to the real estate and the farm bank account were in joint tenancy. As such, the surviving spouse of the deceased “partner” was entitled to one-half of the farm assets instead of the land and bank account passing to the surviving joint tenant.
Formality in business relationships can go along way to avoiding legal issues and costly court proceedings when expectations don’t work out as anticipated. Putting agreements in writing by professional legal counsel often outweighs the cost of not doing so.
Tuesday, August 31, 2021
In response to attempts by activist groups opposed to animal agriculture, legislatures in several states over the last 30 years have enacted laws designed to protect specified livestock facilities from certain types of interference. Some of the laws have been challenged on free speech and equal protection grounds with a few courts issuing opinions that have largely found the laws constitutionally suspect. Most recently, the statutes in Iowa and Kansas were construed by two different U.S. Circuit Courts of Appeals.
Recent court developments involving legislative attempts to protect confinement animal agriculture – it’s the topic of today’s article.
General Statutory Construct
The basic idea of state legislatures that have attempted to provide a level of protection to livestock facilities is to bar access to an animal production facility under false pretenses. At their core, the laws attempt to prohibit a person having the intent to harm a livestock production facility from gaining access to the facility (such as via employment) to then commit illegal acts on the premises. See, e.g., Iowa Code §717A.3A. Laws that bar lying and trespass coupled with the intent to do physical harm to an animal production facility likely are not constitutionally deficient. Laws that go beyond those confines may be.
Recent Court Opinions
2017 developments. 2017 saw several courts issue opinions on various state provisions. In North Carolina, a challenge to the North Carolina statutory provision was dismissed for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017). The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act. They claimed that the law unconstitutionally stifled their ability to investigate North Carolina employers for illegal or unethical conduct and restricted the flow of information those investigations provide. As noted, the court dismissed the case for lack of standing. On appeal, however, the appellate court reversed. PETA, Inc. v. Stein, 737 Fed. Appx. 122 (4th Cir. 2018). The appellate court determined that the plaintiffs had standing to challenge the law through its “chilling effect” on their First Amendment rights to investigate and publicize actions on private property. They also alleged a reasonable fear that the law would be enforced against them.
The Utah law, however, was deemed unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017). At issue was Utah Code §76-6-112 which criminalizes the entering of a private agricultural livestock facility under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist.” For those reasons, the court determined that the Act was unconstitutional.
A Wyoming law experienced a similar fate. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016). In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" included numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection of resource data.
Ninth Circuit. In early 2018, the U.S. Circuit Court of Appeals for the Ninth Circuit issued a detailed opinion involving the Idaho statutory provision. Animal Legal Defense Fund v. Wasden, 878 F.3d 1184 (9th Cir. 2018). The Ninth Circuit’s opinion provides a roadmap for state lawmakers to follow to provide at least a minimal level of protection to animal production facilities from those that would intend to do them economic harm. According to the Ninth Circuit, state legislation can bar entry to a facility by force, threat or trespass. Likewise, the acquisition of economic data by misrepresentation can be prohibited. Similarly, criminalizing the obtaining of employment by false pretenses coupled with the intent to cause harm to the animal production facility is not constitutionally deficient. However, provisions that criminalize audiovisual recordings are suspect.
Eighth Circuit. In 2021, the U.S. Court of Appeals for the Eighth Circuit construed the Iowa law and upheld the portion of it providing for criminal penalties for gaining access to a covered facility by false pretenses. Animal Legal Defense Fund v. Reynolds, No. 19-1364, 2021 U.S. App. LEXIS 23643 (8th Cir. Aug. 10, 2021). This is the first time that any federal circuit court of appeals has upheld a provision that makes illegal the gaining of access to a covered facility by lying.
Conversely, the court held that the employment provision of the law (knowingly making a false statement to obtain employment) violated the First Amendment because the law was not limited to false claims that were made to gain an offer of employment. Instead, the provision provided for prosecution of persons who made false statements that were incapable of influencing an offer of employment. A prohibition on immaterial falsehoods was not necessary to protect the State’s interest – such as false exaggerations made to impress the job interviewer. The court determined that barring only false statements that were material to a hiring decision was a less restrictive means to achieve the State’s interest.
Note. The day before the Eighth Circuit issued its opinion concerning the Iowa law, it determined that plaintiffs challenging a comparable Arkansas law had standing the bring the case. Animal Legal Defense Fund v. Vaught, No. 20-1538, 2021 U.S. App. LEXIS 23502 (8th Cir. Aug. 9, 2021).
Tenth Circuit. In Animal Legal Defense Fund, et al. v. Kelly, No. 20-3082, 2021 U.S. App. LEXIS 24817 (10th Cir. Aug. 19, 2021), the court construed the Kansas provision that makes it a crime to take pictures or record videos at a covered facility “without the effective consent of the owner and with the intent to damage the enterprise.” The plaintiffs claimed that the law violated their First Amendment free speech rights. The State claimed that what was being barred was conduct rather than speech and that, therefore, the First Amendment didn’t apply. But, the court tied conduct together with speech to find a constitutional violation – it was necessary to lie to gain access to a covered facility and consent to film activities. As such, the law regulated protected speech (lying with intent to cause harm to a business) and was unconstitutional. The court determined that the State failed to prove that the law narrowly tailored to a compelling state interest in suppressing the “speech” involved. The dissent pointed out (correctly and consistently with the Eighth Circuit) that “lies uttered to obtain consent to enter the premises of an agricultural facility are not protected speech.” The First Amendment does not protect a fraudulently obtained consent to enter someone else’s property.
There presently is a split between the Eighth and Tenth Circuits on the constitutionality of the Iowa and Kansas laws with respect to the issue of gaining access to a covered facility by lying. That’s a key point. If access can be barred by sifting out liars with intent to do a covered facility harm, then the video issue is largely mooted. The issues will likely continue in the courts for the foreseeable future.
Sunday, August 29, 2021
The research and promotion of numerous ag products is funded by the producers that raise the commodities via “checkoff” programs. Sometimes producers object to the content and manner of various promotions and claim that being compelled to fund the offensive advertising is private speech that they cannot be compelled to fund. But, is a mandatory checkoff private speech or is it constitutionally protected government speech? Recently the U.S. Court of Appeals addressed the question again in the context of the beef checkoff.
Checkoff programs and the Constitution – it’s the topic of today post.
Legislation has established mandatory assessments for promotion of particular agricultural products. An assessment (or “checkoff”) is typically levied on handlers or producers of commodities with the collected funds to be used to support research promotion and information concerning the product. Such checkoff programs have been challenged on First Amendment free-speech grounds. For example, in United States v. United Foods, Inc., 533 U.S. 405 (2001), the U.S. Supreme Court held that mandatory assessments for mushroom promotion under the Mushroom Promotion, Research, and Consumer Identification Act violated the First Amendment. The assessments were directed into generic advertising, and some handlers objected to the ideas being advertised. In an earlier decision, the Court had upheld a marketing order that was part of a greater regulatory scheme with respect to California tree fruits. Glickman v. Wileman Brothers & Elliott, Inc., 521 U.S. 457, rev’g, 58 F. 3d 1367 (9th Cir. 1995). In that case, producers were compelled to contribute funds for cooperative advertising and were required to market their products according to cooperative rules. In addition, the marketing orders had received an antitrust exemption. None of those facts was present in the United Foods case, where the producers were entirely free to make their own marketing decisions and the assessments were not tied to a marketing order. The Supreme Court did not address, however, whether the checkoffs at issue were government speech and, therefore, not subject to challenge as an unconstitutional proscription of private speech.
The Government Speech Issue
In Livestock Marketing Association v. United States Department of Agriculture, 335 F.3d 711 (8th Cir. 2003), the Eighth Circuit held unconstitutional the beef checkoff authorized under the Beef Promotion and Research Act of 1985. The court ruled that the mandatory assessment of one dollar per-head violated the free-speech rights of those who objected to the generic advertising of beef funded by the check-off because cattle producers and sellers were not regulated nearly to the extent the California tree fruit industry was regulated in Wileman Brothers. As such, the beef industry was similar to the mushroom industry, and United Foods controlled. The court also ruled that the beef checkoff did not constitute government speech.
The Supreme Court agreed to hear the Livestock Marketing Association case on the narrow grounds of whether the beef checkoff was government speech. The Court reversed the Eighth Circuit and upheld the check-off as government speech. Johanns v. Livestock Marketing Association, 544 U.S. 550 (2005). The case involved (in the majority’s view) a narrow facial attack on whether the statutory language of the Act created an advertising program that could be classified as government speech. That was the only issue before the Court.
Elements of constitutionality. While the government speech doctrine is relatively new and is not well-developed, prior Supreme Court opinions not involving agricultural commodity checkoffs indicated that to constitute government speech, a checkoff must clear three hurdles: (1) the government must exercise sufficient control over the content of the check-off to be deemed ultimately responsible for the message; (2) the source of the checkoff assessments must come from a large, non-discrete group; and (3) the central purpose of the checkoff must be identified as the government’s. Based on that analysis, it was believed that the beef checkoff would clear only the first and (perhaps) the third hurdle, but that the program would fail to clear the second hurdle. Indeed, the source of funding for the beef check-off comes from a discrete identifiable source (cattle producers) rather than a large, non-discrete group. The point is that if the government can compel a targeted group of individuals to fund speech with which they do not agree, greater care is required to ensure political accountability as a democratic check against the compelled speech. That is less of a concern if the funding source is the taxpaying public which has access to the ballot box as a means of neutralizing the government program at issue and/or the politicians in support of the program. While the dissent focused on this point, arguing that the Act does not establish sufficient democratic checks, Justice Scalia, writing for the majority, opined that the compelled-subsidy analysis is unaffected by whether the funds for the promotions are raised by general taxes or through a targeted assessment. That effectively eliminates the second prong of the government speech test. The Court held that the other two requirements were satisfied because the Act vests substantial control over the administration of the checkoff and the content of the ads in the USDA Secretary.
The Supreme Court, in Johanns, did not address (indeed, the issue was not before the Court) whether the advertisements, most of which are credited to “America’s Beef Producers,” give the impression that the objecting cattlemen (or their organizations) endorse the message. Because the case only involved a facial challenge to the statutory language of the Act, the majority examined only the Act’s language and concluded that neither the statute nor the accompanying Order required attribution of the ads to “America’s Beef Producers” or to anyone else. Thus, neither the statute nor the Order could be facially invalid on this theory. However, the Court noted that the record did not contain evidence from which the Court could determine whether the actual application of the checkoff program resulted in the message of the ads being associated with the plaintiffs. Indeed, Justice Thomas, in his concurring opinion, noted that the government may not associate individuals or organizations involuntarily with speech by attributing an unwanted message to them whether or not those individuals fund the speech and whether or not the message is under the government’s control. Justice Thomas specifically noted that, on remand, the plaintiffs could possibly amend their complaint to assert an attribution claim which ultimately could result in the beef checkoff being held unconstitutional. If that occurred, and the ads were found to be attributable to the complaining ranchers or their associated groups, the beef checkoff could still be held to be unconstitutional.
In the first check-off opinion rendered by a federal court after the U.S. Supreme Court’s opinion in the beef check-off case, the Federal District Court for the Central District of California issued a preliminary injunction against enforcement of the California Pistachio check-off on the basis that the plaintiffs were likely to succeed on the merits of their claim that the program was unconstitutional. Paramount Land Co., et al. v. California Pistachio Comm’n, No. 2:05-cv-05-07156-mmm-pjw (C.D. Cal. Dec. 12, 2005). The court reasoned, based on Johanns, that the check-off was not government speech and that the industry regulation of the marketing aspects of pistachios was more like the regulatory aspects of the Mushroom industry at issue in United Foods than the regulatory aspects of the California tree fruit industry at issue in Glickman. However, on appeal, the district court’s opinion was reversed. Paramount Land Company, LP v. California Pistachio Commission, 491 F.3d 1003 (9th Cir. 2007). The appellate court determined that the First Amendment was not implicated because, consistent with Johanns, the Secretary of the California Department of Food and Agriculture retained sufficient authority to control both the activities and the message under the Pistachio Act. The court reasoned that the fact that the Secretary had not actually played an active role in controlling pistachio advertising could not be equated with the Secretary abdicating his regulatory role. In another California case, a court held that milk producer assessments used for generic advertising to stimulate milk sales were constitutional under the Johanns rationale. Gallo Cattle Co. v. A.G. Kawamura, 159 Cal. App. 4th 948, 72 Cal. Rptr. 3d 1 (2008).
The government speech issue came up again in the context of the beef checkoff in Ranchers Cattlemen Action Legal Fund United Stockgrowers of America v. Vilsack, No. 20-35453, 2021 U.S. App. LEXIS 22189 (9th Cir. Jul. 27, 2021). The plaintiff represents cattlemen that are subject to the $1 per head of cattle sold in the United States federal beef checkoff created under the Beef Promotion and Research Act of 1985. The checkoff funds promotions to “maintain and expand domestic and foreign markets and uses for beef and beef products.” The USDA Secretary, the defendant in the case, oversees the checkoff through the Cattlemen’s Beef Promotion and Research Board that consists of members the Secretary appoints. A qualified state beef council typically collects the checkoff, retains half of the amount collected to fund state marketing efforts and forwards the balance to the federal program. A cattle producer may opt out of funding their state beef council and direct the entire assessment to the federal program.
The plaintiff’s members object to their states’ advertising campaigns, and claim in particular that the distribution of funds to the Montana Beef Council under the federal program is an unconstitutional compelled subsidy of private speech. Later, the plaintiff amended its complaint to include numerous other states where it had members. The trial court entered a preliminary injunction preventing the use of checkoff funds for promotional campaigns absent the producers' consent. On the merits, the trial court determined that by virtue of a memorandum of understanding that the Montana Beef Council and the other state beef councils had entered into with the defendant, the defendant had sufficient control over the promotional program to make the speech of the various state beef councils effectively government speech.
On appeal, the appellate court affirmed. The appellate court noted that the critical question in determining whether speech is public or private is whether the speech is “effectively controlled” by the government. The appellate court determined that the challenged speech was. Under the memorandums of understanding, the state beef councils had to submit for the defendant’s pre-approval “any and all promotion advertising, research, and consumer information plans and projects" and "any and all potential contracts or agreements to be entered into by state beef councils for the implementation and conduct of plans or projects funded by checkoff funds." The state beef councils also had to submit "an annual budget outlining and explaining . . . anticipated expenses and disbursements" and a "general description of the proposed promotion, research, consumer information, and industry information programs contemplated.” Failure to comply could lead to the defendant’s de-certification of a state beef council. The appellate court noted that this established "final approval authority over every word used in every promotional campaign,” and constituted government speech. In addition, all private contracted third parties that were not subject to pre-approval were “effectively controlled” by the government. The appellate court noted that the Congress expressly contemplated the participation of third parties in the beef checkoff program, designating several "established national nonprofit industry-governed organizations" with whom the Operating Committee could contract to "implement programs of promotion."
In addition, the appellate also pointed out that the state beef councils had to give the defendant notice of all board meetings and allow the defendant or his designees to participate in any discussions about payment to third parties. It was this ability to control speech that was the key rather than whether the defendant exercised final pre-approval authority over some third-party speech. On that point, the appellate court noted it had previously ruled similarly in 2007 in the Paramount Land Company, LP case.
If by use of a memorandum of understanding the USDA is able to create sufficient theoretical control over a checkoff to transform the program into government speech, there isn’t much of a viable path forward for claiming that a checkoff isn’t government speech. Any future challenge, as Justice Thomas pointed out in Johanns, would have to clearly and convincingly posit that an unwanted message is being attributed to particular producers.
Saturday, August 28, 2021
In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Clearly, if a farmer constructs a confinement building, places their own livestock in the building, provides all management and labor, and pays all expenses, the net profit from the activity will be subject to self-employment tax. But, what if the livestock production activity conducted in the confinement building is done so under a contract with a third party? Is the farmer’s net income from the activity subject to self-employment tax in that situation?
Livestock confinement buildings and self-employment tax – it’s the topic of today’s post.
Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax if the operation constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business. In general, to be subject to self-employment tax, an activity must be engaged in on a substantial basis with continuity and regularity.
Livestock Confinement Buildings and Contract Production
Does self-employment tax apply to the net income derived from livestock production activities conducted in a farmer’s confinement building pursuant to a contract with a third party? As with many tax answers, “it depends.”
The U.S. Tax Court provided guidance on the issue in 1995. In Gill v. Comr., T.C. Memo. 1995-328, a corporation that produced, processed and marketed chicken products bought breeder stock from primary breeders and placed them in farmer-owned buildings for 20 weeks. The placement of the chicks with individual farmers was done in accordance with production contracts. The petitioners (two different farmers) constructed broiler barns with the corporation’s assistance in obtaining financing and established that the petitioners had the ability to maintain their facilities. Each contract was for 10 years and the corporation paid the petitioners a fixed monthly amount tied to the space inside each building ($.045 per month/per square foot) that was supplemented over time to reflect inflation. The petitioners were required to perform certain maintenance items, inspections and general flock management responsibilities.
The petitioners did not report the income received under the contracts as subject to self-employment tax. They claimed that they did not materially participate in the production or the management of the production of the poultry in the barns that they leased to the corporation. As such, they claimed that the payments they received were excluded from the definition of “net earnings from self-employment” as “rents from real estate.”
The Tax Court disagreed. The Tax Court noted that the apparent intent of the Congress was to exclude from self-employment tax only those payments for use of space and, by implication, such services as are required to maintain the space in condition for occupancy. Thus, when a taxpayer performs additional services of a substantial nature that compensation for the additional services can be said to constitute a material part of the payment the made to the owner, the payment is income that is attributable to the performance of labor. It’s not incidental to the realization of return from a passive investment, and the payment is included in the computation of the taxpayer’s “net earnings from self-employment.” Applying the analysis to the facts, the Tax Court determined that the petitioners (and their children) performed each and every task necessary to raise the flocks of birds that the corporation delivered. This constituted material participation subjecting the contract payments to self-employment tax. The payments were not excluded from net earning from self-employment as “real estate rents.” See also Schmidt v. Comr., T.C. Memo. 1997-41.
Many ag production contracts like the ones at issue in Gill require the farmer/producer to perform substantial services in connection with the production of the livestock or poultry. Therein lies the problem. To avoid having the income subjected to self-employment tax, the farmer/building owner must not participate to a significant degree in the production activities or bear a substantial risk of loss.
So, are there any planning avenues to address the self-employment tax issue? One option may be to split the contractual arrangement into two separate agreements. One agreement would be strictly for the “rental” of the building with IRS Form 1099 issued for the rental income. Given the typical high capital costs for livestock confinement buildings, a return on capital shown as “rent” should not be unreasonable. A second agreement would be entered into providing for herd/flock management with the issuance of a separate Form 1099 for non-employee compensation or a Form W-2 for wages. These payments would be subject to self-employment tax or FICA tax.
Another approach was established by the Tax Court in 2017. In Martin v. Comr., 149 T.C. 293 (2017), the petitioners, a married couple, operated a farm in Texas. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the “grower” under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.
The Tax Court determined that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure of return on the petitioners’ investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business. Importantly, the Tax Court noted that the IRS failed to brief the nexus issue and simply relied on the Tax Court to broadly interpret “arrangement” to include all contracts related to the S corporation. Accordingly, the Tax Court held that the petitioners’ rental income was not subject to self-employment tax.
Aside from the “two-check” approach, leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement. Services and labor participation should remain solely within the domain of the employment agreement. In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases. See e.g., Johnson v. Comm'r, T.C. Memo. 2004-56. If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services. See, e.g., Solvie v. Comm'r, T.C. Memo. 2004-55. If the lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services.
Whether self-employment tax is incurred or not will likely be determined by the extent of involvement the owner retains with regard to the confinement building. But, a word of caution. With the ability to claim substantial depreciation and large interest expense payments (associated with financing the confinement building), a loss could be created. Thus, classification of the arrangement as a rental activity with no self-employment tax may not be the best tax strategy. Instead, the preference might be to offset the loss against self-employment income. This last point raises a question. Can a taxpayer “change horses” mid-stream when the confinement building is sufficiently paid for such that interest expense is lower and, also, depreciation deductions have dropped significantly? Can the contract then be modified at that point so that self-employment tax is avoided?
Interesting tax planning questions.
Sunday, August 22, 2021
Many people have had or will have a family member in need of in-home or nursing home care. Medical issues are often frequently associated with advanced age. Those issues can result in at least part-time care or, in some cases, a full-time in-home nursing aide or even institutionalized care.
A significant concern of family members of a loved one requiring some level of nursing care, whether by an in-home aide or in a nursing home, is the potential for abuse, particularly financial abuse, of their family member. What steps can be taken to minimize the potential for elder abuse?
Planning steps to take to avoid elder abuse – it’s the topic of today’s post.
Tax Court Saga
A unique place to find an example to use for discussing elder abuse is in a U.S. Tax Court opinion. But elder abuse was certainly involved in Alhadi v. Comr., T.C. Memo. 2016-74. The case involved Dr. Marsh. He was born into a Montana farm family in 1915. After World War II, he moved to California and practiced optometry. He never married and lived a frugal life in his small second story apartment. He invested his money prudently and grew the sum to over $3 million.
At age 85 Dr. Marsh fell and broke his hip. He rehabilitated, but by the time he reached age 91 he could no longer drive, couldn’t prepare his own food and couldn’t go to the doctor by himself. He suffered from hearing and vision loss and also had a stroke. He was eventually diagnosed with dementia and cognitive decline. His short-term memory was diminished, and he had trouble recalling details about his personal assets and finances. He also suffered from incontinence, atrial fibrillation, congestive heart failure, hypertension, chronic back pain, and arthritis,
Dr. Marsh eventually outlived his siblings and had no other family members, and at age 91 was hospitalized again for his numerous conditions. His doctor determined that he could not be discharged unless in-home care was arranged for him. A hospital employee, Ms. Alhadi learned that Dr. Marsh wouldn’t be discharged without in-home care. Even though the hospital had a policy that employees couldn’t solicit work from patients, Ms. Alhadi slipped a note to Dr. Marsh offering her services for in-home care. He accepted her offer and she became his primary caregiver. Dr. Marsh initially paid her by the hour, but then switched payment to a $6,000 per month amount – more than 50 percent above the going rate. He also paid her an additional monthly amount for groceries. Within a few months, she used the money she received from Dr. Marsh to put a down payment on a $1 million home and began to pressure him to help her with the mortgage payments. Over the next few months, Dr. Marsh wrote her checks totaling $400,000. She used the money to pay off her husband's $80,000 interest in their old home and to remodel her new home. Dr. Marsh also bought $7,000 worth of furniture for her, and she paid $8.,000 for a new stone façade, $34,000 for landscaping work at the new home and $73,000 for a new pool complete with a spa and a "therapeutic turtle mosaic."
Ms. Alhadi also convinced Dr. Marsh to pay $25,000 for a cruise. She took him along but left him alone sitting in the sun while she spent time with her own children. Dr. Marsh later couldn’t remember paying for the cruise and was surprised when he was shown the check he had written.
Dr. Marsh had a niece that lived in Seattle that would call him each Sunday evening, but within a year of Ms. Alhadi becoming his primary caregiver, she encountered difficulty in reaching him. Ultimately, neither she nor any other relatives could get in touch with Dr. Marsh. Ms. Alhadi, would tell Dr. Marsh that she loved him and suggested that they get married. She would sit in front of him and cry about her financial struggles.
Ms. Alhadi divorced her husband, and in the divorce action didn’t disclose any of the money that she was being paid for her in-home care job. She hired a tax preparer to prepare her 2007 return, but again didn’t disclose the income from her in-home care work. However, on mortgage applications for her new home, she did disclose the income received from working for Dr. Marsh.
By the end of 2008, Dr. Marsh had written checks to her totaling almost $800,000. She then got Dr. Marsh to write her five more checks worth $100,000 each. Because most of Dr. Marsh’s wealth was held in Vanguard Group mutual funds, a Vanguard representative questioned why five checks were written in a short timeframe. On Vanguard’s recorded calls with Dr. Marsh, Ms. Alhadi could be heard in the background coaching him. Vanguard suspected fraud, dishonored the checks and suspended his accounts. Vanguard also suspected elder abuse and sent a report to the California Department of Health and Human Services. An investigator checked into the matter and learned about what had been happening. Ms. Alhadi also took Dr. Marsh to an estate attorney to try to have him name her his agent under a power of attorney so that she could get the Vanguard accounts unblocked. She also wanted Dr. Marsh to have a will prepared that named her as the beneficiary.
Finally, the state filed a petition in state court to put Dr. Marsh under a temporary guardianship. The court granted the petition in January of 2009 on two grounds – 1) his assets were at risk; and 2) he wasn’t being provided even a bare minimum of care. The court’s description of his living conditions in his apartment were truly disgusting. The next month, Dr. Marsh died. Ms. Alhadi appeared at the funeral screaming and made an attempt to get into Dr. Marsh’s casket with him.
In 2010, Dr. Marsh’s trust settled a lawsuit it had brought against Ms. Alhadi. The trust recovered $310,000 in cash, but the home was lost to foreclosure, and she had spent the balance of the money. Ultimately, the IRS caught up with Ms. Alhadi and sent her a notice of deficiency for 2007 and 2008 for over $1 million. She claimed in Tax Court that the funds she received from Dr. Marsh were either loans or nontaxable gifts. The Tax Court agreed with the IRS that they were neither. Rather, the amounts totaling over $900,000 in checks were taxable income subject to self-employment tax. The Tax Court noted that Dr. Marsh never referred to the amounts provided to her as anything other than compensation and that, in any event, she never had any intent to repay the amounts. The funds were also not gifts because any donative intent on Dr. Marsh’s part was negated by undue influence. The Tax Court also upheld penalties, including the fraud penalty of I.R.C. §6663.
Avoiding Elder Abuse
The saga of Dr. Marsh and his in-home aide is a sorrowful tale. What steps can be taken to minimize the likelihood of elder abuse happening to a loved one of yours? Consider the following suggestions:
- Keep your eyes and/or ears open. Be alert for situations where a vulnerable person can be taken advantage of. Clearly, in Dr. Marsh’s situation, his niece should have taken the time to physically visit him. A surprise visit might be the key to spotting abuse.
- Stay on top of the cognitive ability of the family member. Cognitive ability is not always tied to age, but it’s a good idea to have cognitive ability professionally evaluated. Those in cognitive decline can more easily be manipulated by others with nefarious goals.
- Make sure you know the nature and extent of the loved one’s assets before in-home or nursing home care begins. Include all assets, including household and personal assets. It’s the small things that be taken without anyone noticing. The only way to determine if assets or funds are missing is to know what exists at the start. Then, commit to a periodic review of income and assets.
- It might be a good idea to have a family member control the loved one’s mail. Setting up direct deposit for incoming checks, etc., can also be a good idea.
- Monitor receipts. If an aide is buying groceries and supplies, require that receipts be retained and then commit to checking them at least periodically.
- Negotiate a contract with the aide that builds in a vacation. During the time the aide is on vacation, make sure the substitute is not related to or a colleague of the normal full-time aide. The vacation time can tend to reveal issues if the normal full-time aide is not there for several consecutive days.
- Make sure valuables are kept in a safety deposit box or in a safe that the aide can’t access.
- Make sure that appropriate legal documents are in place. This includes a power of attorney for financial and health care decisions as well as a will or a trust.
I am sure that the list of planning steps could include additional suggestions. But the basic point is to stay on top of the situation and not leave the family member to the complete discretion of an aide. That can go along way toward avoiding the disastrous elder abuse situation that befell Dr. Marsh.
Thursday, August 19, 2021
Concerns about the possibility of a reduction in the federal estate tax exemption is significant in agriculture. If a significant drop in the exemption would impact the farming or ranching business, is there a plan in place to pay the resulting tax? It’s a real problem because ag estates are typically illiquid – as you’ve probably heard it said, ag estates are often “asset rich, but cash poor.”
The issue of illiquidity in an ag estate, and some thoughts on what can be done about it – it’s the topic of today’s post.
The Problem of Illiquidity
Farmers and ranchers engaged in the production of agricultural commodities often face the same estate and succession planning problems that confront all businesses. But there are unique issues that face those engaged in agriculture, and the law often treats farm and ranch businesses differently than it does other business types. In numerous other posts, I have highlighted these differences. Entity structuring can aid in taking advantage of some of those differences. But, those differences often don’t provide any relief from a common issues for agricultural estates – that of illiquidity. capital assets, but little cash or assets that are readily convertible into cash. If the federal estate tax exemption falls significantly as current proposed legislation promises to do starting next year, an estate’s tax bill could pose a significant burden. That raises a question – has the estate plan been structured in a manner that provides liquidity to pay costs associated with death? Planning for the potential problem of illiquidity at death That means that planning for this potential problem at should be part of the farm and ranch estate plan.
What is at the heart of the liquidity (or the lack thereof) issue? Farming and ranching often involves a substantial investment in farm capital assets (land, buildings, equipment, etc.). It also commonly involves large borrowings that can carry significant interest charges. This is typically coupled with fluctuating income (or loss) from year-to-year because of diverse weather and market conditions. On the positive side, ag land values tend to rise over the long-term, but short-term shocks to the land market do occur and can present timing issues for the estate planner. All of these factors require the use of estate planning strategies that will minimize death taxes and estate administration costs, preserve liquidity of the estate and provide for a systematic and economic disposition (or continuance) of the farm business on the death of the farm owner. In addition, it’s important that the estate plan take full advantage of the ag-tailored tax provisions designed to alleviate the tax burdens of farmers.
Illiquidity of the farm or ranch estate makes it difficult for the estate executor to find readily available cash, or assets that are readily convertible to cash, with which to pay monetary legacies (such as the buy-out of an off-farm heir), administration costs, debts, taxes and other estate obligations. Planning to improve the liquidity of the estate before death can prevent losses which might otherwise be incurred through a quick or forced sale of estate assets to meet post-death obligations. It can also avoid the necessity of borrowing funds and can avoid post-death disputes (and possible litigation) among beneficiaries over the sale of assets. Planning can also help minimize the resulting income and capital gain taxes triggered by assets sold to generate funds to pay obligations associated with death.
Pre-Death Liquidity Planning
Where an objective of the estate plan is to preserve as much of the farm business in the hands of the farmer’s heirs, proper planning for liquidity can minimize or eliminate the sale of farm assets. Various steps can be taken during the lifetime of the farmer or rancher to improve the liquidity of the estate. Some common planning steps include deliberately building up liquid assets; buying life insurance; properly using buy-sell agreements; and utilizing other available techniques to reduce the potential estate tax liability at death.
One approach to liquidity planning is to make a current estimate of existing monetary obligations that the estate is expected to face upon death. Given the current uncertain status of the transfer tax system, the estimate should involve various projections based on anticipated levels of the federal estate tax exemption and applicable rates at death, with those estimates serving as a rough guide to the amount of funds needed in the estate. The plan should be reviewed periodically to account for changes in asset values.
During profitable years, post-tax investments can provide additional liquidity. While farmers and ranchers tend to reinvest any surplus back into farm/ranch capital assets, a liquidity planning strategy might be to invest surplus funds in liquid assets such as interest-bearing bank deposits and marketable stocks and bonds. Likewise, surplus funds could be invested in other agricultural real estate with a potential for appreciation, such as from development, with an eye toward later sale. This could be accomplished without interfering with any objective to keep the original farming operation in-tact for subsequent generations of the farm family.
Life insurance under a policy on the life of the estate owner can provide an appropriate amount of cash for the estate. Those funds can then be used to meet estate obligations upon death. This can substantially improve estate liquidity. But care must be exercised to minimize or eliminate estate tax on the life insurance proceeds. This can be accomplished by properly structuring the ownership of the policy and the beneficiary designation(s).
Where the farm is operated in partnership or corporate form, a buy-sell agreement among partners or stockholders is often a good planning tool. A well-drafted buy-sell agreement with well-defined triggering events that is properly funded (likely with life insurance) can ensure that there will be a buyer for the decedent’s ownership interest upon death. Likewise, a buy-sell agreement can ensure that the estate will have liquid funds from the sale of the decedent’s interest in the farming/ranching entity.
There are also provisions included in the tax Code that can aid in providing liquidity at death. Special use valuation allows the agricultural land in the estate to be valued at its use value for agricultural purposes rather than fair market value at death. I.R.C. §2032A. There are many rules that must be satisfied for the executor of the decedent’s estate to make a special use valuation election and reduce the land value in the estate by up to (for 2021) $1,190,000. In addition, the family (knowns as “qualified heirs”) must continue to farm the elected land for 10 years (and, possibly, 12 years) after the decedent dies.
Another Code provision allows the decedent’s estate to pay federal estate tax in installments over 15 years coupled with a special rule for interest payments. I.R.C. §6166. Normally, federal estate tax is due nine months after the date of the decedent’s death. But, again, this is a complex provision that requires proper pre-death planning for the estate executor to utilize it.
The possibility of a decline in the federal estate tax exemption raises real concerns about liquidity in an ag estate. While the estate of a farmer or rancher valued at $12 million net worth at death would presently have no federal estate tax bill, for instance, that same estate would likely owe more than $2 million in federal estate tax if the exemption were to drop to $3.5 million as currently proposed. That makes liquidity planning very important to farm and ranch families – particularly those intending on keeping the family business intact for future generations.