Wednesday, August 12, 2020

Demolishing Farm Buildings and Structures – Any Tax Benefit?

Overview

The acquisition of a farm or changes in the farming business may lead to the need demolish existing buildings and structures.  Also, the recent major wind and rainstorm that stretched from Nebraska to Indiana damaged many farm buildings and structures that may now be irreparable and require demolition.  Is there any tax benefit associated with demolishing buildings and structures?  If not, perhaps it’s most economical to leave unused buildings and other improvements standing.

Tax issues associated with demolishing farm buildings and structures – it’s the topic of today’s post.

General Rules

Capitalize into land basis.  I.R.C. §280B provides that “in the case of the demolition of any structure…no deduction otherwise allowable under this chapter shall be allowed to the owner or lessee of such structure for any amount expended for such demolition, or any loss sustained on account of such demolition.”  Instead such amounts “shall be treated as properly chargeable to capital account with respect to the land on which the demolished structure was located.”  Thus, the amounts must be capitalized and added to the income tax basis of the land on which the building or structure was located.  Likewise, effective for tax years beginning after 1985, it became no longer possible to receive a tax deduction for the removal of trees, stumps and brush and for other expenses associated with the clearing of land to make it suitable for use in farming.  I.R.C. §182, repealed by Pub. L. 99-514, Sec. 402(a), 100 Stat. 2221 (1986).  Accordingly, the cost of removing trees and brush, capping wells and grading the land to make it suitable for farming cannot be presently deducted.  Instead, such costs are treated as development expenses (capital investment) that are added to the basis of the land. 

Use before demolishing.  If a farm building or structure is used in the taxpayer’s trade or business of farming for a period of time before being demolished, depreciation can be claimed for the period of business use.  Treas. Reg. §1.165-3.  Upon demolition, the remaining undepreciated basis of the building or structure would be added to the basis of the land along with the demolition costs.  In situations where the taxpayer purchased the property with the intent of demolishing the buildings and/or structures after using them in the taxpayer’s trade or business for a period of time, the fact that the taxpayer ultimately intended to demolish the buildings is taken into account in making an apportionment of basis between the land and the buildings under Treas. Reg. §1.167(a)-5.  Treas. Reg. §1.165-3.  In this situation, the amount allocated to the buildings/structures cannot exceed the present value of the right to receive rentals from the buildings/structures over the period of their intended use.  Id. 

Abandonment.  If the buildings and structures are simply abandoned, any remaining basis is treated as a disposition or a sale at a zero price.  That means that the remaining income tax basis becomes an ordinary loss that is reported on Form 4797.  If the abandoned buildings and structures are eventually demolished at least one year after the taxpayer ceased using them in the farm business, they have no remaining basis and only the cost of demolition would be added to the land’s basis. 

Demolition After Casualty 

As noted above, the inland hurricane that pelted parts of Iowa and Illinois with sustained winds near 100 miles-per-hour that ultimately traveled nearly 800 miles in 14 hours, created significant damage to farm structures.  When a casualty event such as this occurs, the normal capitalization rule of I.R.C. §280B does not apply when a structure that is damaged by the casualty is demolished. In Notice 90-21, 1990-1 C.B. 332, the IRS said that the capitalization rule does not apply to “amounts expended for the demolition of a structure damaged or destroyed by casualty, and to any loss sustained on account of such demolition.”  Instead, the income tax basis of the structure is reduced by the deductible casualty loss before the “loss sustained on account of” the demolition is determined.  That means for a farm building or structure destroyed in the recent inland hurricane, for example, the income tax basis in the building or structure at the time of the casualty would be deductible as a casualty loss but the cost of cleaning up the mess left behind would be capitalized into the land’s basis.  In essence, the loss sustained before demolition is not treated as being sustained “on account of” the demolition with the result that the loss isn’t disallowed by I.R.C. §280B.  It’s an “abnormal” retirement caused by the “unexpected and extraordinary obsolescence of the building.”  See, e.g., DeCou v. Comr., 103 T.C. 80 (1994); FSA 200029054 (May 23, 2000); Treas. Reg. §1.167(a)-8(a).  Conversely, if a taxpayer incurs a loss to a building or structure and decides to withdraw a building or structure from use in the trade or business and then demolish it in a later year with no tax event occurring in the interim, the demolition costs are subject to the disallowance rule of I.R.C. §280BSee, e.g., Gates v. United States, 168 F.3d 478 (3d Cir. 19998), aff’g., 81 AFTR 2d 98-1622 (M.D. Pa. 1998).  In that situation, the taxpayer might be able to claim a casualty loss for the year in which the loss occurred (consistent with the casualty loss rules in place at the time), and if the structure is later demolished the structure’s basis must be reduced by the casualty loss that was allowed by I.R.C. §165 before the nondeductible loss sustained on account of the demolition can be determined.  Notice 90-21, 1990-1 C.B. 332.

Tangible Property Regulations

In late 2013, the IRS released final regulations providing rules regarding the treatment of materials and supplies and the capitalization of expenditures for acquiring, maintaining, or improving tangible property (the final repair regulations).  T.D. 9636 (Sept. 13, 2013).  About a year later, the IRS issued final regulations on dispositions of tangible property, including rules for general asset accounts (GAAs) (the final disposition regulations).  T.D. 9689 (Aug. 14, 2014). These regulations are generally effective for tax years beginning on or after Jan. 1, 2014. Under the regulations, a taxpayer generally must capitalize amounts paid to acquire, produce, or improve tangible property, but can expense items with a small dollar cost or short useful life. The regulations also provide a de minimis safe harbor that can be elected on a yearly basis to expense all items under a certain dollar cost.  The repair regulations also contain specific rules for determining whether an expenditure qualifies as an improvement or a betterment (essentially following established caselaw) and provide a safe harbor for amounts paid for routine property maintenance.  There is also an election that can be made to capitalize certain otherwise deductible expenses for tax purposes if they are capitalized for book purposes.

The repair/disposition regulations provide a potential opportunity for a taxpayer to continue depreciating a building/structure after demolition has occurred.  Under the regulations, a taxpayer doesn’t have to terminate a GAA upon the disposition of a building/structure.  Thus, the taxpayer that has included buildings and structures in a GAA may choose whether to continue to depreciate them when they are disposed of (e.g., demolished) or capitalize the adjusted basis into the land under I.R.C. §280B

The adjusted basis of any asset in a GAA that is disposed of is zero immediately before its disposition.  The basis associated with such an asset remains in the GAA where it will continue to depreciate.  See Treas. Reg. §§1.168(i)-1(e)(2)(i) and (iii).  Consequently, the basis of a demolished building/structure where the cost of the demolition would be subject to capitalization under I.R.C. §280B is zero and the taxpayer can continue to depreciate the basis in the GAA.  But, if only one demolished building/structure is in a GAA and the taxpayer elects to terminate the GAA, the adjusted basis of the building/structure would, in effect, be capitalized in under I.R.C. §280B.  Likewise, the strategy doesn’t apply if the building or structure is acquired in the same year that it is demolished or if the taxpayer intended to demolish the building/structure at the time it was acquired.  See Treas. Reg. §§1.168(i)-(c)(1)(i); 1.168(i)-1(e)(3)(vii). 

The opportunity to use the technique is further limited by a requirement that the taxpayer must have elected to include the building in a General Asset Account (GAA) in the year the taxpayer placed the building/structure in service and is in compliance with the GAA rules.  The election must have been made on an original return. 

Conclusion

The inland hurricane of August 10 wreaked havoc on a great deal of agricultural assets that were in its path.  The tax rules surrounding the disposition of disaffected assets is important to understand.

August 12, 2020 in Income Tax | Permalink | Comments (0)

Monday, August 10, 2020

Exotic Game Activities and the Tax Code

Overview

Wild game “farms” are big business in the United States.  In Texas alone, in excess of four million acres are devoted to wild game farming activities.  Interest continues to grow in such activities such as the raising of captive deer, for example, often as a result of the possibility of greater profitability on fewer acres than is presently possible with raising cattle. But, how does the IRS view such activities?  Is it a “farm” for purposes of tax Code provisions that provide special tax status to “farm” businesses?

The tax treatment of wild game activities – it’s the topic of today’s post.

Definition of “Farming”

I.R.C. § 464(e) broadly defines “farming” to include the feeding, caring for and management of animals.  In addition, Treas. Reg. §1.61–4(d) defines “farm” as including stock farms and ranches owned and operated by a corporation.  For purposes of the deduction for soil and water conservation expenses, I.R.C. §175(c)(2) defines “land used in farming” to include land used for the sustenance of livestock.  Under the uniform capitalization rules, the term “farming business” includes a trade or business involving the raising, feeding, caring for, and management of animals. Treas. Reg. §1.263A–4T(c)(4)(i)(A).  For purposes of ag labor I.R.C. §3121(g)(1) includes within the meaning of “agricultural labor,” service connected with raising wildlife. Taken together, these provisions are broad enough to classify the raising of exotic and wild game as a farm.  Likewise, the tax Code defines an exotic game rancher as a “farmer.”  Work on an exotic game ranch meets the definition as agricultural labor.

1996 IRS Technical Advice

In Tech. Adv. Memo. 9615001 (Oct. 17, 1995) involved a taxpayer (an S corporation) that maintained a hunting property where deer were raised and managed for ultimate “harvest” by hunters who paid to come onto the property to hunt.  It was a “trophy deer” operation.  The taxpayer operated the activity such that each animal attained a body weight and antler size far exceeding that occurring naturally among deer of the same species.  The deer were enclosed behind a game fence and all native deer on the enclosed property were then hunted and killed.  The taxpayer bought whitetail deer from various locations in the United States, and brought them to the property where they were tagged, medically examined and treated as necessary.  The deer were then released into the enclosed property.  The taxpayer hired a genetic and nutritional consultant to help assure the economic success of the activity and to structure it as a research project to that it was in compliance with state law.  The state exercised substantial control over the activity, deeming the deer to be the state’s natural resources that could only be harvested by hunting.  The taxpayer culled the deer herd with hunts by paying hunters.  The taxpayer sought a private letter ruling which addressed the question of whether the taxpayer was a “farmer” operating a “farm for profit.” 

The IRS, in answering that question, noted that Treas. Reg. §1.162-12 does not define the terms “farmer,” “farms” or the “business of farming.”  But, the IRS referenced the Code sections discussed above and that I.R.C. §1231 property (characterizing gain or loss realized on the disposition of certain business property) includes livestock held by the taxpayer for draft, dairy or sporting purposes.  I.R.C. §1231(b)(3).  That’s virtually any mammal held for breeding or sporting purposes.    

Also, the IRS noted that Treas. Reg. §1.1231-2(a)(3) provides that for purposes of I.R.C. §1231, the term “livestock” is given a broad, rather than a narrow, interpretation and includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.  It does not include poultry, chickens, turkeys, geese, pigeons, other birds, fish, frogs, reptiles, etc.  When defining the term “gross income of farmers” the term “farm” includes stock, dairy, poultry, fruit and truck farms, as well as plantations, ranches and all other land used for farming operations.  Treas. Reg. 1.61-4(d).  The IRS also pointed out that “agricultural labor” includes services in connection with raising wildlife.  I.R.C. §3121(g)(1). 

Thus, the Code and Regulations broadly classified deer as “livestock,” a deer ranch as a “farm,” a deer rancher as a “farmer” and work on a deer ranch as agricultural labor.  Likewise, the taxpayer’s activities involving the importing, breeding, raising, feeding, protecting and harvesting the captive deer involved the operation of a farm by a farmer similar to the production of more conventional livestock such as cattle and hogs.  The Code makes no distinction as to the type of livestock or the method of harvest.  What is key are the activities the taxpayer engaged in to produce stock of marketable size and quantity.    

Thus, the IRS concluded that the taxpayer was engaged in the business of farming for purposes of Treas. Reg. §1.162-12 (deducting from gross income all amounts expended in carrying on the business of farming) if the activities were engaged in for profit. 

Depreciation

What is the appropriate depreciable recovery period of exotic game animals, including domesticated deer under the Modified Accelerated Cost Recovery System (MACRS)?  Under MACRS, cattle, sheep and goats have a five-year recovery period. Rev. Proc. 87-56, 1987-2 C.B. 647.  Breeding hogs are three-year property.  Id.  Under Rev. Proc. 87-56, 1987-2 C.B. 647, any property that is not described in an asset class or used in a described activity defaults to the seven-year classification under MACRS (12 years for alternative MACRS).  Rev. Proc. 87-56, 1987-2 C.B. 647 does not mention exotic game animals, thus the animals would be classified as seven-year property.  But, as “farm animals” and, thus, a depreciable asset used in farming, a plausible argument can be made that while they would have a recovery period of seven years, their alternative live would be ten years (rather than twelve).  Also, because there is no requirement for depreciation purposes that animals be domesticated, an argument could also be made that a five-year recovery period applies for certain types of exotic sheep and goats.  Indeed, perhaps all ruminant exotic game animals could be classified as five-year MACRS property on the basis that the livestock species in the five-year category are ruminant animals – cattle, sheep and goats.  Hogs and horses, non-ruminant animals, have different recovery periods than cattle, sheep and goats. 

Because the activity is classified as a farming activity, the fencing used in exotic game (including captive deer) activities would be an agricultural asset and classified as seven-year MACRS property.  In addition, as livestock that are tangible personal property, the game animals would qualify for expense method depreciation.  I.R.C. §179.  The same is true for qualifying costs of game fences and catch pens. 

Unanswered Question

A question that the TAM lest unanswered is whether the hunters’ activity would meet the definition of “hunting” for tax purposes.  That could have implications for the meal and entertainment rules as well as deducting travel and lodging costs. 

Conclusion

With the increase in non-traditional uses of agricultural land, the questions of whether the use of the land is a “farming activity” and the assets involved are “farming” assets has become an important question. 

August 10, 2020 in Income Tax | Permalink | Comments (0)

Wednesday, August 5, 2020

The Use of the LLC For the Farm or Ranch Business – Practical Application

Overview

Last week I wrote a two-part series on how the single-member LLC can be utilized as part of a farming or ranching business.  A large part of my focus was on the single-member LLC and what it means to be a disregarded entity.  In part two, I noted that the Tax Court has held that while a single-member LLC is a disregarded entity for federal income tax purposes, it is respected for federal estate and gift tax purposes.  As a result, valuation discounts can be available to decrease the taxable value of the owner’s interest in the single-member LLC.

In today’s post, guest author Marc Vianello, of Vianello Forensic Consulting, provides a practical application of the concepts that I discussed last week.  Many thanks to Marc for today’s article.

Single-Member LLCs – Valuation Implications

Assume that Broad Horizon Family Farms is a Kansas farming/ranching family comprised of a father, mother, son, and daughter.  The farm/ranch is operated as a unified business under the ownership of a four-partner general partnership.  As an unincorporated entity, this structure allows for four payment limitations for federal farm program payment purposes.  The partners of the partnership are four Kansas LLCs that each own an equal 25 percent interest in the partnership—no partner has control, and no family member is a partner. 

Also assume that father, mother, son, and daughter each own 100 percent of one of the four LLCs.  Each family member, therefore, owns a 100 percent interest in an LLC that owns a 25 percent interest in the partnership.  Assuming that the partnership agreement does not limit the partners’ LLC transfer rights, how does this play out for valuation purposes?

To answer that question, we need to know what the partnership owns; its expected future cash flows; and a valuation date.  For purposes of the example, assume that the valuation date is June 30, 2020, and that Broad Horizon Family Farms has the following assets and liabilities:

  • 2,000 acres of farm and ranch land with a real estate valuation of $8,000,000;
  • 200 cow/calf pairs with an auction value of $300,000;
  • $1,000,000 fair market value of equipment;
  • $700,000 of harvested grains and in on-farm storage priced at current commodity prices;
  • Cash on hand of $150,000.
  • Land debt of $3,050,000, with interest accruing at the annual rate of 6.75 percent We will assume that the partner LLCs and their individual owners have guaranteed the debt.

These assumptions result in the following partnership balance sheet stated at fair market value (not cost), and a capital structure that is approximately 30 percent debt and 70 percent equity without regard to built-in gains taxes, and  38.1 percent debt, 61.9 percent equity after deducting the taxes:

 

 Appraised Value

 Tax Basis

 Tax Rate

 After-Tax Value

 Cash

$   150,000

 n/a

 n/a

$   150,000

 Commodities

             700,000

                      -

40%

       420,000

 Cattle

              300,000

                      -

20%

      240,000

 Equipment

          1,000,000

                      -

40%

       600,000

 Land

    8,000,000

     1,000,000

20%

   6,600,000

 Total assets

$10,150,000

   

$8,010,000

         

 Debt (6.75% rate)

 3,050,000

   

       3,050,000

 Partnership equity

  7,100,000

 

  _4,960,000

 Total debt and equity

$10,150,000

   

 $8,010,000

On an asset basis, the Partnership equity might have an asset based “as if marketable” value of $4,960,000 as an operational whole, or $1,240,000 per LLC partner.  But that is not the fair market value of the LLC partner’s interest in the Partnership, because a hypothetical buyer would be buying into a partnership of which 75% ownership is held be family-related parties.  Accordingly, a minority discount is appropriate.  Let’s assume a 15 percent discount in this case, resulting in a minority discounted value of $1,054,000 per 25 percent Partnership interest.      

Now let’s make some assumptions regarding the annual operations of the Partnership.  For this discussion, we will make the simplifying assumption of constant results subject to inflationary growth of 1.25 percent annually:

  • Because the partnership is comprised of four equal partners, assume that there are no perquisites of control in the manner of operation and the handling of distributions. The projected operations are assumed to continue in all respects as in the past.
  • Father, mother, son, and daughter provide all of the labor, and work 50 hours weekly. The LLCs receive periodic distributions equal to 75 percent of book net income.  These payments total $554,344 annually ($138,586 to each partner LLC).  Let’s also assume that the LLC partners flow the payments directly through to their owners, that is, to father, mother, son, and daughter. 
  • Valuation requires that the fair market value of the work being performed by related parties be determined. Accordingly, we will assume that the labor provided by father, mother, son, and daughter could be replaced with a three-employee independent work force at an average hourly rate of $20, with each employee working a 50-hour week.  Note that the allocation of wages in the valuation scenario would not be equal; some higher paid person would be the manager, and the lowest paid worker may receive just minimum wage.  The independent work force payroll on a 50-hour week would be $156,000.
  • The farm/ranch generates $1,500,000 of annual gross revenues, which is $750 per acre.
  • Annual crop inputs are $300,000.
  • Annual animal care costs are $95,000
  • Annual other operating expenses are $160,000.
  • Annual interest of $205,875 (6.75 percent) is paid on the $3,050,000 of debt.
  • Net capital expenditures equal to 25% of book net income are incurred. This represents net capital costs of $184,781 annually, for which Section 179 deductions are assumed to be taken.
  • A 40 percent effective income tax rate is assumed to impute taxes to the Partnership. This is necessary to equate the Partnership’s income to that of a C corporation, because the cost of equity capital valuation metrics derive from publicly traded C corporations.
  • A 20 percent tax rate is assumed to calculate the effect of dividend tax avoidance by the flow through tax nature of the Partnership compared to the non-flow through nature of C corporations from which the cost of equity capital valuation metrics are derived.

These assumptions result in the below operating results.  The “adjusted” column is used for further valuation analysis.

 

 Operating Results

 

 Unadjusted

 Adjusted

     

 Gross revenues

$1,500,000

$1,500,000

     

 Wages

-

156,000

 Crop inputs

 300,000

300,000

 Animal care costs

95,000

95,000

 Other operating expenses

    160,000

    160,000

 Total operating expenses

    555,000

    711,000

     

 Operating profit

945,000

789,000

 Interest expense

   (205,875)

          0

 Book net income

739,125

 

 Net capital expenditures

(184,781)

(184,781)

 Distributions to the LLCs

   (554,344)

                  -

 Net cash flow from operations

$                -  

 604,219

 Imputed income taxes at 40%

 

   (241,688)

 Imputed after-tax cash flow to capital

 

$   362,531

If an 18 percent cost of equity is assumed as well as a forty percent tax deduction benefit for interest expense, the assumed 38.1 percent/61.9 percent debt/equity capital structure results in a weighted average cost of capital (“WACC”) of 12.688 percent.  The assumed growth rate of 1.25 percent therefore results in a capitalization rate of 11.438 percent.  Thus, we calculate a capitalized value of $3,169,478.  But because the partnership is a flow through entity, it is necessary to make another adjustment to equate it to the financial effects of a C corporation.  Assuming a 20 percent qualified dividend tax rate, the value of the avoided shareholder dividend taxes is $792,369.  Accordingly, the partnership equity might have cash flow based “as if marketable” value of $3,961,847 as an operational whole - $990,462 per 25 percent Partnership interest.  No discount for minority interest applies to this calculation. 

Imputed after-tax cash flow to capital

 

 $   362,531

 Assumed capitalization rate

 

11.438%

 Capitalized value

 

     3,169,478

 Adjustment for avoided shareholder dividend taxes

     792,369

 "As if marketable" value based on cash flow

 

$3,961,847

Valuation professionals must reconcile the “as if marketable” values of their different approaches.  It is often concluded that the value is not less than the amount that could be realized based on liquidation, but a 25 percent partner would not be able to compel liquidation.  Thus, the common conclusion is that the “as if marketable” value of a 25 percent partnership interest is $990,462 based on the partnership’s cash flow.  But this is not fair market value.  The valuation metrics derive from C corporations whose shares are traded in the public markets—they are liquid, while the 25% partnership interests held by the LLCs are not—they are illiquid.  Accordingly, a discount for lack of marketability (“DLOM”) must be subtracted from the “as if marketable” value to arrive at fair market value. 

Practitioners use a variety of tools to estimate DLOMs.  The most simplistic approaches use the average of various small published studies of the discounts reflected in the prices of (1) restricted stocks compared to their publicly traded versions; and (2) stocks sold before completion of an initial public offering (“IPO”) to their IPO prices.  Through 1988, these restricted studies a range of 30-35 percent.  The implied discounts trended downward thereafter with changes in SEC Rule 144.  The pre-IPO studies suggested larger discounts in the 40-45 percent range.  Larger databases of restricted stock and pre-IPO transactions now exist, and are used by many practitioners to estimate DLOM.  Nevertheless, relying on restricted stock and/or pre-IPO transactions for DLOM estimate is problematic and may be unreliable.  To support this see Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Chapters 3-5 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.

An alternative method of estimating an appropriate DLOM uses the VFC DLOM Calculator, which couples the time and price risks associated with marketing privately held securities to various option pricing formulae.  Unlike other methodologies, the VFC DLOM Calculator is a date specific, facts and circumstances tool supported by empirical research.  The formula most appropriate for DLOM estimation is the VFC Longstaff formula.  You can find the VFC DLOM Calculator and its supporting empirical research at https://dlomcalculator.com/

Using the partnership’s characteristics (an SIC Code range of 0100 to 0299; Asking Price of $2,000,000 to $4,000,000; 4 Employees; Annual Revenues of $1,000,000 to $2,000,000), a reasonable conclusion is that the average marketing time required by an LLC partner to sell its interest in the Partnership is 232 days, with a standard deviation of 197 days.  This compares to an average of 123 days to obtain SEC approval for a public offering by a large business in the 0000 to 0999 SIC Codes.  See Vianello, Empirical Research Regarding Discounts for Lack of Marketability, Table 1.1 (July 2019).  Available at https://dlomcalculator.com/wp-content/uploads/2019/07/Empirical-Research-Regarding-DLOM-with-Guide.pdf.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average marketing period is between 226 and 239 days based on these statistics.

Using a selection of four publicly traded classified as “Agriculture Production – Crops” (SIC Code 0100) and “Agriculture Production – Livestock & Animal Specialties” (SIC Code 0200), the VFC DLOM Calculator tells us that the long-term average price volatility of the companies’ stocks is 38.1 percent, with a standard deviation of 59.0 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 37.3 percent and 39.0 percent using the complete set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 22.3 percent.

But there has recently been increased price volatility in the stock market because of coronavirus uncertainty.  Looking only at the 90 trading days before June 30, 2020, the VFC DLOM Calculator tells us that the average price volatility was 70.2 percent, with a standard deviation of 76.9 percent.  The VFC DLOM Calculator informs us that we can be 95 percent confident that the average price volatility is between 62.2 percent and 78.1 percent using the more current set of price data.  Using this data and the above marketing period parameters, results in a risk-adjusted DLOM estimate of 40.3 percent.  The VFC DLOM Calculator informs us that we can be 95 percent certain that the appropriate DLOM based on the more current price data is between 35.0 percent and 45.7 percent. The economic circumstances prevailing as of June 30, 2020, counsel to this higher DLOM estimate.

Using a 40.3 percent DLOM, we might conclude that the fair market value of a 25 percent interest in the partnership held by the partner LLC is $591,306 ($990,462 x (1-.403))

 However, the family members don’t own interests in the partnership.  They instead own 100 percent interests in their respective LLCs.  What is the fair market value of these LLCs?  It’s something less than $591,306, because the LLC, too, is subject to a lack of marketability.  Additional professional consideration must be given to developing the appropriate DLOM.  For example, it may be a discount more associated with financial portfolio risks than with agriculture risks.

Conclusion

This use of the single-member LLC can be a valuable aspect of an intergenerational transfer of the farming or ranching business.  Coupled with a general partnership farming entity, the single-member LLC can also optimize receipt of federal farm program payment limitations.  Further structuring of the management form of the LLC can also bring additional income and self-employment tax savings. 

August 5, 2020 in Business Planning | Permalink | Comments (0)

Friday, July 31, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part Two)

Overview

In Part One earlier this week, I focused on the use of a single-member limited liability company (LLC) as part of the estate/business/succession plan for the farming and ranching operation.  As noted in Part One, a single-member LLC is often used to hold general partner interests in the farming general partnership so that federal farm program payments can be maximized and achieve liability protection.  Also, noted in Part One was that a single-member LLC can be a “disregarded entity.”  That means that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability.

For a single-member LLC that is a disregarded entity, what does the single-member of the LLC own?  Is it the interest in the LLC or the underlying asset(s) of the LLC?  If the entity is respected as an entity separate from its owner, can valuation discounts for the owner’s interest in the entity be achieved for federal estate and gift tax purposes?  If so, that’s a big planning (and tax saving) opportunity.

How a single-member LLC as a disregarded entity is treated for federal estate and tax purposes – it’s the topic of today’s post.

Valuation Concepts – In General

The answer to the question of what an owner of a single-member LLC owns makes a difference as far as the valuation of the interest owned is concerned because of the possible effect of valuation discounts.  Those discounts are for lack of control and minority interest.  With a single-member LLC, there is no discount for lack of control – the single-owner has full control.  But, as a privately held business, a discount for lack of marketability might be available if the LLC is respected as an entity. 

The value of an asset for federal gift and estate tax purposes is “fair market value.”  That’s defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.” Treas. Reg. §§20.2031-1(b); 25.2512-1; Rev. Rul. 59-60, 1959-1 C.B. 237.  State law controls the determination of what has been transferred in the valuation process. 

Under the “check-the-box” regulations, a business entity that is not classified as a corporation is a “domestic eligible entity” and, without an election, is “[d]isregarded as an entity separate from its owner if it has a single owner.”  Treas. Reg. §301.7701-3(b)(1)(ii).  Under Treas. Reg. §301.7701-1(a) and 301.7701-2(c)(2), an entity with a single member is disregarded as an entity separate from its owner “for federal tax purposes.”  That definition raises two questions: 1) What does “for federal tax purposes” mean?  Does it mean federal income as well as federal transfer (estate and gift) taxes?; and 2) does it bar the use of the “willing buyer/willing seller” valuation rule?   In 2004, the IRS shed some light on the first  question when it ruled that although a disregarded entity is not recognized for federal income tax purposes, the entity exists under state law and state law controls the owner’s rights and economic interests.  Rev. Rul. 2004-88, 2004-2 C.B. 165.  In 2009, the full Tax Court answered both questions and defined the interest owned by a single-member LLC owner.

The Pierre Case

In Pierre v. Comr., 133 T.C. 24 (2009), the petitioner received a $10 million gift in 2000.  Later that year, she created a single-member LLC in accordance with New York law and transferred cash and marketable securities to it worth about $4.25 million.  She held 100% ownership of the LLC and did not file an election with Form 8823 to be treated as an association taxable as a corporation.  Thus, the LLC was a disregarded entity.  Twelve days after funding the LLC, the petitioner transferred her entire interest in the LLC to trusts established for the benefit of her son and granddaughter.  She accomplished that by gifting a 9.5 percent interest in the LLC to each trust and then by selling a 40.5 percent interest in the LLC to each trust in exchange for promissory notes with a face amount of slightly over $1 million each.  In valuing the transfers for gift tax purposes, her valuation expert applied a 30 percent discount to the value of the LLC’s underlying assets (which turned out to be 36.5% for gift tax purposes due to an error in valuing the underlying assets).  The petitioner filed a federal gift tax return (Form 709) reporting the taxable value of the gift to each trust in accordance with the valuation expert’s report.  The IRS issued a notice of deficiency on the basis that the gifts should have been treated as gifts of proportionate shares of the LLC’s assets rather than transfers of interests in the LLC.  As such, as 100% owner of the LLC’s assets, no discount was appropriate.  The IRS took the position that the entity was the check-the-box regulations meant that the LLC was to be disregarded as an entity separate from the petitioner – they were one in the same. 

The petitioner claimed that NY state property law governed for transfer tax purposes rather than federal tax law.  Under NY law, the LLC was not to be disregarded.  Rather, upon the LLC’s formation, NY law created an interest in the LLC that was distinguishable from the petitioner.  The LLC became the petitioner’s personal property that held legal title to the assets that the entity contained.  Indeed, the NY LLC statute stated that, “A member has no interest in the specific property of the limited liability company.”  N.Y. Limited Liability Company Law Section 601

The full Tax Court, in a 10-6 decision, agreed with the petitioner and determined that “for federal tax purposes” was limited to federal income tax and that the petitioner owned an interest in the LLC rather than the underlying assets of the LLC.  As such, the willing buyer/willing seller valuation test applied to valuing the transferred interests which could then carry out any applicable valuation discounts.  The Tax Court pointed out that “state law defines and federal tax law determines the tax treatment of property rights and interests.”  See also Morgan v. Comr., 309 U.S. 78 (1940); United States v. National Bank of Commerce, 472 U.S. 713 (1985); Knight v. Comr., 115 T.C. 506 (2000).  The Tax Court also concluded that the check-the-box regulations don’t define property interests.  Instead, they merely allow the election of specific tax treatment for federal tax purposes, and that the Congress did not specifically disallow valuation discounts in the context of single-member LLCs – they aren’t listed in I.R.C. §§2701-2704 along with other transactions that can’t claim valuation discounts.  Thus, the petitioner’s gift tax liability was to be determined by the value of the transferred LLC interests rather than by a hypothetical transfer of the underlying assets of the LLC. 

In a second Tax Court opinion in the case, the Tax Court noted that the petitioner made the gifts and sales on the same day.  Pierre v. Comr., T.C. Memo. 2010-106.  Thus, the court treated them as a single part-gift/part-sale transaction.  That had the effect of reducing the lack of control discount slightly (from a claimed 35 percent to 30 percent) because the combined 50% gift/sale to each transferee could block the appointment of a new manager under the LLC operating agreement.  The petitioner also couldn’t come up with any non-tax reasons for separating the transfers into gifts and sales. 

Conclusion

The Pierre case is important because, as full Tax Court opinion, it provides strong support for the proposition that the asset to be valued for transfer tax purposes is the LLC interest and not the property that the LLC holds.  Planning and valuation opportunities are possible based on that notion.  A single-member LLC holding a farmer’s general partnership interest in a farming operation can be structured to obtain valuation discounts when the interest is gifted to a member of the subsequent generation as well as at death.  That makes the cost of intergenerational transfers of farming interests less which will be even more important if the federal estate and gift tax exemption level declines from its present level.

In a post next week, the concepts discussed in this two-part series will be applied to a family farm operation engaged in an intergenerational transfer.

July 31, 2020 in Business Planning | Permalink | Comments (1)

Monday, July 27, 2020

Estate and Business Planning for the Farm and Ranch Family – Use of the LLC (Part 1)

Overview

In the family business planning context for a farm and ranch, the key to success is for the senior generation to clearly express goals.  Doing so assists the planning team in using entities and associated tax planning techniques to satisfy those goals.  For business transition/succession purposes, the use of the limited liability company (LLC) is one entity structure that can work in the right situation and with the right set of facts. 

Often, in agriculture, the entity that conducts the farming operations is established as a general partnership with each partner having his own single-member LLC.  This is done in order to optimize (under most farm programs) the receipt of payment limitations.  The general partnership doesn’t limit liability, but it also doesn’t limit at the entity level the number of “person” determinations for payment limitation purposes.  Limited liability for each partner is achieved via the use of the single-member LLC to hold the partnership interest.

A single-member LLC can also be a “disregarded” entity?  What does that mean?  Is the entity simply disregarded for tax purposes, or is the entity respected in ways that make a big difference from a tax and estate planning perspective?  How does it all fit together for a farming operation? 

Utilizing an LLC as part of farm/ranch business succession – it’s the topic of today’s post – Part One of a two-part series.

Business/Succession Planning Goals

I have worked with farm families on estate and business succession plans for almost 30 years.  Each situation is unique.  There is no “one size fits all.”  However, I can make an observation concerning what are typical goals of the farm or ranch family, at least from the senior generation’s perspective.  The senior generation typically wants to retain control of the operation for as long as possible.  But, along with that goal of retaining control is often the desire to transfer equity ownership in the operational entity to other family members.  Any transfer is often required to be with restrictions that bar transfer outside the family.  Limited liability is commonly desired, as is flexibility in any entity form to deal with changes in the family structure and the tax landscape.  Also, it is a common desire to minimize taxation both upon entity formation and throughout the future; maximize government payments; and create the potential for valuation discounts – both for gifted interests and for the interests retained by the parents at death.

An LLC – What is it?

An LLC is an S corporation with fewer eligibility requirements and more flexibility with regards to the capital structure.  When an LLC is taxed as a partnership, it can be more advantageous than an S corporation – debt can be included in member basis; there is more flexibility given to multiple classes of interest; and distributions are more tax advantageous.  As compared to a limited partnership, LLC members can participate in management without losing the feature of limited liability.  Thus, an LLC basically blends the advantages of both the corporate and partnership form of business.  It has the advantage of a flow-through entity with the structure of a corporation.  An LLC’s management can either be conducted by all of the members acting together or by managers that the members select.  The members can choose the management structure desired, and multiple classes of ownership are allowed.  If the LLC is classified as a partnership or sole proprietorship for tax purposes, the entity is not taxed on business income.  All items of income, loss, deduction and credit are passed through to the member(s) and taxed at the member’s individual ratesI.R.C. 704(a). 

What Does It Mean To Be a “Disregarded” Entity?

While it takes at least one member for an LLC to be formed there is no limitation on the number of members – unlike an S corporation which is limited to 100 shareholders.  I.R.C. §1361(b)(1)(A). Under what are known as the “check-the-box” regulations,” an LLC with only one member can elect to be treated for tax purposes an association taxable as a corporation or as an entity disregarded as an entity separate from its owner.  Regs. Secs. 301.7701-1, et seq.  If no election is made on Form 8832, the default rule is that the entity is disregarded as an entity separate from its owner if the owner does not have limited liability. 

A single-member LLC is a separate entity from its owner, except when it comes to taxes.  That is a distinguishing feature from a sole proprietorship, and it protects the owner from debts and liabilities of the business.  But, both a single-member LLC and a sole proprietorship file a Schedule F (or C for non-farm businesses) to report business income and deductions.  The amounts on the Schedule are then included with the owner’s individual income tax return. 

That raises a question – for tax purposes, what does the single-member of the LLC own?  Is it an interest in the LLC or the underlying asset(s) of the LLC?  Why might that matter?

Guaranteeing debt.  Insight into precisely what a single-member LLC owner owns can be gleaned from IRS guidance on the handling of debt in a single-member LLC.  Under the “at-risk” rules of I.R.C. §465, a loss from an activity to which the rules apply are disallowed unless the taxpayer is “at risk” with respect to the activity.  A taxpayer is “at risk” with respect to an activity to the extent that the taxpayer contributes money or basis or borrows funds that are contributed to the activity, but only to the extent that the taxpayer is personally liable for repayment or to the extent of the value of collateral pledged to secure the borrowed funds.  I.R.C. §§465(b)(1)-(2).  But, what if the member of a single-member LLC that is a disregarded entity guarantees the debt?  Does that count as being “at risk” in the entity’s activity?  The Code doesn’t address the issue. The answer to that question turns on what the single member actually owns. 

In CCA 201308028 (Nov. 14, 2012), the taxpayer was the sole owner of an LLC that was treated as a disregarded entity.  The LLC owned a second LLC that was also treated as a disregarded entity.  The second LLC borrowed funds for use in its business activity.  The taxpayer, the first LLC and two S corporations that the taxpayer wholly owned guaranteed the debt.  The taxpayer also provided the lender with a commercial guarantee for the full loan amount.  The taxpayer unconditionally guaranteed the full prepayment of the loan but did not waive subrogation or reimbursement rights against the second LLC or the right of contribution from the first LLC and the two S corporations.  The IRS, following the approach of the Second, Eighth and Eleventh Circuits, determined that the taxpayer would be ultimately liable as the payor of last resort and not protected against loss and, therefore, would be “at risk” if the taxpayer did not have a right of contribution from the other co-guarantors. See  Waters v. Commissioner, 978 F.2d 1310 (2d Cir. 1992), cert. denied, 507 U.S. 1018 (1993); Young v. Commissioner, 926 F.2d 1083 (11th Cir. 1991); Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990).  It’s an “economic realities” test.  That rationale applies when a taxpayer guarantees debt of an LLC that is taxed either as a partnership or as a disregarded entity. 

The IRS followed up the CCA with A.M. 2014-3 (Aug. 27, 2013) where the IRS concluded that an LLC member that guarantees the LLC’s debt is at risk for purposes of I.R.C. §465 in the situation where the LLC is treated as a partnership or a disregarded entity.  The IRS said that a member’s guarantee of qualified non-recourse (debt whose satisfaction may be obtained on default only out of the particular collateral given and not out of the debtor's other assets) financing of an LLC increased the member’s amount at risk to the extent of the guarantee. 

With this IRS guidance in mind, transactions involving debt guarantees have more certainty.  That means that planners can structure deals in accordance with the economics of the particular situation and lender requirements. The guidance also supports the notion that a member of an LLC that is treated as a disregarded entity owns an interest in the entity rather than the underlying assets in the entity.  The entity is respected for tax purposes. 

Employment tax.  A disregarded entity is treated as a corporation for employment tax purposes.  Treas. Reg. §301.7701-2(c)(2).  Thus, the entity is responsible for paying employment taxes and any excise taxes that apply.  Consequently, a single-member LLC must have an EIN and a bank account in its name.  Self-employment tax also applies.  If a partnership owns a disregarded entity, the partners are treated as self-employed.  They are not employees of the disregarded entity.  REG-114307-15, 81 F.R. 26763 (May 4, 2016), 2016 I.R.B. 1006. 

Identification of the entity.  The IRS can require the owner of a disregarded entity to report the entity’s employer identification number (EIN) on the taxpayer’s individual return.  I.R.C. §§6011(b); 6109(b); PMTA 2016-08.  The basic requirement is that there must be sufficient information on the return so that the taxpayer is properly identified.  Because an individual taxpayer that is a member of a single-member LLC has both a social security number and an EIN, listing both numbers on the taxpayer’s return could help the IRS to cross-reference the numbers and associate correct information and returns with the taxpayer.  Including both numbers does not invalidate the return and could avoid confusion on the IRS part. 

Conclusion

In Part Two, I will explore how a single-member LLC as a disregarded entity is treated for federal estate and gift tax purposes.  If a single-member LLC is a respected entity separate from its owner, perhaps valuation discounts for entity interests can apply.  Again, the outcome of the issue turns on what the owner of the single-member LLC actually owns. 

July 27, 2020 in Business Planning | Permalink | Comments (0)

Saturday, July 25, 2020

Recent Court Developments of Interest

Overview

The court decisions of relevance to agricultural producers, rural landowners and agribusinesses keep on coming.  There never seems to be a slack time.  Today’s article focuses on some key issues involving bankruptcy, business valuation, and insurance coverage for loss of a dairy herd due to stray voltage.  More ag law court developments – that’s the topic of today’s post.

 

Court Determines Interest Rate in Chapter 12 Case

In re Key Farms, Inc., No. 19-02949-WLH12, 2020 Bankr. LEXIS 1642 (Bankr. D. Wash. Jun. 23, 2020)

 The bankrupt debtor in this case is a family farming operation engaged in apple, cherry, alfalfa, seed corn and other crop production. The parents of the family own 100 percent of the debtor. In 2014, the debtor changed its primary lender which extended a line of credit to the debtor that the father personally guaranteed and a term loan to the debtor that the father also personally guaranteed. The lender held a first-priority security interest in various real and personal property to secure loan repayment. The debtor became unable to repay the line of credit and the default caused defaults on the term loan and the guarantees. The lender sued to foreclose on its collateral and have a receiver appointed.

The debtor filed Chapter 12 bankruptcy and proposed a reorganization plan where it would continue farming during 2020-2024 in accordance with proposed budgets. The plan provided for repayment of all creditors in full, and repayment of the lender over 20 years at a 4.5 percent interest rate (prime rate of 3.25 percent plus 1.25 percent). The lender opposed plan confirmation.

In determining whether the reorganization plan was fair and equitable to the lender based on the facts, the bankruptcy court noted the father’s lengthy experience in farming and familiarity with the business and that the farm manager was experienced and professional. The court also noted that parents had extensive experience with crop insurance and that they were committing unencumbered personal assets to the plan.  In addition, the court took note of the debtor’s recent shift to more profitable crops and a demonstrated ability to manage around cash flow difficulties, and that the lender would be “meaningfully oversecured.” The court also determined that the debtor’s farming budgets appeared to be based on reasonable assumptions and forecasted consistent annual profitability. However, the court did note that the debtor had a multi-year history of operating losses in recent years; was heavily reliant on crop insurance; was engaged in an inherently risky business subject to forces beyond the debtor’s control; had no permanent long-term leases in place for the considerable amount of acreage that it leased; could not anticipate how the Chinese Virus would impact the business into the future; and proposed a lengthy post-confirmation obligation to the lender.

Accordingly, the court made an upward adjustment to the debtor’s prosed additional 1.25 percent to the prime rate by increasing it by at least 1.75 percent. The court scheduled a conference with the parties to discuss how to proceed.

 

Valuation Discount Applies to Non-Voting Interests

Grieve v. Comr., T.C. Memo. 2020-28

The petitioner was the Chairman and CEO of a company. After his wife’s death, he established two limited liability companies, with a management company controlled by his daughter as the general partner in each entity holding a 0.2 percent controlling voting manger interest and a 99.8 percent nonvoting interest in each entity held by a family trust – a grantor retained annuity trust (GRAT). The petitioner gifted the 99.8 percent interest in the two entities and filed Form 709 to report the gifts. The IRS revised the reported value of the gifts and asserted a gift tax deficiency of about $4.4 million based on a theoretical game theory construct.

According to the IRS, a hypothetical seller of the 99.8 percent nonvoting interests in the two LLCs would not sell the interests at a large discount to the net asset value (NAV), but would seek to enter into a transaction to acquire the 0.2 percent controlling voting interest from the current owner of that interest in order to obtain 100 percent ownership and eliminate the loss in value as a result of lack of control and lack of marketability. In support of this, the IRS assumed that the owner of the 99.8 percent nonvoting interest would have to pay the controlling 0.2 percent voting member a premium above their undiscounted NAV. Under traditional methodology, the IRS expert estimated that a 28 percent discount to the NAV was appropriate for the 99.8 percent nonvoting units. But, instead of accepting that level of discount, the IRS proposed that the owner of the nonvoting units would pay a portion of the dollar amount of the discount from NAV to buy the remaining 0.2 percent voting interest.

The petitioner’s expert used a standard valuation methodology to prepare valuation appraisal reports. This expert applied a lack of control discount of 13.4 percent for the gift to the GRAT and a 12.7 percent lack of control discount for the gift to the irrevocable trust. The valuation firm also applied a 25 percent discount for both gifts.

The Tax Court determined that the IRS failed to provide enough evidence for its valuation estimates. The Tax Court also rejected the IRS assumption of the impact of future events on valuation, noting that the IRS valuation expert reports lacked details on how the discounts were calculated. Thus, the Tax Court rejected the proposed valuation estimates of the IRS and accepted those of the petitioner. The result was a 35 percent discount (total) for entity-level lack of control and lack of marketability compared to a 1.4 percent discount had the IRS approach been accepted.

 

S Corporation Value Accounts for Tax on Shareholders

Kress v. United States., 327 F. Supp. 2d 731 (E.D. Wisc. 2019)

The taxpayers, a married couple, gifted minority interests of stock in their family-owned S corporation to their children and grandchildren in 2007-2009. The taxpayers paid gift tax on the transfers of about $2.4 million. The taxpayers’ appraiser valued the S corporation earnings as of the end of 2006, 2007 and 2008 as a fully tax-affected C corporation. On audit, the IRS also followed a tax-effected approach to valuation of the S corporation earnings but applied an S corporation premium (pass-through benefit) and asserted that the gifts were undervalued as a result. The IRS assessed an additional $2.2 million of federal gift tax. The taxpayers paid the additional tax and sued for a refund in 2016.

The issue was the proper valuation of the S corporation. Historically, the IRS has not allowed for tax-affected S corporation valuation based on Gross v. Comr., T.C. Memo. 1999-254; Wall v. Comr., T.C. Memo. 2001-75; Estate of Heck v. Comr., T.C. Memo. 2002-34; Estate of Adams v. Comr., T.C. Memo. 2002-80; Dallas v. Comr., T.C. Memo. 2006-212; and Estate of Gallagher v. Comr, T.C. Memo. 2011-148. The IRS also has an internal valuation guide that provides that “…no entity level tax should be applied in determining the cash flows of an electing S corporation. …the personal income taxes paid by the holder of an interest in an electing S corporation are not relevant in determining the fair market value of that interest.”

But other courts have allowed the tax impact on shareholders. See, e.g., Delaware Open MRI Radiology Associates, 898 A.2d 290 (Del. Ct. Chanc. 2006); Bernier v. Bernier, 82 Mass. App. Ct. 81 (2012).

The court accepted the tax-affect valuation but disallowed the S corporation premium that IRS asserted. The court also allowed a discount for lack of marketability between 25 percent and 27 percent depending on the year of the transfer at issue.

 

Stray Voltage Could Lead to Partial Insurance Coverage

Hastings Mutual Insurance Co. v. Mengel Dairy Farms, Inc., No. 5:19CV1728, 2020 U.S. Dist. LEXIS 87612 (N.D. Ohio May 19, 2020)

 The defendant unexpectedly had several cows and calves die and also suffered a loss of milk production and profits. The defendant filed a claimed against the plaintiff for insurance coverage for death of livestock, cost of investigation and repairs, and loss of business profits. The plaintiff investigated the claim, utilizing an electrical company to do so. The electrical company found a stray electrical current present on the property. The plaintiff then hired a fire and explosion company to investigate the property. This investigation resulted in a finding of no stray voltage on the property, but the company did express its belief that stray voltage did cause the defendant’s harm. As a result, the plaintiff paid the insurance claim for death of livestock and repairs, but not for loss of business profits.

The plaintiff then filed an action for a determination under the policy of whether loss of business profits was a covered loss. The plaintiff sought a declaratory judgment specifying that coverage for loss and damage resulting from the stray voltage was not triggered because the defendant was not subject to a “necessary suspension” of farming operations, and that the defendant’s loss or damage had to be directly caused by a “peril insured against” rather than being caused by dehydration which resulted from the cattle’s reaction to the stray voltage. The defendant filed a counterclaim for breach of contract; breach of good faith and fair dealing; and unjust enrichment. The plaintiff moved for summary judgment on the basis that the policy wasn’t triggered for lack of electrocution and that there was no suspension in the defendant’s business operations. The court determined that the policy did not define the term electrocution in the context of dairy animals. As such, the court concluded that the term could be reasonably interpreted to mean death by electrical shock or the cause of irreparable harm. As an ambiguous term, it was defined against the plaintiff and in the defendant’s favor. The court also refused to grant summary judgment on the cause of death issue. In addition, because the defendant did not cease operations, the court concluded that the policy provided no coverage for lost profits. The court also rejected the defendant’s breach of contract claim due to lack of suspending the business and rejected the good faith/fair dealing claim because mere negligence was not enough to support such a claim. The unjust enrichment claim was likewise denied.

Conclusion

The cases discussed above are all quite relevant to agricultural producers.  For those struggling financially that find themselves in a Chapter 12, the interest rate utilized in the case is of primary importance.  Many factors go into determining the rate, and farming operations can achieve a lower rate by meeting certain factors listed by the court in the decision mentioned above.  Likewise, the valuation issue is critical, particularly if the federal estate tax exemption amount were to drop.  When federal (and, possibly, state) estate tax is involved, valuation is the “game.”  Finally, in all insurance cases, the language of the policy is critical to determine coverage application.  Any ambiguous terms will be construed against the company.  In all situations, having good legal counsel is a must.

July 25, 2020 in Bankruptcy, Business Planning, Insurance | Permalink | Comments (0)

Wednesday, July 22, 2020

The Supreme Court’s DACA Opinion and the Impact on Agriculture

Overview

Last month, the U.S. Supreme Court issued its opinion in Department of Homeland Security, et al. v. Regents of the University of California, et al., 140 S. Ct. 1891 (2020) where the Court denied the U.S. Department of Homeland Security’s (DHS) revocation of the Deferred Action for Childhood Arrivals (DACA).  The Court’s decision is of prime importance to agriculture because the case involved the ability of a federal government agency to create rules that are applied with the force of law without following the notice and comment requirements of the Administrative Procedure Act.  Agricultural activities are often subjected to the rules developed by federal government agencies, making it critical that agency rules are subjected to public input before being finalized.

The Supreme Court’s DACA opinion and agriculture – it’s the topic of today’s post.

Background

The DHS started the DACA program by issuing an internal agency memorandum in 2012.  The DHS took this action after numerous bills in the Congress addressing the issue failed to pass over a number of years.  The DACA program allowed illegal aliens that were minors at the time they illegally entered the United States to apply for a renewable, two-year reprieve from deportation.  The DACA program also gave these illegal immigrants work authorizations and access to taxpayer-funded benefits such as Social Security and Medicare.  Current estimates are that between one million and two million DACA-protected illegal immigrants are eligible for benefits  In 2014, the DHS attempted to expand DACA to provide amnesty and taxpayer benefits for over four million illegal aliens, but the expansion was foreclosed by a federal courts in 2015 for providing benefits to illegal aliens without following the procedural requirements of the Administrative Procedure Act as a substantive rule and for violating the Immigration and Naturalization Act.  Texas v. United States, 809 F.3d 134 (5th Cir. 2015), aff’g., 86 F. Supp. 3d 591 (S.D. Tex. 2015)In 2016, the U.S. Supreme Court affirmed the lower court decisions.  United States v. Texas, 136 S. Ct. 2271 (2016).  Based on these court holdings and because DACA was structured similarly, the U.S. Attorney General issued an opinion that the DACA was also legally defective.  Accordingly, in June of 2017, the DHS announced via an internal agency memorandum that it would end the illegal program by no longer accepting new applications or approving renewals other than for those whose benefits would expire in the next six months.  Activist groups sued and the Supreme Court ultimately determined that the action of the DHS was improper for failing to provide sufficient policy reasons for ending DACA.  In other words, what was created with the stroke of a pen couldn’t be eliminated with a stroke of a pen. 

Administrative Procedure Act (APA)

The APA was enacted in 1946.  Pub. L. No. 79-404, 60 Stat. 237 (Jun. 11, 1946).  The APA sets forth the rules governing how federal administrative agencies are to go about developing regulations.  It also gives the federal courts oversight authority over all agency actions.  The APA has been referred to as the “Constitution” for administrative law in the United States.  A key aspect of the APA is that any substantive agency rule that will be applied against an individual or business with the force of law (e.g., affecting rights of the regulated) must be submitted for public notice and comment.  5 U.S.C. §553.  The lack of DACA being subjected to public notice and comment when it was created and the Court’s requirement that it couldn’t be removed in like fashion struck a chord with the most senior member of the Court.  Justice Thomas authored a biting dissent that directly addressed this issue.  He wrote, “Without grounding its position in either the APA or precedent, the majority declares that DHS was required to overlook DACA’s obvious legal deficiencies and provide additional policy reasons and justifications before restoring the rule of law. This holding is incorrect, and it will hamstring all future agency attempts to undo actions that exceed statutory authority.” Justice Alito joined Justice Thomas in dissent stating, “DACA presents a delicate political issue, but that is not our business. As Justice Thomas explains, DACA was unlawful from the start, and that alone is sufficient to justify its termination. But even if DACA were lawful, we would still have no basis for overturning its rescission. First, to the extent DACA represented a lawful exercise of prosecutorial discretion, its rescission represented an exercise of that same discretion, and it would therefore be unreviewable under the Administrative Procedure Act.  5 U.S.C. §701(a)(2)…. Second, to the extent we could review the rescission, it was not arbitrary and capricious.”  Justice Thomas went on to term the majority’s decision “mystifying.” 

Application to Agriculture

Farmers and ranchers often deal with the rules developed by federal (and state) administrative agencies.  Those agency rules often involve substantive rights and, as such, are subject to the notice and comment requirements of the APA.  Failure to follow the APA often results in the restriction (or outright elimination) of property rights without the necessary procedural protections the APA affords. It’s also important that when administrative agencies overstep their bounds, a change in agency leadership has the ability to swiftly rescind prior illegal actions – a point Justice Thomas made clear in his dissent. The importance of holding government agencies accountable to the requirements of the APA is illustrated below.

USDA.  The USDA has a history of being notoriously poor at complying with the APA.  Both the Farm Service Agency (FSA) and the Natural Resource Conservation Service (NRCS) issue manuals and numerous amendments containing provisions that are applied against farmers with the force of law without subjecting the provisions to the APA. The National Food Security Act Manual (NFSAM), the key publication detailing the requirements for participating in federal farm programs, is presently in its fifth edition.  Many amendments have been made to the various editions, none of which have been subjected to the APA.

The history of Swampbuster is also illustrative.  The legislation creating Swampbuster was contained in the 1985 Farm Bill.  It made no mention of farmed wetlands.  An interim agency rule in March 1986 also did not mention the concept.  However, a final rule issued in September 1987 added farmed wetland, commenced conversions and minimal effect with no opportunity for farmers, ranchers and other landowners to comment. In the mid-1990s an interim final rule was issued under the APA and comments were solicited. The rule is still in effect. It was never made a final rule and it is still in interim status 20+ years later. It has even been amended a few times. In 1996 the Congress amended the law requiring that changes to all wetland conservation and highly erodible land provisions be adopted pursuant to public review and comment. In all practicality, however, the USDA merely solicits comments and makes no revisions after comments have been made. 

As for drain maintenance, the U.S. Court of Appeals for the Eighth Circuit in Barthel v. United States Department of Agriculture, 181 F.3d 834 (8th Cir. 1999), held that a drainage device can be manipulated after December. 23, 1985, to the extent necessary to allow the best historic drainage of the affected land.  In other words, the landowner is entitled to the “wetland and farming regime” on the land irrespective of what manipulation occurs to the specific drainage device.  However, the NRCS did not respond to Barthel decision until 2015 with the issuance of state offsite methods that looked at historic photographs and supported mathematical modeling.

The Iowa Experience.  Wetland issues often interact with common farming and ranching activities.  Wetland rules come from two sources - the Clean Water Act (CWA) and the United States Department of Agriculture (USDA).  The wetland rules of the CWA have been developed by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE).  More specifically, the CWA rules are administered by the COE for the EPA. The EPA can veto COE decisions, but rarely does. That the EPA and COE comply with the APA is critical. 

For Iowa farmers, the need for government agencies to comply with the APA has been recently illustrated in several important ways. 

  • When evaluating wetland mitigation, the COE is required to consider wetland functions and societal values. For example, a nutrient removal wetland would normally be valued higher over its flooding of a channelized low value headwater stream that is only wet due to drainage from tile lines. But the COE does not administer the law in that manner.  Instead, the COE determines what mitigation is needed to offset lost stream functions. Then it decides if that mitigation satisfies societal values in its permit decision. This COE policy has been developed outside of the APA and adds cost to nutrient removal wetlands, eliminates some, and protects lower-valued common headwater streams. The public is provided no input into the process (as it would via the APA process) as to whether the flooding of headwater streams without mitigation of lost stream channel functions would be an acceptable loss in favor of the creation of highly-valued nutrient removal wetlands.
  • The COE and the Iowa Department of Natural Resources (IDNR) worked together to create an Iowa Stream Mitigation Method without observing either the state or federal APA. The COE simply used, without any formal rulemaking, the Missouri stream mitigation method (a rather strict method) in Iowa for determining mitigation needs and permits. The Iowa Department of Transportation asked the IDNR for an in-lieu fee mitigation option for stream mitigation in road projects. Ultimately, the COE adopted the IDNR’s stream mitigation method without following the Iowa APA, published it as its own, solicited comments and adopted the rule.
  • In 2017 the NRCS pursued a consistent state off-site method (SOSM) for the prairie pothole states of ND, SD, MN and IA. On June 22, 2017 the SOSM was published in the federal register and comments solicited. Iowa and MN received no comments. The SOSM endorsed the use of a water balance software called SPAW. It had been In the NRCS wetland hydrology tools manual since 1997. In late 2017, the Midwest Regional Conservationist directed all 4 pothole states to install the 2017 SOSM in their field office technical guides and to begin using them. However, in December 2018 the Iowa NRCS changed the SOSM to discourage the use of SPAW and to return to aerial photographs. This change was not subjected to public review or comment.
  • Presently, the NRCS is planning to triple the setback for new tile from a farmed wetland in soils that are classified as possible discharge soils. These soils are common. A procedure used to identify such soils was expected to be announced and subjected to public comment and review.  Instead, Iowa moved ahead in tripling the setback without public rulemaking. 

The IRS.  With respect to payments received under Conservation Reserve Program (CRP), the historic position of the IRS had been that, for a retired taxpayer who is not materially participating in the farm operations, payments received under the CRP would not be considered net income from self-employment. Priv. Ltr. Rul. 8822064 (Mar. 7, 1988).  Likewise, the IRS position has been that where the farm operator or owner is materially participating in the farm operation, CRP payments constitute receipts from farm operations includible in net earnings from self- employment.  Letter from Peter K. Scott, Associate Chief Counsel, Technical, March 10, 1987.  Thus, the IRS took the position that someone must be materially participating to cause receipt of CRP rental to constitute net earnings from self-employment. The IRS had taken the same position with respect to payments received under the precursor program to the CRP – the Soil Bank.

The IRS informally (without going through the notice and comment procedures of the APA) changed its historic position concerning the self-employment tax treatment of CRP payments in a Chief Counsel's Letter Ruling dated May 29, 2003. C.C.A. 200325002 (May 29, 2003).   In the ruling, IRS took the position directly contrary to Priv. Ltr. Rul. 8822064 and held that a landowner's activities under a CRP contract amount to material participation and the payments should be reported on Schedule F, not Schedule E or Form 4835.  That is the Chief Counsel's position for retired landowners as well as those conducting a farming business and those who are not conducting a farming business.  In late 2006, IRS issued a Notice of proposed revenue ruling essentially following the 2003 CCA letter ruling. Notice 2006-108, I.R.B. 2006-51.  After the comment period ended (during which IRS received zero public comments supporting its proposed change of position) the IRS announced that it was canceling its plans to issue a Revenue Ruling on the issue, but that it was not changing its position on the matter. However, the IRS never issued the Revenue Ruling that would have obsoleted the key Revenue Rulings from 1960s concerning the self-employment tax treatment of Soil Bank payments.  Rev. Rul. 60-32; Rev. Rul 65-149.    Ultimately, the U.S. Circuit Court of Appeals ruled against the new IRS position, noting that the IRS had said it was going to promulgate a new rule announcing its changed position on the issue, but that it failed to do so.  The court voiced its displeasure with the IRS antics in adopting a changed position that it was asserting against taxpayers by agency fiat.  Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014). 

More recently, in Feigh v. Comr., 152 T.C. No. 15 (2019), the petitioner received a Form W-2 reporting a difficulty of care payment under I.R.C. §131(c). However, such payments are excluded from income as a type of qualified foster care payment if made under a state’s foster care program. In Tech. Adv. Memo. 2010-007, the IRS took the position that the payment of a difficulty care payment to the parent of a disabled child to the parent was not excludible because the “ordinary meaning” of foster care excluded care by a biological payment. But, in Notice 2014-7, and informal IRS pronouncement that is not “substantial authority” for tax purposes and was not subjected to formal rulemaking procedures under the APA, the IRS treated the payment as nontaxable to the recipient. The petitioner did not include the payment in income but did include the amount as earned income in computing the earned income credit under I.R.C. §32 and in computing the refundable child tax credit under I.R.C. §24. The IRS position was that since the amount was not taxable under Notice 2014-7, the amount did not count as earned income for computing the credits. I.R.C. §32(c)(2)(A)(i) states that earned income includes wages, salaries, tips and other employee compensation that has been included in gross income for the tax year.

The petitioner claimed that nothing in the actual statute, I.R.C. §131, allowed the IRS to treat the payment as not includible in gross income. The court agreed, noting that the IRS position was only a Notice and not a formalized Revenue Ruling with the result that the petitioner could exclude the difficulty of care payment and obtain credits on that (untaxed) earned income. The IRS was not allowed to change the impact of the tax law without going through the proper administrative procedure. The IRS later acquiesced in result only to the Tax Court’s decision. A.O.D. 2020-20, 2020-14 IRB 558.

Conclusion

The Supreme Court’s DACA decision is a huge blow to the rule of law as applied in the context of administrative agencies, and the requirement that  agency rules applied with the force of law to farmers and ranchers (and other landowners) must be subjected to the public notice and comment requirement of the APA. 

July 22, 2020 in Regulatory Law | Permalink | Comments (0)

Wednesday, July 15, 2020

Transitioning the Farm or Ranch – Stock Redemption

Overview

A major issue for farm and ranch families that have at least one child or other heir that is interested in taking over the business after the senior generation either retires or dies, is how to transition the business to that next generation of managers/operators. 

For farming and ranching operations that operate in a corporate structure, one way to transition the business is by means of a corporate stock redemption.  What are the pros and cons of a corporate redemption?  How does it actually work mechanically?

Corporate stock redemptions – it’s the topic of today’s post.

“Retiring” the Senior Generation

Compared to a sole proprietor farming operation, the tax “hit” to a retiring owner can often be much less in the corporate structure.  When a sole proprietor retires and assets are sold, the tax consequences can be harsh.  Grain and livestock in inventory and depreciable property (other than 20-year general purpose farm buildings) are subject to ordinary income tax treatment upon sale.  In addition, any I.R.C. §1245 depreciation recapture is not eligible for the installment method of reporting.  However, the sale of corporate stock by a retiring owner is taxed at capital gain rates that are lower than the ordinary income tax rates.  That’s the case whether the stock is sold directly to the buyer or by means of a stock redemption.  In addition, the installment method of reporting the income is available allowing for income tax deferral. 

On the other end of the transaction, the next generation that is acquiring an ownership interest in the farming entity also has tax implications.  When assets are purchased directly from a sole proprietor farmer or when a partnership interest is acquired with a basis-step up election in place, enhanced tax deductions are available.  In addition, any basis that can be allocated to depreciable property results in deferred deductions.  On the other hand, the seller recognizes depreciation recapture that must be recognized at the time of sale.  See I.R.C. §1245.

One advantage of a stock redemption over a direct sale (at least to the buyer) is that a stock redemption can be used to fund the acquisition of stock with corporate earnings that are taxed at a 21 percent rate under current law. 

Advantages

The primary advantage of a corporate stock redemption is that it can remove post-tax wealth that has built up inside the corporation at a 21 percent rate.  The same is true for future wealth built up if the payout occurs by virtue of installment reporting.  In addition, interest expense is deductible inside the corporation if, for example, a member of the next generation individually buys the stock  Likewise, there is no additional payroll tax burden that would otherwise occur if a person in the subsequent generation withdrew funds from corporate earnings to acquire stock from the senior generation. 

Disadvantage

With a corporate stock redemption, there is no increase in stock basis in the hands of the acquiring next generation.  That’s the case even though the seller (senior generation) could have a large gain to report on the transaction. 

Complete Redemption

The redemption of the senior shareholder’s stock must be a complete redemption to achieve capital gain tax treatment. The redeemed shareholder’s interest in the corporation must be completely extinguished. If it is, the proceeds received by the retiring shareholder, as indicated above, are treated as capital gain.  That’s the case even if the corporation has earnings and profits what would otherwise be taxed as ordinary income if they were distributed to the retiring shareholder.  I.R.C. §302(a).  A complete redemption also eliminates characterization of the redemption as a dividend that would be taxed at ordinary income tax rates up to the amount of the earnings and profits of the corporation. 

A complete redemption is also required for the transaction to be eligible for installment reporting.  I.R.C. §302(b)(3).  To accomplish a complete redemption, the senior shareholder must agree to have no involvement in the corporation for 10 years following the transaction.  That means the former senior shareholder can’t be a consultant or an employee or a director during that time-span.  No salaries or director fees for 10 years!  However, it is permissible for the corporation to continue to employ the redeemed shareholder’s spouse and provide fringes via a lease of real estate to the corporation (and collateralization agreements) if the arrangement is structured to ensure payment on the installment note involving the redeemed stock, the employment contract for the spouse and the lease.  That is especially true if the collateralization agreements are entered into in an arms’-length transaction and is comparable to arrangements involving unrelated parties.  See, e.g., Hurst v. Comr., 124 T.C. 16 (2005).  But, it is important that the redeemed shareholder not be determined to be involved in the business via the spouse. 

As for being a consultant to the corporation, the U.S. Tax Court held in 1984 that consulting services could be provided by the redeemed shareholder occasionally and medical insurance benefits could continue without the redemption being taxed as a dividend.  Lynch v. Comr., 83 T.C. 597 (1984).  But, the IRS doesn’t like consulting arrangements involving a redeemed shareholder.  See Rev. Rul. 70-104, 1970-1 C.B. 66.  In addition, an ongoing consulting arrangement is not permissible.  Lynch v. Comr., 801 F.2d 1176 (9th Cir.1986).      

If a prohibited interest is acquired within the 10-year post transaction timeframe, the redeemed shareholder  must notify the IRS.    Indeed, the redeemed shareholder must attach an agreement to the tax return saying that such notification will be made.  I.R.C. §302(c)(2)

If the rules for a complete redemption are violated, stock basis won’t offset gain and installment sale treatment is not available.    

How is a complete stock redemption accomplished?  The rules governing a complete stock redemption are set forth in I.R.C. §302(b)(3).  As noted above, the senior generation shareholder must surrender all of his stock either all at once or in exchange for an installment note that is payable over time.  After the redemption, if the remaining shareholders are related (in accordance with family attribution rules) to the shareholder that is being bought out, the redeemed shareholder can’t have any interest in the corporation for 10 years except for an interest acquired by bequest or inheritance.  An exception from this rule, however, allows the redeemed shareholder to be a landlord or a creditor. See, e.g, Priv. Ltr. Rul. 8551014 (Sept. 19, 1985). 

A redemption can also occur in the context of an I.R.C. §1041 transaction (such as incident to a divorce or otherwise between spouses).  Prop. Treas. Reg. §1.1041-2. 

Prior Family  Transfers

Another potential “snag” in the planning process is that an “anti-abuse” rule says that  capital gain treatment is not available if there have been family transfers of stock within 10 years before  the redemption.  I.R.C. §302(c)(2)(B).  Family attribution rules of I.R.C. §318 apply to define family members in this context. The rule seems to disallow gifts to family members.  However, if tax avoidance wasn’t one of the principal purposes of the transfer, then the transfer is permissible.  Basically, it comes down to whether the taxpayer can prove a non-tax purpose for the transfer and that avoiding tax was not a principal purpose.  Thus, if the prior transfer involved, for example, a parent that owned all of the corporate stock of a family farming or ranching corporation and gifted stock to a child that was being groomed as the successor as part of the parent’s estate and succession plan, a complete stock redemption would still be available and treated favorably from a tax standpoint.  See Rev. Rul. 77-293, 1977-2 C.B. 91.

Conclusion

A stock redemption can be part of a business succession transition plan for farming and ranching corporations.  But, planning for it is a necessity to ensure that the redemption achieves the anticipated benefits.

July 15, 2020 in Business Planning | Permalink | Comments (0)

Sunday, July 12, 2020

Imputation – When Can an Agent’s Activity Count?

Overview

The tax Code often requires a taxpayer to materially participate in a farm business activity as a pre-requisite to receiving a tax benefit.  This is not an issue if the taxpayer is directly involved in the farming activity.  However, many farming activities are conducted by a tenant.  In those situations, can the landlord receive the tax benefit or benefits that might be available?  The answer is that it “depends.”  What it depends upon is the particular Code section involved and whether the conduct of the tenant can be imputed to the landlord for tax purposes.

The issue of imputation and the tax Code – it’s the topic of today’s post.

A Bit of History

In Hoffman v. Gardner, 369 F.2d 837 (8th Cir. 1966), the court acknowledged the role of an agent in meeting the material participation requirement. The plaintiff grew up on a farm in south-central Iowa.  After graduating college in 1913, he got married in 1914 and took a teaching job in Iowa almost two hours from where he grew up.  That same year he bought two farms in the Iowa county where he was from.  Two years later he moved to the St. Louis area where he continued to teach school for the next 40 years.  He and his brother-in-law managed the farms by keeping in touch with the tenants.  The brother-in-law lived near the farms.  He compensated his brother-in-law with a percentage of the farms’ income.  In 1957, a year after retiring from school teaching, the plaintiff entered into agreements with the tenants that gave him complete managerial control, subject only to the right of the tenants to make suggestions.  The agreements specified that the plaintiff would pay for all grass seed, one-half of the corn seed, one-half of the baling expense and all of the fertilizer expense.  The straw, threshed hay and stalks were to be fed to livestock on the farms.  The plaintiff was not required to pay for the oats seed or the expense of threshing.  The agreements further provided that he controlled the place and time of crop planting and crop cultivation and harvesting.  He also retained decisionmaking control over the crops to be sprayed and how they were to be tended to.  The plaintiff kept charts on his farms that detailed all types of crop and soil information, and he annually sent this information to the tenants along with information on fencing and terracing.  He consulted periodically with his brother-in-law and the tenants by telephone and letter, and occasionally spent time on the farms with his daughter during which times he would inspect the crops and walk the fields and provide crop growing advice to his brother-in-law and the tenants.  His brother-in-law inspected the farms several times monthly during the growing season and often served as a middleman between the tenants and the plaintiff in terms of conveying information about the farms. 

Also in 1957, at the age of 71, the plaintiff applied for Social Security benefits based on his self-employment earnings by virtue of his management of the farms and the conduct of his brother-in-law and the tenants.  In other words, the plaintiff claimed that he had been material participating in the operation of the farms that would entitle him to Social Security benefits.  The local Social Security Office denied the claim as did the Hearing Examiner on appeal.  The plaintiff’s request for formal review was denied, and the federal trial court also ruled against the plaintiff.  On further review, the U.S. Court of Appeals noted that the facts showed that the plaintiff was the one that made the key decisions involving the production activities on the farms.  The evidence also revealed that the plaintiff kept informed of issues that arose on the farms and educated himself by reading farm production literature and by seeking input from experts at agricultural colleges.  He also made decisions to start new farming practices and establish longer term farming practices and techniques to improve the farms’ profitability.  The appellate court also noted that the plaintiff kept close track of any new production technique or crop that was tried on the farms. 

Based on the evidence, the appellate court reversed the trial court and held that the plaintiff had materially participated in crop production and in the management of crop production on the farms.  Importantly, the appellate court determined that the plaintiff qualified for Social Security benefits based on his own material participation in the farming activities and the activities of his brother-in-law as his agent.  In other words, the brother-in-law’s activities were imputed to the plaintiff for purposes of the material participation test. 

Statutory Modification

 In 1974, the Congress amended the material participation statute to provide that the activities of an agent were thereafter to be irrelevant in determining whether the material participation requirement has been met.    Currently, I.R.C. §1402(a)(1) reads as follows:

“(a)Net earnings from self-employment. The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member; except that in computing such gross income and deductions and such distributive share of partnership ordinary income or loss—

            (1) there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares, and including payments under section 1233(a)(2) of the Food Security Act of 1985 (16 U.S.C. 3833(a)(2)) to individuals receiving benefits under section 202 or 223 of the Social Security Act) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer; except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity;…”

For purposes of imputation, the key is the parenthetical language contained in §1402(a)(1)(A) – “…there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant).”  In addition, when read as a whole, the bar on imputation only applies when the production of agricultural or horticultural commodities is involved. 

Satisfying Material Participation

For purposes of Social Security and “net earnings from self-employment” material participation must be achieved personally when agricultural or horticultural crop production is involved.  How is that accomplished?  The IRS has offered three safe harbors and one catchall for determining whether the material participation test has been satisfied.    See Farmers Tax Guide, IRS Pub. 225, page 75 (2019).  The first test requires the landlord to satisfy any three of the following:  (1) advance, pay, or stand good for at least half of the direct costs of producing the crop; (2) furnish half of the tools, equipment and livestock used in producing the crop; (3) advise and consult with the tenant periodically; or (4)  inspect production activities periodically.  The second test requires the landlord to regularly and frequently make, or take an important part in making, management decisions substantially contributing to the success of the enterprise.  Under this test, it appears that decisions should be made throughout the year, such as when to plant, cultivate, dust, spray, or harvest; what items to buy, sell or rent; what records to keep; what reports to make; and what bills to pay and when. Establishing a lease arrangement at the beginning of the season probably will not be regarded as making management decisions.  The third test requires the landlord to work 100 hours or more over a period of five weeks or more in activities connected with producing the crop.  The fourth test requires the landlord to do things which, in total affect, show that the landlord is materially and significantly involved in the production of farm commodities.  This fourth test is the catchall that a landlord can attempt to utilize if the landlord is not able to satisfy any of the first three tests.  The litigated cases on the material participation issue have arisen primarily from this catchall provision.

Other Code Provisions

“Material participation” is required by other tax provisions which are not subject to the 1974 amendment. In other words, when the issue of material participation does not route through I.R.C. §1402, imputation is not blocked.  For example, the qualified business income deduction of I.R.C. §199A does not bar the imputation of an agent’s activity to the principal for purposes of the principal claiming the 20 percent deduction.  There is also no specific statutory bar of imputing an agent’s activity to the principal for purposes of the passive loss rules of I.R.C. §469 (although Committee Report language seems to indicate that there is a bar).

Whether the landlord materially participates in the tenant’s farming business is irrelevant for farm income averaging purposes.  I.R.C. §1301.  Thus, non-materially participating landlords are eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land.  That places a premium on written leases.

There are other sections of the Code where the imputation issue also matters.

The Type of Lease Matters

If a landowner is in the business of farming, the landowner's expenses and income are reported on Schedule F where the net income is subject to self-employment tax.  Income and expenses associated with a material participation crop share lease are reported on Schedule F.  The rental income is subject to self-employment tax and the owner is able to deduct soil and water conservation expenses attributable to the real estate, as well as qualify for the exclusion of cost-sharing payments associated with the rented real estate.  Similarly, the landlord could qualify for expense method depreciation under I.R.C. §179.  In addition, CRP payments received by a materially participating landlord are subject to self-employment tax only if there is a nexus between the CRP land and the materially participating landlord’s farming operation. The IRS continues to deliberately misstate this point in IRS Publication 225. 

A landlord who is not materially participating under a crop share lease receives the income from the lease not subject to self-employment tax.  While the landlord still qualifies for special treatment of soil and water conservation expenses and is eligible for exclusion of cost-sharing payments, and may, as noted below, be eligible for expense method depreciation, the income is to be reported on IRS Form 4835 rather than the Schedule F.

Income under a cash rent lease is income from a passive rental arrangement and is not subject to self-employment tax.  Cash rent landlords do not qualify for special treatment of soil and water conservation expenses but apparently qualify for the exclusion of cost sharing payments received from the USDA.  At least that the conclusion to be drawn from an IRS Private Letter Ruling from 1990. See, e.g., Priv. Ltr. Rul. 9014041 (Jan. 5, 1990).   In the ruling, there was no mention of the type of lease involved.   

As for expense method depreciation, the landlord must be “meaningfully participating” in the management or operations of the trade or business, (Treas. Reg. §1.179-2(c)(6)(ii)) and avoid the “noncorporate lessor” rules.  I.R.C. §179(d)(5).  Income from a cash rent lease is to be reported on the Schedule E -Supplemental Income and Loss.

Conclusion

Imputation is a key concept in several areas of farm income taxation.  It’s made trickier because sometimes it applies and sometimes it does not.  It’s all a matter of which Code section applies and how the material participation requirement is routed through the Code. 

July 12, 2020 in Income Tax | Permalink | Comments (0)

Wednesday, July 8, 2020

More Developments Concerning Conservation Easements

Overview

The U.S. Tax Court continues to issue decisions involving conservation easements.  The IRS has many of these cases in the pipeline which means that the decisions will keep on coming.  This is definitely one area of tax that has been audited heavily and it can be anticipated that the audits will continue.  I have written prior posts on the issues surrounding conservation easements.  They can be beneficial for rural landowners from a tax perspective, but the deeds granting the easement must be drafted very carefully and attention to detail is a must.

In today’s post, I look at a few recent cases and an important IRS development concerning conservation easements.

Extinguishment Regulation Upheld.

Oakbrook Land Holdings, LLC v. Comr., 154 T.C. No. 10 (2020); Oakbrook Land Holdings, LLC v. Comr., T.C. Memo. 2020-54

In 2008, the petitioner donated a permanent conservation easement to a qualified organization and claimed a charitable deduction. The easement deed specified that upon extinguishment of the conservation restriction the donee would receive a share of the proceeds equal to the fair market value of the easement as of the date of the contribution. That value, the deed specified, was to be reduced by the value of any improvements that the donor made after granting the easement. The IRS denied the charitable deduction because (inter alia) the deed language violated the extinguishment regulation of Treas. Reg. §1.170A-14(g)(6).

The full Tax Court, agreeing with the IRS, upheld the validity of the regulation on the basis that the extinguishment regulation had been properly promulgated and did not violate the Administrative Procedure Act. The full Tax Court also determined that the construction of I.R.C.§170(h)(5) (e.g., that the donated easement be exclusively for conservation purposes), as set forth in the extinguishment regulation, was valid under the agency deference standard set forth in Chevron, U.S.A. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984).

In a related memorandum opinion, the Tax Court held that the easement deed did not create a perpetual easement because the donee’s share of the extinguishment proceeds was based on fixed historical value, reduced by the value of improvements that the donor made. It was not, as it should have been, based on a proportionate share of extinguishment proceeds that are at least equal to the total proceeds (unadjusted by the value of the petitioner’s improvements), multiplied by a fraction defined by the ratio of the fair market value of the easement to the fair market value of the unencumbered property determined as of the date of the execution of the deed. However, the Tax Court did not uphold penalties that the IRS imposed, finding that the petitioner’s position was reasonable. 

Charitable Deduction Denied – Bad Deed Language and Overvaluation

Plateau Holdings LLC, et al. v. Comr., T.C. Memo. 2020-93.

The petitioner, an entity, owned two parcels of rural land and donated two open-space conservation easements on the parcels to a land trust. The deeds were recorded the next day, and included language expressing an intent to ensure that the land “be retained forever in its current natural, scenic, forested and open land condition” and language preventing any use of the conserved area inconsistent with the conservation purpose. The petitioner claimed a $25.5 million charitable deduction for the donation. Eight days before the donation, an investor acquired nearly 99 percent ownership in the petitioner for less than $6 million.

The Tax Court determined that the deed language was similar to that deemed invalid in Coal Property Holdings LLC v. Comr., 153 T.C. 126 (2019) because the grantee wouldn’t receive a proportionate amount of the full sale proceeds. The Tax Court also upheld a 40 percent penalty under I.R.C. §6662(e) and I.R.C. §6662(h) for a gross misstatement of the value of the contribution. The Tax Court noted that the petitioner valued both properties well above 200 percent of market value, the cut-line for the gross misstatement penalty.  One parcel was valued a$10.9 million, or 852 percent of its correct value.  The other easement was valued at $14.5 million, or 1,031 percent of its proper value. 

Conservation Easement Not Protected In Perpetuity – The Extinguishment Issue 

Hewitt v. Comr., T.C. Memo. 2020-89.

The petitioner owned farmland and deeded a conservation easement on a portion of the property to a qualified charity as defined in I.R.C. §170(h)(3). The petitioner continued to own a large amount of agricultural land that was contiguous with the easement property, and he continued to live on the land and use it for cattle ranching. The petitioner claimed a charitable contribution deduction for the donation of $2,788,000 (the difference in the before and after easement value of the property) which was limited to $57,738 for the tax year 2012 – the year of donation. The petitioner claimed carryover deductions of $1,868,782 in 2013 and $861,480 in 2014.

The petitioner could not determine his basis in the property and, upon the advice of a CPA firm, attached a statement to Form 8283 explaining his lack of basis information. The deed stated that its purpose was to preserve and protect the scenic enjoyment of the land and that the easement would maintain the amount and diversity of natural habitats, protect scenic views from the roads, and restrict the construction of buildings and other structures as well as native vegetation, changes to the habitat and the exploration of minerals, oil, gas or other materials. The petitioner reserved the right to locate five one-acre homesites with one dwelling on each homesite. The deed did not designate the locations of the homesites but required the petitioner to notify the charity when he desired to designate a homesite. The charity could withhold building approval if it determined that the proposed location was inconsistent with or impaired the easement’s purposes.

The deed provided for the allocation of proceeds from an involuntary extinguishment by valuing the easement at that time by multiplying the then fair market value of the property unencumbered by the easement (less any increase in value after the date of the grant attributable to improvements) by the ratio of the value of the easement at the time of the grant to the value of the property, without deduction for the value of the easement at the time of the grant. The deed also stated that the ratio of the value of the easement to the value of the property unencumbered by the easement was to remain constant. The charity drafted the deed and a CPA firm reviewed it and advised the petitioner that it complied with the applicable law and regulations, and that he would be entitled to a substantial tax deduction.

The IRS denied the carryover deductions for lack of substantiation and assessed a 40 percent penalty under I.R.C. §6662(h) for gross valuation misstatement and, alternatively, a 20 percent penalty for negligence or disregard of the regulations or substantial understatement of tax. The petitioner bought additional land that he held through pass-through entities that would then grant easements. The petitioner recognized gain of over $3.5 million on the sale of interests in the entities to investors who then claimed shares in the easement deductions. The IRS claimed that these entities overvalued the easements for purposes of the deductions. Individuals in the CPA firm invested in the entities and claimed easement deductions. The Tax Court determined that the deed language violated the perpetuity requirement of I.R.C. §170 because of the stipulation that the charity’s share of proceeds on extinguishment would be reduced by improvements made to the land after the easement grant. The Tax Court did not uphold the penalties. 

Conservation Easement Doomed by Bad Deed Language

Woodland Property Holdings, LLC v. Comr., T.C. Memo. 2020-55

The petitioner donated a conservation easement to a qualified charity. The deed conveying the property contained a judicial extinguishment provision stating that the easement gave rise to a vested property right in the donee, the value of which "shall remain constant." The value of the donee's property right was defined as the difference between (a) the fair market value (FMV) of the conservation area as if unburdened by the easement and (b) the FMV of the conservation area as burdened by the easement, with both values being "determined as of the date of this Conservation Easement." The IRS took the position that the language failed to satisfy the "in perpetuity" requirement for such gifts. The petitioner pointed to the following deed language for support of the his position that the perpetuity requirement was satisfied:  "If any provision of this Conservation Easement is found to be ambiguous, an interpretation consistent with its purposes that would render the provision valid should be favored over any interpretation that would render it invalid."

The Tax Court, however, held that the provision did not help the taxpayer because it was a cure only for ambiguous provisions and the deed was unambiguous in limiting the donee's vested property right. In addition, the Tax Court noted that a statement from the donee organization that the easement be in full compliance with the tax law was immaterial. 

Conservation Easement Deduction Allowed At Reduced Amount. 

Johnson v. Comr., T.C. Memo. 2020-79

The petitioner is the president of a west-central Colorado company that manufactures and sells disposable ink pans for printing presses. He purchased a ranch in 2002 for 200,000 and carved out a permanent conservation easement that he donated to the Colorado Open Lands, a qualified charity. He made the donation in 2007. The easement encumbered 116.14 acres along with the water rights, leaving the remaining five acres unencumbered. The easement restricted the encumbered area from being subdivided, used as a feedlot, or used for commercial activities. It also restricted all construction within the encumbered area except for five acres that was designated a “building envelope”. The deed limited constructed floor space inside the building envelope to 6,000 square feet for single residential improvements and a cumulative maximum of 30,000 square feet for all improvements.

On his return for 2007, the petitioner claimed a $610,000 charitable contribution deduction for the donated easement, with carryover amounts deducted in future years. He also claimed certain farm-related expenses. The IRS denied the carryover charitable deductions in three carryover years on the basis that he had already deducted more than the easement’s value for previous tax years. The petitioner and the IRS agreed that the property’s highest and best use was for farming and a residence. The petitioner’s valuation expert used a quantitative approach by taking comparable sales adjusted by time between the time of those easement donations and when the petitioner donated his easement. The petitioner’s expert then adjusted for nearness of the encumbered property to town and size. He then factored in irrigation, topography and improvements to arrive at the value of the property before the easement. The expert did not have many post-donation comparable sales to work with in arriving at the value of the petitioner’s property after the easement donation.

The valuation expert for the IRS used the qualitative approach. By comparing several characteristics for each comparable, including market conditions at the time of sale, location/access, size, aesthetic appeal, zoning, and available utilities, to evaluate the relative superiority, inferiority, or similarity of each comparable to the ranch. The expert then evaluated the overall comparability of each property to the ranch.

The Tax Court preferred the approach of the petitioner’s expert, due to the IRS’s expert ignoring the quantitative factors. However, the Tax Court adjusted the value arrived at by the petitioner’s expert. Post-encumbrance nearby comparable sales were lacking, the Tax Court rejected both experts’ post-encumbrance direct comparable sales analyses. By ignoring an outlier from both of the experts, the parties were only two percent apart on value. The Tax Court split the difference between the parties and added it to the pre-easement value as adjusted to arrive at the easement’s value. Thus, the Tax Court allowed a $373,000 deduction for the easement. The Tax Court also disallowed various farming expense deductions including travel-related expenses due to the lack of substantiation. 

Conclusion

The saga of claimed charitable deductions for donated conservation easements will continue.  It seems that nothing generates more Tax Court litigation than a Code provision that the IRS despises.

July 8, 2020 in Income Tax | Permalink | Comments (0)

Monday, July 6, 2020

How Many Audit “Bites” of the Same Apple Does IRS Get?

Overview

Experiencing a tax audit can be a traumatic experience.  Often, the level of trauma depends on the examining agent(s).  It can also depend on how aggressive the IRS National Office is on the issue under examination.  But, once an audit is completed can the IRS return to the same issue involving the same tax year and with the same taxpayer and get a “do-over”?  In other words, how many times can the IRS audit the same issue?

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

Applicable Code Section

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

I.R.C. §7605(b) states as follows:

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

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

Recent Case

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

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

Recent Chief Counsel Legal Advice

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

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

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

Conclusion

Almost 100 years ago, the Congress determined that taxpayers needed protection against abuses from the IRS.  That determination manifested itself in I.R.C. §7605(b) which was enacted within the first ten years of the creation of the tax Code.  But, whether or not the IRS can get a “second-bite” at the audit apple is highly fact-dependent.  However, it is probably a decent bet that audit activity will be extremely low in the coming months due to circumstances beyond the control of the IRS.

July 6, 2020 in Income Tax | Permalink | Comments (0)

Friday, July 3, 2020

The “Cramdown” Interest Rate in Chapter 12 Bankruptcy

Overview

In the context of Chapter 12 (farm) bankruptcy, unless a secured creditor agrees otherwise, the creditor is entitled to receive the value, as of the effective date of the plan, equal to the allowed amount of the claim.  Thus, after a secured debt is written down to the fair market value of the collateral, with the amount of the debt in excess of the collateral value treated as unsecured debt which is generally discharged if not paid during the term of the plan, the creditor is entitled to the present value of the amount of the secured claim if the payments are stretched over a period of years.

What does “present value” mean?  It means that a dollar in hand today is worth more than a dollar to be received at some time in the future.  It also means that an interest rate will be attached to that deferred income.  But, what interest rate will make a creditor whole? A recent decision involving a farming operation in the state of Washington is a good illustration of how courts address the issue.

“Cramdown” and Present Value

When a farmer files a Chapter 12 bankruptcy, the law allows the “cramdown” of a secured creditor if the farmer reorganization plan provides that the secured creditor gets to retain the lien that secures the claim and the value, as of the effective date of the plan, of property to be distributed by the trustee or the debtor under the plan on account of the claim is not less than the allowed amount of the claim.  11 U.S.C. §1225(a)(5)(B)(i)-(ii).  The real issue is what “not less than the allowed amount of the claim” means.  That’s particularly true when the rule is applied in the context of cash payments that are to be made in the future.  In that instance, a value must be derived as of the plan’s effective date, that is discounted to present value.  Present value is the discounted value of a stream of expected future incomes.  That stream of income received in the future is discounted back to present value by a discount rate. 

The determination of present value is highly sensitive to the discount rate, which is commonly expressed in terms of an interest rate.  Several different approaches have been used in Chapter 12 bankruptcy cases (and nearly identical situations in Chapters 11 and 13 cases) to determine the discount rate.  Those approaches include the contract rate – the interest rate used in the debt obligation giving rise to the allowed claim; the legal rate in the particular jurisdiction; the rate on unpaid federal tax; the federal civil judgment rate; the rate based on expert testimony; a rate tied to the lender’s cost of funds; and the market rate for similar loans.

Supreme Court Decision

In 2004, the U.S. Supreme Court, in, addressed the issue in the context of a Chapter 13 case that has since been held applicable in Chapter 12 cases.  Till v. SCS Credit Corporation, 541 U.S. 465 (2004).    In Till, the debtor owed $4,000 on a truck at the time of filing Chapter 13.  The debtor proposed to pay the creditor over time with the payments subject to a 9.5 percent annual interest rate.    That rate was slightly higher than the average loan rate to account for the additional risk that the debtor might default.  The creditor, however, argued that it was entitled to a 21 percent rate of interest to ensure that the payments equaled the “total present value” or were “not less than the [claim’s] allowed amount.”  The bankruptcy court disagreed, but the district court reversed and imposed the 21 percent rate.  The United States Court of Appeals for the Seventh Circuit held that the 21 percent rate was “probably” correct, but that the parties could introduce additional concerning the appropriate interest rate.  

On further review by the U.S. Supreme Court, the Court held that the proper interest rate was 9.5 percent.  That rate, the Court noted, was derived from a modification of the average national loan rate to account for the risk that the debtor would default.  The Court’s opinion has been held to be applicable in Chapter 12 cases.  See, e.g., In re Torelli, 338 B.R. 390 (Bankr. E.D. Ark. 2006); In re Wilson, No. 05-65161-12, 2007 Bankr. LEXIS 359 (Bankr. D. Mont. Feb. 7, 2007); In re Woods, 465 B.R. 196 (B.A.P. 10th Cir. 2012).   The Court rejected the coerced loan, presumptive contract rate and cost of funds approaches to determining the appropriate interest rate, noting that each of the approaches was “complicated, impose[d] significant evidentiary costs, and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments ha[d] the required present value.”  A plurality of the Court explained that these difficulties were not present with the formula approach.  The Court opined that the formula approach requires that the bankruptcy court determine the appropriate interest rate by starting with the national prime rate and then make an adjustment to reflect the risk of nonpayment by the debtor.  While the Court noted that courts using the formula approach have typically added 1 percent to 3 percent to the prime rate as a reflection of the risk of nonpayment, the Court did not adopt a specific percentage range for risk adjustment.

Subsequent Cases

Since the Supreme Court’s Till decision, the lower courts have decided many cases in which they have attempted to apply the Till approach.  Indeed, the Circuit Courts have split on whether the appropriate interest rate for determining present value should be the market rate or a rate based on a formula.  For example, in a relatively recent Circuit Court case on the issue, the Second Circuit held that a market rate of interest should be utilized if an efficient market existed in which the rate could be determined.  In re MPM Silicones, L.L.C., No. 15-1682(l), 2017 U.S. App. LEXIS 20596 (2nd Cir. Oct. 20, 2017).  In the case, the debtor filed Chapter 11 and proposed a reorganization plan that gave first-lien holders an option to receive immediate payment without any additional “make-whole” premium, or the present value of their claims by utilizing an interest rate based on a formula that resulted in a rate below the market rate.   The bankruptcy court confirmed the plan, utilizing the formula approach of Till.   The federal district court affirmed.  On further review, the appellate court reversed noting that Till had not conclusively specified the use of the formula approach in a Chapter 11 case.  The appellate court remanded the case to the bankruptcy court for a determination of whether an efficient market rate could be determined based on the facts of the case. 

Recent Washington Case

A recent case from the state of Washington is a good illustration of how a court can use the Till opinion to fashion an interest rate suitable to the debtor’s particular farming operation.  In In re Key Farms, Inc., No. 19-02949-WLH12, 2020 Bankr. LEXIS 1642 (Bankr. D. Wash. Jun. 23, 2020), the debtor was a family farming operation engaged in apple, cherry, alfalfa, seed corn and other crop production. The parents of the family owned 100 percent of the debtor, the farming entity. In 2014, the debtor changed its primary lender which extended a line of credit to the debtor that the father personally guaranteed and a term loan to the debtor that the father also personally guaranteed. The lender held a first-priority security interest in various real and personal property to secure loan repayment. The debtor became unable to repay the line of credit and the default caused defaults on the term loan and the guarantees. The lender sued to foreclose on its collateral and have a receiver appointed.

The debtor then filed Chapter 12 bankruptcy and proposed a reorganization plan where it would continue farming under 2020-2024 in accordance with proposed budgets through 2024. The plan provided for repayment of all creditors in full. The plan proposed to repay then lender over 20 years at a 4.5 percent interest rate (prime rate of 3.25 percent plus 1.25 percent). The lender opposed plan confirmation. A primary issue was what an appropriate cramdown interest rate would be.

The court looked at the unique features of the debtor to set the rate.  Indeed, in determining whether the reorganization plan was fair and equitable to the lender based on the facts, the court noted the father’s lengthy experience in farming and familiarity with the business and that the farm manager was experienced and professional. The court also noted that the parents had extensive experience with crop insurance and that they were committing unencumbered personal assets to the reorganization plan. The court also noted the debtor’s shift in recent years to more profitable crops, a demonstrated ability to manage around cash flow difficulties, and that the lender would be “meaningfully oversecured.” The court also determined that the debtor’s farming budgets appeared to be based on reasonable assumptions and forecasted consistent annual profitability.

However, the court did note that the debtor had a multi-year history of operating losses in recent years; was heavily reliant on crop insurance; was engaged in an inherently risky business subject to forces beyond the debtor’s control; had no permanent long-term leases in place for the considerable amount of acreage that it leased; could not anticipate how the Chinese Virus would impact the business into the future; and proposed a lengthy post-confirmation obligation (30 years) to the lender. Accordingly, the court made an upward adjustment to the debtor’s proposed additional 1.25 percent to the prime rate by increasing it by at least 1.75 percent. The court scheduled a conference with the parties to discuss how to proceed. 

Conclusion

The interest rate issue is an important one in reorganization bankruptcy.  the market rate, as applied to an ag bankruptcy, does seem to recognize that farm and ranch businesses are subject to substantial risks and uncertainties from changes in price and from weather, disease and other factors.  Those risks are different depending on the type of agricultural business the debtor operates.  A market rate of interest would is reflective of those factors.

July 3, 2020 in Bankruptcy | Permalink | Comments (0)

Tuesday, June 30, 2020

PPP and PATC Developments

Overview

The Paycheck Protection Program (PPP) was enacted into law in late March and has now been statutorily modified by the Paycheck Protection Program Flexibility Act (PPFA).  It is designed to provide short-term financial relief to qualified businesses that have been negatively impacted by the action of state Governors in response to the virus. The Small Business Administration (SBA) administers the law. 

The Premium Assistance Tax Credit (PATC) is a refundable credit designed to offset the higher cost of health insurance triggered by Obamacare for eligible individuals and families that acquire health insurance purchased through the Health Insurance Marketplace.  In recent days important developments have involved the PATC. 

Prior posts have discussed various aspect of the PPP, particularly as applied to farm and ranch businesses.  In today’s post I take a brief look at a couple of PPP court developments and key information involving the PATC.  Recent developments of the PPP and the PATC – it’s the topic of today’s post.

PPP Court Developments

Maine case.  The SBA has promulgated a rule taking the position that an individual PPP applicant that is in bankruptcy is ineligible for PPP funds.  Also, if the applicant is an entity and a majority owner is in bankruptcy, the SBA also denies PPP eligibility to the entity.  In recent days, two more courts have addressed various aspects of the SBA position. 

In a recent case from Maine, the plaintiff had filed Chapter 11 and sought approval of a disclosure describing its Chapter 11 plan.  The statement acknowledged the problems the virus presented to its business, but assured creditors that the plan was feasible.  The plaintiff continued to project that its business would be viable and would continue in business and meet plan obligations.  The statement also described a general effort to get assistance, but did not suggest any likelihood of suffering immediate and irreparable harm in the form of ceasing business if access to the PPP were denied.  The plaintiff’s statement also pointed to a forecasted ability to weather the current economic problems after July 2020 and into 2022, even without receipt of funds under the PPP. 

The court noted the devoid record of any showing of projected receipts and disbursements and determined that it didn’t have enough information to determine if the state Governor’s conduct seriously impaired the plaintiff’s financial projections.  The court denied the temporary restraining order (TRO).  In re Breda, No. 20-1008, 2020 Bankr. LEXIS 1246 (Bankr. D. Me. May 11, 2020).  In a later proceeding the plaintiff claimed that the defendant violated the anti-discrimination provisions of 11 U.S.C. §525.  The court granted the defendant’s motion to dismiss.  In re Breda, No. 18-10140, 2020 Bankr. LEXIS 1626 (Bankr. D. Me. Jun. 22, 2020).

Fifth Circuit case.  As noted above, the SBA created a regulation with respect to eligibility for the PPP that makes an applicant ineligible to receive program funds if the applicant is a debtor in a bankruptcy proceeding.  85 Fed. Reg. 23, 450 (Apr. 28, 2020).  In In re Hidalgo County Emergency Service Foundation v. Carranza, No. 20-40368, 2020 U.S. App. LEXIS 19400 (5th Cir. Jun. 22, 2020), the debtor was in Chapter 11 bankruptcy and was denied PPP funds.  The debtor claimed that such denial violated the anti-discrimination provisions of 11 U.S.C. §525(a) which bars discrimination based on bankruptcy status in certain situations.  The debtor also claimed that the regulation was arbitrary and capricious and an abuse of the SBA’s discretion. 

The bankruptcy court agreed and issued a preliminary injunction mandating that the SBA handle the debtor’s PPP application without considering that the debtor was in bankruptcy.  The district court stayed the injunction and certified the case for direct appeal to the appellate court.  On further review, the appellate court vacated the preliminary injunction noting that federal law prohibits injunctive relief against the SBA. 

Premium Assistance Tax Credit

The IRS recently proposed regulations clarify that the reduction of the personal exemption deduction to zero for tax years beginning after 2017 and before 2026 does not affect an individual taxpayer’s ability to claim the PATC.  The regulations essentially adopt the guidance set forth in Notice 2018-84.  The proposed regulations apply to tax years ending after the date the regulations are finalized as published in the Federal Register.  Taxpayers can rely on the proposed regulations for tax years beginning after 2017 and before 2026 that end on or before the date the Treasury decision adopting the regulations as final regulations is published in the Federal Register.  Prop. Treas. Reg. 124810-19.

On another angle, the self-employed health insurance deduction may allow for a PATC.  In Abrego, et ux. v. Comr., T.C. Memo. 2020-87, the petitioners, a married couple, received an advance premium assistance tax credit under I.R.C. §36B to help offset the higher cost of health insurance acquired through the Health Insurance Marketplace as a result of Obamacare.  The advance credit was received for a tax year during which the wife worked as a housekeeper and the husband worked as a driver for a transport company.  The husband also operated his own tax return preparation business. The IRS determined that the entire advanced credit had to be paid back based on the petitioners’ actual income for the year as reported on the tax return. 

The Tax Court held that the repayment amount was capped under I.R.C. §36B(f)(2) when taking into account the partial self-employment health insurance deduction that lowered the petitioners’ “household income” to just under 400 percent of the federal poverty line.  Thus, the petitioners were eligible for some advance credit amount under I.R.C. §36B(b)(2) rather than being completely ineligible.

Conclusion

These are just a small sample of what’s been happening in the courts that might impact a client’s return.  Unfortunately, it’s still tax season.  Fortunately, the IRS has announced that the end of tax season won’t be postponed again.  You can sign up for two days of continuing education on these and other topics at the National Farm Income Tax & Estate and Business Planning Conference in Deadwood, SD on July 20-21. You may either attend in-person or online.  For more information click here:  https://washburnlaw.edu/employers/cle/farmandranchtax.html

June 30, 2020 in Income Tax | Permalink | Comments (0)

Saturday, June 27, 2020

Is It A Gift or Not a Gift? That is the Question

Overview

Either as part of an estate plan or for purposes of setting up another person in business or for other reasons, a gift might be made.  But when is a transfer of funds really a gift?  Why does it matter?  The recipient doesn’t have to report into income gifted amounts.  If the amount transferred is not really a gift, then it’s income to the recipient.  When large amounts are involved, the distinction is of utmost importance.

When is a transfer of funds a gift?  It’s the topic of today’s blog article

Definition of a “Gift”

Under the Internal Revenue Code (“Code”), gross income is income from whatever source derived unless otherwise excluded.  I.R.C. §61(a)However, gross income does not include the value of property that is acquired by gift.  I.R.C. §102(a).  In Comr. v. Duberstein, 363 U.S. 278 (1960), the U.S. Supreme Court defined a gift under I.R.C. §102 as a transfer that proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity or like impulses.  As a result, the Supreme Court concluded that the most important consideration in determining whether a gift has been made is the donor’s intent.  That’s a broader inquiry than simply looking at how the donor characterizes a particular transaction.  A court will examine objectively whether a gift occurs based on the facts and if those facts support a donor that intended a transfer based on affection, etc.  Detached and disinterested generosity is the key.  If the transfer was made out of a moral duty or some sort of expectation on the recipient’s part, it is not a gift under I.R.C. §102 because it did not arise out of a detached and disinterred generosity.  Similarly, when the recipient has rendered services to a donor, a payment for services is not a gift even if the transferor had no legal obligation to pay the remuneration for the services.   

Apart from the Court’s analysis in Duberstein, a particular transaction may amount to a “common law” gift.  A common law gift requires only a voluntary transfer without consideration.  If the donor had no legal obligation to make the payment, the transfer is a gift under the common law standard.  That’s an easier standard to satisfy than the Code definition set forth in Duberstein

Recent Case

The recent Tax Court case of Kroner v. Comr., T.C. Memo. 2020-73 illustrates how the courts examine whether a particular transfer constitutes a gift and the consequences of misreporting the transaction(s) for tax purposes.  The petitioner was the CEO of a business that bought and sold structured settlement payments and lottery winnings.  The company would buy structured payments from lottery winners and resell the payments to investors.  The petitioner had historically worked in the discounted cashflow industry and, as a result, met a Mr. Haring, a wealthy British citizen, sometime in the 1990s.  Their business relationship lasted until 2007.

In 2003 and 2004, the petitioner was interested in protecting his assets and an attorney recommended the use of an “offshore” trust to hold the petitioner’s assets.  An offshore trust is often associated with tax scams, but I reserve that discussion for another post in the future.  In any event, the petitioner established the “Kroner Family Trust” in a small island in the Caribbean.  The petitioner was the beneficiary of the trust along with his son.  In 2007, the petitioner established another trust in the Bahamas to hold business assets.  From 2005-2007, the petitioner received wire transfers from Mr. Haring totaling $24,775,000.  Some of the transferred funds went directly to the petitioner, but others went to the trust in the Caribbean island and still others went to the petitioner’s business.  The lawyer that set up the offshore trusts “advised” the petitioner that the transfers were gifts that the petitioner didn’t have to report as taxable income.  The attorney’s legal “analysis” which led him to this conclusion was a conversation he had with the petitioner and a note that he drafted for Mr. Haring stating that the transfers were gifts.  The attorney also advised the petitioner of the requirements to file Form 3520 every year that he received a transfer from Mr. Haring to report the gifts from a foreign person.  A CPA prepared the Form 3520 for the necessary years.  The petitioner never reported any of the transfers from Mr. Haring as taxable income. 

The petitioner was audited for tax years 2005-2007.  The IRS took the position that the transfers were not gifts, should have been reported as taxable income, and assessed accuracy-related penalties on top of the tax deficiency. 

The Tax Court agreed that the transfers should have been included in the petitioner’s taxable income.  They were not gifts.  The Tax Court noted that Mr. Haring’s intention was the most critical factor in determining the status of the transfers.  The petitioner bore the burden to establish Mr. Haring’s intent by a preponderance of the evidence.  However, Mr. Haring never appeared at trial and didn’t provide testimony.  Instead, the petitioner tried to establish the gift nature of the transfers by his own testimony.  The petitioner and Mr. Haring had operated some business interests together in the 1990s, and the petitioner acted as a nominee for Mr. Haring for certain of Mr. Haring financial interests.  He even formed a trust in Liechtenstein for Mr. Haring in 2000.  Mr. Haring also provided a loan for the petitioner’s credit counseling business in 2000.  That loan was paid off in 2007.  Mr. Haring also held about a 70 percent equity interest in the petitioner’s cashflow industry business in exchange for providing funding and loan guarantees.  He later liquidated his interest for $255 million. 

The petitioner last saw Mr. Haring in 2002 and testified at trial that he didn’t know where he lived and that he didn’t know his telephone number.  He did, however, receive a telephone call from Mr. Haring in 2005 that lasted no more than three minutes.  The petitioner claimed that Mr. Haring told him during the call that Mr. Haring had a “surprise” for the petitioner.  The petitioner later met with Mr. Haring’s associate and they set up the ability to receive wire transfers from Mr. Haring into the petitioner’s bank account.  That’s when the attorney drafted a note to the petitioner from Mr. Haring stating that the transfers would be gifts. 

The Tax Court didn’t buy the petitioner’s story, finding that neither the petitioner nor the attorney were credible witnesses.  The Tax Court stated that the petitioner’s testimony was self-serving and that the attorney’s testimony was “simply not credible.”  There was no supporting documentary evidence.  In addition, the attorney represented both Mr. Haring and the petitioner.  The Tax Court also noted that the attorney was “evasive in his answers and in his selective invocation of the attorney-client privilege with regard to the legal advice provided to Mr. Haring about the transfers.”  The Tax Court also doubted the authenticity and credibility of the 2005 note allegedly from Mr. Haring but drafted by the attorney regarding his desire to gift funds to the petitioner.  Thus, the note carried little weight in determining whether the transfers were gifts.     

The Tax Court also determined that the petitioner failed to prove that the transfers were made with disinterested generosity.  The record was simply devoid of any credible evidence to prove that Mr. Haring transferred the funds to the petitioner with detached and disinterested generosity.  The Tax Court noted that timing of some of the transfers with liquidity events of the petitioner’s business of which Mr. Haring was an investor.  That raised a question as to whether Mr. Haring was acting as the petitioner’s nominee. 

The Tax Court determined that the petitioner need not pay the 20 percent accuracy-related penalty because the IRS failed to satisfy its burden of production under I.R.C. §6751(b)

Conclusion

The Kroner case is a textbook lesson on what constitutes a gift – detached and disinterested generosity.  The burden of establishing that a transfer is a nontaxable gift is on the party asserting that the transfer amounted to a gift.  The case is also a lesson into the messes that sloppiness and questionable lawyering can get a client into.  When the amount of the gift (or gifts) is as large as that involved in the Kroner case, attention to detail is a must.  The income tax consequences from being wrong are enormous. 

June 27, 2020 in Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, June 24, 2020

Valuing Farm Chattels and Marketing Rights of Farmers

Overview

When a farmer or rancher dies, often left behind are assets that are unique to agriculture.  For tax purposes, these assets present unique valuation issues.  For practitioners handling ag estates, it’s important to get values correct for federal estate tax purposes and/or a county inheritance tax worksheet.  What are the basics tenets of valuing these unique farm and ranch items?  This was an issue that Don Kelley, who I started out my practice career out with in North Platte, NE, wrote about in his two-volume treatise, Estate Planning for Farmers and Ranchers, and his other two-volume set, Farm Business Organizations.  Don recently turned over the editorship of those treatises to me.  In working on updating those volumes recently, I thought it would be a useful topic for today's article.  

Valuing farm chattels and marketing rights of a farmer at death – it’s the topic of today’s post

Valuing Chattels

There is no specific Treasury Regulation that addresses the valuation of tangible chattel property (personal property) beyond Treas. Reg. §20.2031-6 (addressing household goods/personal effects) and Treas. Reg. §20.2031-1 which addresses general valuation concepts. 

Treas. Reg. §20.2031-1(b) states:

“Livestock, farm machinery, harvested and growing crops must generally be itemized and the value of each item separately returned.  Property shall not be returned at the value at which it is assessed for local property tax purposes unless that value represents the fair market value as of the applicable valuation date.  All relevant facts and elements of value as of the applicable valuation date shall be considered in every case.”

It’s often easier to value chattels and inventory them than it is to value farm/ranch real estate.  Most farm machinery has an established market.  As a result, appraisals of farm machinery and equipment usually are not controversial.  If there is an established retail market for chattel property, it is to be value at retail.  Treas. Reg. §20.2031-1(b).  As the regulation states, “For example, the fair market value of an automobile (an article generally obtained by the public in the retail market) includible in the decedent's gross estate is the price for which an automobile of the same or approximately the same description, make, model, age, condition, etc., could be purchased by a member of the general public and not the price for which the particular automobile of the decedent would be purchased by a dealer in used automobiles.  Examples of items of property which are generally sold to the public at retail may be found in §§ 20.2031-6 and 20.2031-8.”  Id.

This same approach is to be used with respect to farm machinery and equipment and also farm vehicles.  For example, in Estate of Love v. Comr., T.C. Memo. 1989-470, the decedent was in the business of breeding and racing thoroughbred horses and died 11 days after a brood mare mated.  It was not possible as of the date of the decedent’s death (the valuation date) to determine whether the mare was pregnant at the time the decedent died, but the IRS went ahead and assumed that the mare was pregnant on the date of the decedent’s death for valuation purposes.  Doing so greatly increased the value of the mare.  The Tax Court determined that that post-death pregnancy of the mare was not to be taken into account when valuing the mare for estate tax purposes.  There was no way that a hypothetical willing buyer would have known that the mare was pregnant, and the Tax Court determined that the assumption by the IRS of the mare’s pregnancy was not in accord with Treas. Reg. §20.2031-1(b).  The Tax Court also excluded post-death sales of horses in the determination of the mare’s value and relied on comparable sales of horses near the date of the decedent’s death.  The Tax Court’s opinion was upheld on appeal.  923 F.2d 335 (4th Cir. 1991).  

Valuating Fixtures

Farm buildings, fences, water wells and similar items are customarily appraised as part of the farm real estate.  But, if a fixture (and associated chattel equipment) is linked with crop production, valuation is more problematic.  An example of such an item would be an irrigation well used to pump water for crop irrigation.  At least in the areas of the Great Plains and the western Midwest, IRS offices have historically valued detachable chattel items as farm machinery.  Such items of property include aboveground pivot irrigation systems, motors and pumps.  The associated land on which the irrigated crops are grown is typically appraised along with any immovable fixtures (i.e., wells; well casings; pivot stanchions) in place. 

Inventory

Harvested grain in inventory of a farmer usually doesn’t present a valuation issue.  The grain is valued in accordance with trading exchanges for the type of crop involved as of the date of death.  For example, in Willging v. United States, 474 F.2d 12 (9th Cir. 1973), the plaintiff was a wheat farmer that reported income on the accrual basis.  The value of the 1966 opening grain inventory increased by over $36,000 from January 1, 1966 until the date of the farmer’s death in November.  The estate claimed that the increase in the inventory values escaped taxation because of the basis step-up rule of I.R.C. §1014.  The appellate court disagreed, reversing the trial court.  The court noted that the farmer determined income annually by adding to the sales price of products sold during the year the value of his closing inventory, and then subtracting from that amount the value of the opening inventory.  Inventories were valued under the “farm price” method (market price less direct costs of disposition).  The farmer deducted expenses in the year incurred.  Because the farmer elected to be taxed under the accrual method, the court noted that the value of the grain was realized when it increased the inventory value.  It wasn’t realized when it was later sold.  Thus, his death didn’t have the effect of accruing items which would not otherwise have been accrued, but his death closed the tax year for his last tax year for the income he had received that year. 

Marketing Rights

Many farmers are members of agricultural cooperatives and may hold cooperative marketing rights as of the time of death.  This is particularly true with respect to dairy farmers and is also common among beekeepers.  How are such rights valued?  In Cordeiro’s Estate v. Comr., 51 T.C. 195 (1968), the petitioner acquired a herd of dairy cows from the decedent.  The decedent was a member of a cooperative marketing association and had been required to market all of his milk from the herd through the cooperative.  The decedent had been allocated “base” as a measure of his share in the proceeds of the cooperative’s milk sales.  The decedent’s membership and base expired upon the decedent’s death and the petitioner succeeded to it and membership in the cooperative.  The Tax Court determined that the base was separate from the dairy herd and that the petitioner’s cost basis in the dairy cows was to be determined without any value attributed to the base.  A milk base is an intangible right to sell a certain amount of milk at a particular price.  See, Priv. Ltr. Rul. 7818002 (Jan. 6, 1978).  See also, Vander Hoek v. Comr., 51 T.C. 203 (1968), acq., 1969 A.O.C. LEXIS 210 (May 9, 1969). 

Similarly, a rice allotment has been held to be a right this is devisable, descendible, transferable and salable.  First Victoria National Bank v. United States, 620 F.2d 1096 (5th Cir. 1980).  The court said that the allotment was similar to business goodwill.  That reasoning could support an IRS argument that other USDA program benefits that a decedent had applied for have value for tax purposes associated with death. 

Conclusion

Valuation issues for farmers and ranchers can be unique.  When particular items of chattel property are involved, specific valuation guidance is often lacking, and the existing guidance is dated.  While the courts have addressed some of the issues, the general advice of not being greedy holds true.  If a valuation amount looks reasonable to an IRS examining agent, chances are IRS won’t push the issue.

This is just one of the issues that will be addressed at the 2020 Farm & Ranch Income Tax/Estate and Business Planning national conference in Deadwood, South Dakota on July 20-21.  You may attend either in-person or online.  For more information on the conference and how to registration information click here:  https://washburnlaw.edu/employers/cle/deadwoodcle.html

June 24, 2020 in Estate Planning | Permalink | Comments (0)

Saturday, June 20, 2020

Are Dinosaur Fossils Minerals?

Overview

In the mid-1950s, my Father was having the first of several ponds dug on farm property in northeastern Indiana that he and my Mother had purchased a few years earlier.  During the excavation Mastodon bones (fossils) were unearthed in the muck and grey/blue clay, including a nearly full set of teeth and jaw bones.  Mastodon bones were also unearthed on nearby farms and when a local branch campus of Purdue and Indiana Universities opened in the fall of 1964 it was given the nickname “Mastodons.” 

An issue that I am certain never crossed my Father’s mind, likely because my parents owned both the surface and subsurface estates of the farm, was whether the fossils were “minerals” that would belong to the owner of the mineral estate.  But, the legal classification of fossils is a very important issue when the fossils are valuable. 

Are fossils “minerals” that are owned by the owner of the mineral estate?  It’s the topic of today’s post.

Surface Estate and Mineral Estate

A fee simple owner of real estate can maintain possession and control of the surface of the property and sell/convey the rights to the “minerals” (such as oil and gas).  Upon such a conveyance, the owner of the mineral rights (known as the mineral estate owner) can economically benefit from the extraction of the minerals.  Depending on the mineral deed that conveys the minerals, the deed language may include all minerals known and unknown or the definition of “minerals” may be limited to specific ones. 

Definition of “Minerals”

A common granting clause in a mineral deed specifies that the grantor either conveys or reserves “the oil, gas and other minerals.”  That language can raise an issue concerning what “other minerals” means.  Does it include such things as gravel, clay granite, sandstone, limestone, coal, carbon dioxide, hot water and steam?  The courts have struggled with this issue and have reached differing conclusions.  Does the phrase mean anything that is in the soil that the surface estate owner doesn’t use for agricultural purposes?  Does is matter how the substance is extracted?  Does it matter if the material is located in the subsoil rather than the topsoil?  Is it material if the substance can be extracted without significant damage to the surface estate? 

In 1949, the Texas Supreme Court issued a significant opinion on the issue of whether the term “minerals” includes substances other than oil and gas.  Heinatz v. Allen, 217 S.W.2d 994 (Tex. 1949).  The court utilized the “common meaning” rule under which all substances ordinarily thought of as minerals at the time the deed was executed are deemed to be minerals conveyed by the deed regardless of whether the parties knew the substances existed.  That would seem to include in the definition of minerals such substances as gold, silver, coal, iron ore, etc..  Substances such as sand, gravel, water, etc. that are ordinarily associated with ownership of the surface estate would not be included in the definition of minerals.  But the test is not a perfect, all-inclusive one and other factors can be relevant – such as exceptional value; surface destruction; and commercial and/or industrial meaning.  In addition, state law may have a specific definition that applies in a particular situation.

What Are Fossils?

The issue of whether dinosaur fossils are “minerals” for the purposes of a mineral reservation clause in a mineral deed was an issue in a recent Montana case.  In Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020), the court dealt with the issue in a case with millions of dollars on the line.  Under the facts of the case, the plaintiffs (a married couple), leased farm and ranch land beginning in 1983.  Over a period of years, the owner of the land transferred portions of his interest in the property to his two sons and sold the balance to the plaintiffs.  From 1991 to 2005, the plaintiffs and the sons operated the property as a partnership.  In 2005, the sons severed the surface estate from the mineral estate and sold their remaining interests in the surface estate to the plaintiffs.  A mineral deed was to be executed at closing that apportioned one-third of the mineral rights to each son and one-third to the plaintiffs.  After the transactions were completed, the plaintiffs owned all of the surface estate of the 27,000-acre property and one-third of the mineral (subsurface) estate.  At the time, none of the parties suspected there were valuable dinosaur fossils on the property, and none of them gave any thought to whether dinosaur fossils were part of the mineral estate as defined in the mineral deed.  Likewise, none of the parties expressed any intent about who might own dinosaur fossils that might be found on the property. 

Specifically, the mineral deed stated that the parties would own, as tenants in common, “all right, title and interest in and to all of the oil, gas, hydrocarbons, and minerals in, on and under, and that may be produced from the [Ranch].”  The purchase agreement required the parties “to inform all of the other parties of any material event which may [affect] the mineral interests and [to] share all communications and contracts with all other Parties.” 

In 2006, the plaintiffs gave permission to a trio of fossil hunters to search (and later dig) for fossils on the property.  The hunters ultimately uncovered dinosaur fossils of great value including a nearly intact Tyrannosaurus rex skeleton and two separate dinosaurs that died locked in battle.  The fossils turned out to be extremely rare and quite valuable, with the “Dueling Dinosaurs” valued at between $7 million and $9 million.  In 2014, the plaintiffs sold the Tyrannosaurus rex skeleton to a Dutch museum for several million dollars.  A Triceratops foot was sold for $20,000 and a Triceratops skull was offered for sale for over $200,000.  The proceeds of sale were placed in an escrow account pending the outcome of a lawsuit that the sons filed.  The sons (the defendants in the present action) sued claiming that the fossils were “minerals” and that they were entitled to a portion of any sale proceeds.  The plaintiffs brought a declaratory judgment action in state court claiming that the fossils were theirs as owners of the surface estate.  The defendants removed the action to federal court and asserted a counterclaim on the basis that the fossils should be included in the mineral estate.  The trial court granted summary judgment for the plaintiffs on the basis that, under Montana law, fossils are not included in the ordinary and natural meaning of “mineral” and are thus not part of the mineral estate.  Murray v. Billings Garfield Land Co., 187 F. Supp. 3d 1203 (D. Mont. 2016)

On appeal, the appellate court reversed.  Murray v. BEJ Minerals, LLC, 908 F.3d 437 (9th Cir. 2018).  The appellate court determined that the term “fossil” fit within the dictionary definition of “mineral.” Specifically, the appellate court noted that Black’s Law Dictionary defined “mineral” in terms of the “use” of a substance, but that defining “mineral” in that fashion did not exclude fossils.  The appellate court also noted that an earlier version of Black’s Law Dictionary defined “mineral” as including “all fossil bodies or matters dug out of mines or quarries, whence anything may be dug, such as beds of stone which may be quarried.”  Thus, the appellate court disagreed with the trial court that the deed did not encompass dinosaur fossils.  Turning to state court interpretations of the term “mineral”, the appellate court noted that the Montana Supreme Court had held certain substances other than oil and gas can be minerals if they are rare and exceptional.  Thus, the appellate court determined that to be a mineral under Montana law, the substance would have to meet the scientific definition of a “mineral” and be rare and exceptional.  The appellate court held that those standards had been met.  The plaintiffs sought a rehearing by the full Ninth Circuit and their request was granted.  Murray v. BEJ Minerals, LLC, 920 F.3d 583 (9th Cir. 2019).  The appellate court then determined that the issue was one of first impression under Montana law and certified the question of whether dinosaur fossils constitute “minerals” for the purpose of a mineral reservation under Montana law to the Montana Supreme Court.  Murray v. BEJ Minerals, 924 F.3d 1070 (9th Cir. 2019)

The Montana Supreme Court answered the certified question in the negative – dinosaur fossils are not “minerals” for the purpose of the mineral reservation at issue because they were not included in the expression, “oil, gas and hydrocarbons,” and could not be implied in the deed’s general grant of all other minerals.  “Fossils” and “minerals” were mutually exclusive terms as the parties used those terms in the mineral deed.   Murray v. BEJ Minerals, LLC, No. OP 19-0304, 2020 Mont. LEXIS 1472 (Mont. Sup. Ct. May 20, 2020). 

In making its determination, the Montana Supreme Court reasoned that whether a substance or material is a “mineral” is based on whether it is rare and valuable for its mineral properties, whether the conveying instrument expressed an intent to use the scientific definition of the term, and the relation of the substance or material to the land’s surface and the method and effect of its removal. The Court also noted that deeds are like contracts and should be interpreted in accordance with their plain and ordinary meaning to give effect to the parties’ mutual intent at the time of execution. 

The Court noted that the term “minerals” is defined in various areas of Montana statutory law (including tax provisions) and none include “fossils,” and that the only statutory provision mentioning fossils and minerals in the same statute referred to them separately.  The Court also noted that the U.S. Department of Interior (for purposes of federal law) had made an administrative decision in 1915 that dinosaur fossils are not “minerals.”  As such, the terms were mutually exclusive as used in the mineral deed between the parties, and the plaintiffs maintained ownership of any interests that the two sons had not specifically reserved in the mineral deed.  The deed simply did not contemplate including “fossils” under the mineral reservation clause.  Instead, the Court concluded that “minerals” under Montana law are a resource that is mined as a raw material for further processing, refinement and eventual economic exploitation.  Fossils are not mined, they are excavated, and they are not rare and valuable due to their mineral properties.  Therefore, unless specifically mentioned in the mineral deed, language identifying “minerals” would not “ordinarily and naturally” include fossils.

Based on the Montana Supreme Court’s answer to the certified question, the U.S. Court of Appeals for the Ninth Circuit affirmed the federal district court’s order granting summary judgment to the plaintiffs and declaring them the sole owners of the dinosaur fossils.  Murray v. BEJ Minerals, LLC, No. 16-35506, 2020 U.S. App. LEXIS 19064 (9th Cir. Jun. 17, 2020).

Conclusion

While it’s not possible to anticipate what might be found on or under a tract of land, drafters of mineral deeds must carefully consider the potential impact of drafting language.  This issue can be of primary importance, as the Montana case illustrates.  Also, while it didn’t apply to the Montana case, the Montana Governor signed H.B. 229 into law on April 16, 2019.  That legislation specifies that dinosaur fossils are not minerals and that fossils belong to the holder of the surface estate.  

If only that Mastodon unearthed in the 1950s had been a Tyrannosaurus rex….

June 20, 2020 in Real Property | Permalink | Comments (0)

Wednesday, June 17, 2020

Tax Issues Associated With Options In Wills and Trusts

Overview

As part of an estate plan, an heir may be given an option to buy certain assets of the decedent at a specified price.  In agricultural estates, such an option is typically associated with farmland of the decedent, and often gives the optionee (the person named in the will with the right to exercise the option) a very good deal for the property upon exercise of the option. 

Often the question arises as to the basis of the property in the hands of the optionee when the option is exercised and the resulting tax consequences when the property is later sold. 

Tax issues associated with the exercise of an option – it’s the topic of today’s post.

Options – The Basics

There is no question that an option can be included in a will.  A testator has the right to dispose of their property as desired.  The only significant limitation on testamentary freedom involves the inability to completely disinherit a spouse.  Even if the will leaves nothing for the surviving spouse, under state law the surviving spouse has a right to an elective share entitling the surviving spouse to “elect” to take a portion of the estate regardless of what the deceased spouse’s will says (except, of course, if a valid prenuptial agreement was executed).   Under most state laws, a surviving spouse’s elective share comprises anywhere from between one-third to one-half of the decedent’s estate.  In addition, in some states, the spousal elective share can include retirement assets or life insurance. 

Tax Issues

What are the tax consequences when an optionee exercises an option?  Does the exercise result in tax consequences to the decedent’s estate?  What are the tax consequences if the optionee later sells the property that was acquired by the exercise of the option? 

Decedent’s estate.  The exercise of an option results in no tax consequence to the decedent’s estate.   The exercise of the option, followed by the sale of the property by the estate to the holder of the option does not result in gain or loss to the estate.   In Priv. Ltr. Rul. 8210074, Dec. 10, 1981, the decedent's son was given an option under the terms of the parent’s will to purchase some of the parent’s farmland at $350/acre. The son exercised the option and paid the estate $26,668 for the land. At the time the option was exercised, the farmland was worth $114,293 (as valued on the parent’s estate tax return). The IRS determined that the combined basis of the option and the real estate subject to the option was $114,293 with $26,668 of that allocable to the land. Thus, when the real estate was sold to the son for $26,668, it equaled the basis in the land in the hands of the estate resulting in neither gain nor loss to the estate.

Optionee’s basis. 

When the optionee exercises the option in a will or trust, the primary question is what the income tax basis of the property received under the option is in the optionee’s hands.  I.R.C. §1014 is the applicable basis provision for property acquired from a decedent.  The provision states in pertinent part, “(a)In general Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be— (1) the fair market value of the property at the date of the decedent’s death,… (b)Property acquired from the decedent For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (1) Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent….

This ‘”stepped-up” basis rule applies to property required to be included in the decedent’s gross estate, including property that is subject to an option in a will (or trust) that grants the beneficiary an option to purchase the property at a beneficial price from the estate.  The option is treated as property acquired from the decedent and receives an income tax basis equal to its fair market value as of the date of the decedent’s death.  Its basis is the estate tax value of the property subject to the option less the price the beneficiary must pay to exercise the option.  A beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the optionee’s basis in the property. 

In Cadby v. Comr., 24 T.C. 899 (1955), acq., 1956-2 C.B. 5, the decedent died in 1942.  His will included a provision directing the executor and trustee to sell some of the decedent’s stock to a family member and another person for $25,000 upon proof that the family member had purchased from the decedent’s surviving spouse preferred stock in the same company for $6,000 if payment were made within two years of the decedent’s death.  If payment wasn’t made within the specified timeframe, disposition of the stock was left to the discretion of the executor and trustee. Shortly after the decedent’s death, the family member sold his rights under the will to a third party for $13,000.

In determining the tax consequence of the transaction to the family member, the Tax Court noted that the fair market value of the decedent’s stock interest subject to the option was $55,243 as of the date of death as denoted on the decedent’s federal estate tax return.  In addition, the family member paid $6,000 for the stock he purchased from the decedent’s surviving spouse.  Thus, the family member’s income tax basis in the stock was $61,243.40.  From that amount, the Tax Court subtracted the option price of $25,000 and the payment to the surviving spouse of $6,000.  The result, $30,243.40, was the option price.  Because the family member held a one-half interest in the option, that one-half interest was worth $15,121.70.  Thus, the sale for $13,000 did not trigger any taxable income to the family member. 

IRS Position

Twelve years after the Tax Court’s ruling in Cadby, the IRS issued a Revenue Ruling formally stating its position that a beneficiary who exercises an option under a will may add the basis of the option to the cost of the property (the option amount) to determine the beneficiary’s basis in the property.  Rev. Rul. 67-96, 1967-1 C.B. 195.  In 2003, the IRS issued a private letter ruling again confirming the Tax Court’s approach in Cadby.  Priv. Ltr. Rul. 200340019 (Jun. 25, 2003).  Under the facts of the ruling, under the terms of Mother's will, the taxpayer was given the right to purchase the Mother’s home upon the Mother’s death at an amount less than fair market value.  The basis in the option and in the home upon exercise of the option was determined in accordance with Rev. Rul. 67-96.  Thus, the basis in the option upon its exercise was measured by the difference between the value of the home for federal estate tax purposes and the option price.  In addition, as a result of exercising the option, the taxpayer’s basis in the home was the sum of the basis of the option and the actual option price paid. 

Conclusion

Options can play an important role in transitioning a farming or ranching business to the next generation.  Not only must thought be given to the financial ability of the optionee to exercise the option, the income tax issues triggered upon exercise of the option and, when applicable, the subsequent sale of the property acquired by exercising the option must also be considered.

June 17, 2020 in Estate Planning, Income Tax | Permalink | Comments (0)

Monday, June 15, 2020

Liability For Injuries Associated With Horses (And Other Farm Animals)

Overview

In recent years, all states except California and Maryland (and New York, to some extent) have enacted Equine Activity Liability Acts designed to encourage the continued existence of equine-related activities, facilities and programs, and provide the equine industry limited protection against lawsuits.  The laws vary from state-to-state, but generally require special language in written contracts and liability releases or waivers; require the posting of warning signs; an attempt to educate the public about inherent risks in horse-related activities; and provide immunities designed to limit liability.  The basic idea of these laws is to provide a legal framework to incentivize horse-related activities by creating liability protection for horse owners and event operators.

An important question is whether the laws extend to farm animals and persons working on farms and ranches.

Liability rules involving horses, farm animals and associated events – it’s the topic of today’s post.

State Law Variations

Under the typical statute, an “equine activity sponsor,” “equine professional,” or other person  can only be sued in tort for damages related to the knowing provision of faulty tack failure to determine the plaintiff’s ability to safely manage a horse, or failure to post warning signs concerning dangerous latent conditions.  For example, in Germer v. Churchill Downs Management, No. 3D14-2695, 2016 Fla. App. LEXIS 13398 (Fla. Ct. Ap. Sept. 7, 2016), state law “immunized” (among other things) an equine activity sponsor from liability to a “participant” from the inherent risks of equine activities.  The plaintiff, a former jockey visited a racecourse that the defendant managed.  It was a spur-of-the-moment decision, but he was required to get a guest pass to enter the stables.  He was injured by a horse in the stables and the court upheld the immunity provisions of the statute on the basis that the requirement to get a guest pass before entering the stables was sufficient protocol to amount to “organization” which made the plaintiff’s visit to the stables “an organized activity” under the statute. 

While many state equine activity laws require the postage of warning signs and liability waivers, not every state does.  For example, the statutes in CT, HI, ID, MT, NH, ND, UT, WA and WY require neither signage nor particular contract language.

Recovery for damages resulting from inherent risks associated with horses is barred, and some state statutes require the plaintiff to establish that the defendant’s conduct constituted “gross negligence,” “willful and wanton misconduct,” or “intentional wrongdoing.”  For example, in  Snider v. Fort Madison Rodeo Corp., No. 1-669/00-2065, 2002 Iowa App. LEXIS 327 (Iowa Ct. App. Feb. 20, 2002), the plaintiff sued a parade sponsor and a pony owner for injuries sustained in crossing the street during a parade.  The court determined that the omission of a lead rope was not reckless conduct and that the plaintiff assumed the risk of crossing the street during the parade.  Similarly, in Markowitz v. Bainbridge Equestrian Center, Inc., No. 2006-P-0016, 2007 Ohio App. LEXIS 1411 (Ohio Ct. App. Mar. 30, 2007), the court held that there was no evidence present that the plaintiff’s injuries sustained in the fall from a horse was a result of the defendant’s willful or wanton conduct or reckless indifference.  In addition, the signed liability release form complied with statutory requirements.  However, in Teles v. Big Rock Stables, L.P., 419 F. Supp. 2d 1003 (E.D. Tenn. 2006), the provision of a saddle with stirrups that could not be shortened enough to reach plaintiff’s feet which then caused the plaintiff to fall from a horse raised jury question as to whether faulty tack provided, whether the fall was the result of the inherent risk of horseback riding, and whether the defendant’s conduct was willful or grossly negligent and, thus, not covered by the signed liability release form.

What constitutes an “inherent risk” from horse riding is a fact issue in many states due to the lack of any precise definition of “inherent risk” in the particular state statute.  For example, under the Texas Equine Activity Liability Act, the phrase “inherent risk of equine activity” refers to risks associated with the activity rather than simply those risks associated with innate animal behavior.  See, e.g., Loftin v. Lee, No. 09-0313, 2011 Tex. LEXIS 326 (Tex. Sup. Ct. Apr. 29, 2011).  The Ohio equine activities immunity statute has been held to bar recovery for an injury incurred while assisting an employer unload a horse from a trailer during a day off, because the person deliberately exposed themselves to an inherent risk associated with horses and viewed the activity as a spectator.  Smith v. Landfair, No. 2011-1708, 2012 Ohio LEXIS 3095 (Ohio Sup. Ct. Dec. 6, 2012)Also, in Einhorn v. Johnson, et al., No. 50A03-1303-CT-93, 2013 Ind. App. LEXIS 495 (Ind. Ct. App. Oct. 10, 2013), the Indiana Equine Activity Act barred a negligence action after a volunteer at a county fair was injured by a horse.  The plaintiff’s injuries were determined to result from the inherent risk of equine activities.  Likewise, in Holcomb v. Long, No. A14A0815, 2014 Ga. App. LEXIS 726 (Ga. Ct. App. Nov. 10, 2014), the Georgia Equine Activities Act barred recovery for injuries sustained as a result of slipping saddle during horseback ride; slipping saddle inherent risk of horseback riding.  See also, Fishman v. GRBR, Inc., No. DA 17-0214, 2017 Mont. LEXIS 602 (Mont. Sup. Ct. Oct. 5, 2017).

Application to Farm Animals

Iowa and Texas amended their existing laws in 2011 to include farm animals.  The Iowa provision, known as the “Domesticated Animal Activities Act” (Iowa Code §§673.1-673.3) was amended due to a state Supreme Court decision.  The Texas “Farm Animal Act” is an expanded revision to that state’s Equine Activity Act. 

Iowa.  The Iowa law was enacted in 1997 and amended in 2011 as a result of a 2009 Iowa Supreme Court decision, Baker v. Shields, 767 N.W.2d 404 (Iowa 2009). Under the facts of the case, a farmhand suffered a severe leg fracture in a fall from a horse during an attempt to move his employer’s cattle.  What was assumed to be the employer’s horse was a two-year old that the farmhand had successful ridden a few days earlier. The farmhand sued his employer (a father and son duo) to recover for his damages, claiming that because his employer did not carry workers’ compensation insurance as the plaintiff claimed Iowa law required, he was entitled to a presumption that his injury was the direct result of the employer’s negligence and that the negligence was the proximate cause of his injury.

The employer moved for summary judgment based on the immunity granted in the Domesticated Animal Activities Act (Act). Based on the language of the statute and the history behind enactment in most of the states with equine liability laws, the employer’s claim of immunity under the Act looked to be a long-shot. However, the trial court granted the employer’s motion for summary judgment, finding that a horse is a “domesticated animal,” riding a horse is a “domesticated animal activity,” and the horse’s actions were an inherent risk of that activity. More importantly, the trial court noted that the statute provided that a “person” is not liable under the Act and reasoned that “person” should be broadly construed to include employer/employee settings involving the use of livestock – such as the employer’s horse in this case. The trial court also noted that the Act defined “participant” as “a person who engages in a domesticated animal activity, regardless of whether the person receives compensation” and reasoned that this indicated application to employment situations. 

The Supreme Court affirmed based on its belief that the Iowa legislature intended the statute to apply broadly to all “persons” and that the statutory definitions of “domesticated animal activity sponsor” and “domesticated animal event” did not preclude ag employment situations involving domesticated livestock (although the “sponsors” and “activities” listed in the statute have nothing to do with common ag employment situations).

At trial, and again at the Supreme Court, the farm hand argued that the Act did not specifically exempt farming operations as a “domesticated animal activity sponsor” and, as such, only applied to activities involving participation of members of the general public (as “spectators” in or “participants” of activities involving domesticated animals) and not “traditional farming operations done by employees.” However, the Iowa Supreme Court agreeing with the trial court, determined that the Act applied, and that the employer was immunized from suit.  The Court’s opinion was a stretch (to say the least) of the intent and meaning of the Act’s language.  At the time, the Court’s decision was the first court opinion to hold that a state equine activity (or domestic animal activity) liability act applied to common agricultural employment situations with the effect of immunizing the employer from suit from damages arising from inherent risks associated with the subject animal.  In 2011, the Iowa legislature amended the statute to include domestic animals.

Texas.  In 1995, Texas enacted the Equine Activity Act (Equine Act).  Ch. 87 of Tex. Civ. Prac. & Rem. Code.  The Equine Act provided that “any person, including an equine activity sponsor or an equine professional, is not liable for property damage or damages arising from the personal injury or death of a participant…[that] results from the dangers or conditions that are an inherent risk of equine activity.”  An equine activity sponsor is “a person or group who sponsors, organizes, or provides the facilities for an equine activity…without regard to whether the person operates for profit.”  The statute provides many examples demonstrating the specific application of the Equine Act and its concern for equine activities unrelated to ranching activities such as breeding, feeding and working equine animals as a vocation.  None of the examples hinted at any application to ranchers’ and ranch hands’ involvement with horses. 

In 2011, the Texas legislature amended the Equine Act.  The amendment renamed the law as the “Farm Animal Activity Act” and broadened coverage to include other farm animals in addition to equines.  Veterinarians and livestock shows were also included under its coverage, and the words “handling, loading, or unloading” were added to the definition of “farm animal activity.”  The Farm Animal Activity Act limits the liability of “any person, including a farm animal activity sponsor [or] farm animal professional,” but also includes examples of a person whose liability is limited that is demonstrated to be event organizers and facility providers with “professionals” defined as trainers and equipment renters.  All of the livestock examples relate to shows, rides, exhibitions, competitions and similar events.  The Farm Animal Act limits liability to or for a “participant.”  A “participant is defined as “a person who engage in [a farm animal] activity without regard to whether the person is an amateur or professional or whether the person pays for the activity or participates in the activity for free. 

In Waak v. Rodriguez, No. 19-0167, 2020 Tex. LEXIS 528 (Tex. Sup. Ct. Jun. 12, 2020), ranch owners (a married couple) bred Charolais cattle on their 760-acre ranch in southeast Texas.  They hired an individual (Raul Zuniga) on a part-time basis to work the cattle, do landscaping and cut hay.  Raul later started working full-time for them and lived on the ranch in a mobile home that he was purchasing from them.  After training him how to work and cut cattle, Raul was given daily tasks and often worked cattle alone.  In late 2013, the couple asked Raul to moved cattle to another location on the ranch, a task he had done often in the past.  The couple then went left to run errands in town about 20 miles away.  Upon their return to the ranch, the owners found Raul lying dead behind the barn.  A medical examiner determined that Raul’s cause of death at (almost) age 34 was “blunt force and crush injuries” that were “severe enough to have come from extensive force like that of a large animal trampling the body.”  His surviving parents and children sued the ranch owners for wrongful death.  They did not participate in the Texas workers’ compensation system.  The lawsuit claimed that a bull killed Raul and that the owners were negligent in failing to provide a safe workplace; failing to properly train Raul; and failing to warn of the dangers of working cattle and failing to properly supervise him.  The owners claimed that the Farm Animal Activity Act barred the lawsuit, and the trial court agreed.  The appellate court reversed, however.

On further review, the Texas Supreme Court affirmed the appellate court’s decision – the Farm Animal Activity Act did not apply, and the suit was not barred.  The Court noted that the text and examples contained the legislation did not make any reference to ranchers or ranch hands or otherwise indicate that they were covered.  The Court also indicated its belief that no reported decision anywhere in the country applied an equine statute to farming or ranching or limit an employee’s recovery for on-the-job injuries.  The ranch owners’ attorneys failed to bring the Iowa case to the Court’s attention (the owners’ attorneys were civil litigators from a big-city firm and not rural ag lawyers).  The Court also noted that while the legislature had broadened the statute in 2011 and renamed it, it still limited liability protection to event organizers and facilities providers as well as professional trainers and equipment renters.  All of the livestock examples in the amended statute still were in the context of “shows.”  Ranch hands, the Court noted, do not work as “amateurs” or “professionals” and do not pay to do their work and don’t typically work for free.  Ranch hands are not “participants.”

Conclusion

State Equine Activity Liability laws are designed to provide liability protection for injuries arising from horse-related activities.  The Iowa and Texas provisions have been modified to include farm animals.  It would have been interesting had the ranch owners in the Texas case brought the Iowa case to the Texas Supreme Court’s attention.  While doing so may not have resulted in a different outcome, the Court would have been forced to deal with it.

June 15, 2020 in Civil Liabilities | Permalink | Comments (0)

Thursday, June 11, 2020

What Does a County Commissioner (Supervisor) Need to Know?

Overview

County commissioners (also known in some states as supervisors or something similar) often find themselves dealing with unique situations.  In rural counties, the commissioners are often familiar with the common ag issues that arise that are within the commission’s jurisdiction.  In the more urban counties, some of the things that a county commissioner can have deal with can be rather surprising. So, what are a few of the more common items that a county commissioner must deal with in an agricultural context?

The ag-related matters that a county commissioner may have to deal with – it’s the topic of today’s post.

Fences and State Fence Law

Robert Frost once said that, “Fences make good neighbors.”  G.K. Chesterton has been quoted as saying, “Whenever you remove any fence, always pause long enough to ask why it was put there in the first place.”  For rural landowners, perhaps one of the most common and contentious issues involves disputes concerning partition fences. Partition fences are those that separate adjoining lands. Each state has numerous laws concerning partition fences.  Those laws involve such issues as the construction of fences and what a fence is to be built of, what is deemed to be a “legal” fence, liability for damages caused by livestock that escape their enclosure, the maintenance of partition fences, the role of the county commissioners serving as fence viewers in settling fence disputes and rules for handling stray animals.  

In some instances, adjoining landowners may come to an agreement as to how to allocate the responsibility between themselves for the building and/or maintenance of a partition fence. If an agreement is reached, it may be wise to put the agreement in writing and record it in the county Register of Deeds office in the county where the fence is located. However, if the adjoining landowners cannot reach an agreement concerning fence building and/or maintenance, the “fence viewers” should be called.  In many states, the county commissioners (or their designees) in the county where the fence in question is located are the fence viewers.  The statutory procedures vary from state to state, but the basic approach is that if adjoining landowners can’t settle their dispute personally, then the “fence viewers” can be called to determine how a fence should be built and/or maintained.  That means that country commissioners must know and understand state fence law.

Zoning Issues

County commissioners often must deal with zoning issues.  In the agricultural context, the issues can include matters involving how an applicable zoning ordinance applies to a particular tract of land based on how the land is used as well as the size of the tract.  Many ordinances are drafted in general language designed to have broad application.  That means that they sometimes are not clear in how they apply to a particular agricultural operation.  Is simply cutting hay on a five-acre tract, “agricultural” or is it still residential or some other classification.  Commissioners must be well-trained on zoning issues and what statutory language means and how the courts interpret it. 

Generally, a county’s zoning authority arises under a specific state statute, which grants cities and counties the ability to enact “planning and zoning laws and regulations” “for the protection of the public health, safety and welfare.”  But, as applied to agriculture, care should be taken to think through clearly just exactly what constitutes “agriculture.”  For example, is a 600-head hog confinement building “agriculture” or is it a commercial/industrial building? 

To establish a new zoning regulation, it’s often the case that a county must first require a planning commission to recommend the nature and number of zones or districts which it deems necessary and the boundaries of the same, as well as appropriate regulations.  Additionally, it’s typically the case that regulations must be uniform for each class or kind of building and land uses throughout each district, but the regulations in one district may differ from those in other districts.

Commonly, once the planning commission has made its recommendation based on public input, the governing body either may: (1) Approve the recommendations by the adoption of the same by ordinance in a city or resolution in a county; (2) override the planning commission's recommendations by a super-majority vote of the membership of the governing body; or (3)  return the matter to the planning commission for further consideration, together with a statement specifying the basis for the governing body's failure to approve or disapprove.”  A similar process is followed if a county wishes to amend an existing zoning regulation.

Following this process, a county is limited in what type of zoning regulations may be adopted. Under the usual process that is common in many states, the county may adopt zoning regulations which may include, but are not limited to provisions which:  (1) provide for planned unit developments; (2) permit the transfer of development rights; (3) preserve structures and districts listed on the local, state or national historic register; (4) control the aesthetics of redevelopment or new development; (5) provide for the issuance of special use or conditional use permits; and (6) establish overlay zones. Thus, so long as the zoning regulation is for the protection of the public health, safety and welfare, and falls within one of these six types, then it is within the scope of the county’s zoning authority.


The scope of a county’s zoning authority with regards to wind generation is a big issue in many rural counties.  The Kansas Supreme Court, construing Kansas law, has addressed the issue. Zimmerman v. Board. of County. Commissioners, 289 Kan. 926, 939, 218 P.3d 400, 410 (2009). In Zimmerman, the Wabaunsee County commissioners passed a zoning regulation prohibiting commercial wind farms in the entire county. The Kansas Supreme Court found that under K.S.A. §§12-753(a) and 12-755, the county’s zoning regulation was not unreasonable since the county commissioners found that commercial wind farms would adversely affect aesthetics of the county, commercial wind farms were not in conformance with a comprehensive plan which sought to maintain open spaces and scenic landscape, a large portion of the community’s wishes were against the wind farms.

However, while the county zoning ordinance banned all large-scale commercial windfarms, it allowed for small windfarms, and also established zoning regulations concerning the construction of small windfarms, including density and spacing requirements, as well as setback distance requirements.  The court ultimately upheld the zoning regulation, which established the counties ability to ban all commercial wind development, as well as establish setback distances for small scale wind farms.

Zimmerman also established that a county’s ability to pass zoning regulations affecting wind power generation was not preempted by state law, namely the Kansas Electric Public Utilities Act (KEPUA).  There the court held that KEPUA only preempted local zoning in two situations, (1) placement or siting of nuclear power plants, and (2) placement or siting of electrical transmission lines. Hence, any county regulation regarding wind turbine setbacks would not be preempted by state law, unless it is specifically asserted by the KCC or “clearly stated” by legislation such as KEPUA.

To restate, the Kansas Supreme Court has held local governments have the power to pass zoning regulations, so long as that power is “exercised in conformity with the statute which authorizes the zoning.’ See Genesis Health Club, Inc. v. City of Wichita, 285 Kan. 1021, 1033, 181 P.3d 549 (2008).  The same requirements apply to counties when they adopt or modify zoning regulations, particularly in a wind generation setting.  At least in Kansas, so long as a county follows the state law procedures set out above, and so long as the zoning regulation is for the protection of the public health, safety and welfare, then it will be valid. Particularly in a wind generation setting, a Kansas county has the authority to establish setbacks for wind turbines, under Zimmerman, so long as the state statutory process is followed, and so long as that authority hasn’t been specifically preempted by a state law such as the Kansas Electric Public Utilities Act.  The same is likely true in many other states.

Conclusion

Being a county commissioner can be a rewarding experience. But, it can be a difficult job and requires knowledge of many issues to properly represent the county.  This is particularly true for those counties that have a mix of urban and agricultural interests.  

June 11, 2020 in Regulatory Law | Permalink | Comments (0)

Tuesday, June 9, 2020

Are Advances to Children Loans or Gifts?

Overview

Often a parent (or parents) will advance money to a child.  The reasons for doing so are varied, such as making a large loan but then forgiving the payments each year consistent with the federal gift tax present interest annual exclusion (currently $15,000), but a significant question is whether such an advance of funds is a loan or a gift.  The proper classification makes a difference from a tax standpoint.

Is an advance of funds to a child a loan or a gift – that’s the topic of today’s post.

IRS Factors

The IRS presumption is that an advance is a gift when a transfer between family members is involved.  The taxpayer can overcome the presumption by showing that repayment was expected and that the taxpayer actually intended to enforce the debt.  In making that determination, the IRS utilizes a set of factors to evaluate whether an advance of funds amounts to a loan or a gift.  Those factors include whether the borrower signed a promissory note; whether interest was charged; whether collateral secured the indebtedness; whether payment was actually made; whether demand for repayment occurred when a payment was missed; whether there was a fixed due date for the loan; whether the borrower had the ability to repay the debt; how the parties characterized the transaction, and; whether the transaction was reported for federal tax purposes as a loan.  In essence, the question boils down to whether there is a bona fide debtor-creditor relationship. 

Illustrative Cases

In Miller v. Comr., T.C. Memo. 1996-3, the petitioners (a married couple) operated a ranch and employed their two sons to manage it.  One of the boys also managed his parents’ commercial property business in Georgia and that one of the sons helped manage.  The Mother transferred $100,000 to a son by giving him two $50,000 checks in the summer and fall of 1982.  She wrote the word “loan” on the check register and the check stub for each check and the checks were recorded in an account labeled “Notes Receivable – S. Miller” in the Mother’s general ledger.  She was trying to help him pay off a $56,000 mortgage on a house he and his wife bought in 1980 for $300,000 that became due in 1982.  In November of 1982, he used $56,000 of the $100,000 that he received from his Mother to retire the mortgage. The son signed a non-interest-bearing noted in the principal amount of $100,000 that was payable to his Mother.  The note was not secured by any collateral.   The note specified that the son was to pay his Mother on demand or three years after it was executed if no demand was made.  However, the Mother didn’t consider the three-year-later date to be a fixed date on which the son had to pay her, and she had no intention of demanding payment on that date, or any other date.  She also never discussed with her son any consequences of his failing to make payment.  In late 1982, the son made a $15,000 payment on the note, but didn’t make any more over the next three years.  The Mother never sought to enforce repayment, instead writing a “forgiveness” letter to him each year.  The IRS took the position (based on the multiple factors) that the loans were gifts.  The Tax Court agreed, which meant that the Mother had gift tax liability.  

In Estate of Bolles v. Comr., T.C. Memo. 2020-71, the decedent had five children and expressed a desire to treat them equally upon her death. She kept a personal record of advances to each child and any repayment that a child made. She treated the original advances as loans and forgave the “debt” account of each child annually in the amount of the federal gift tax present interest annual exclusion. The decedent and her spouse established a trust to hold some of their jointly owned property, including a substantial art collection and office building in San Francisco. At the time of her death she and her five children were among the beneficiaries of the trust. Her oldest child encountered financial difficulties and entered into an agreement with the trust to use trust property as security for $600,000 in bank loans. The son also owed the trust back-rent from his architecture practice. The son failed to meet the loan obligations and the trust was liable for the bank loan. The decedent transferred over $1 million to the son from 1985 through 2007. The son did not make any repayments after 1988. The decedent also had a revocable trust created in 1989. That trust specifically excluded the son from any distribution from her estate. It was later amended to include a formula to account for the “loans” made to the son during her lifetime.

Upon her death, another son filed a federal estate tax return and the IRS determined a deficiency of $1,152,356, arguing that the decedent’s advances to the oldest child were taxable gifts and not loans. The Tax Court determined that the amounts were gifts based on a non-exclusive, nine-factor analysis used in determining the status of advances: (1) whether there was a promissory note or other evidence of indebtedness; (2) whether interest was charged; (3) whether there was security or collateral; (4) whether there was a fixed maturity date; (5) whether a demand for repayment was made; (6) whether actual repayment was made; (7) whether the transferee had the ability to repay; (8) whether records maintained by the transferor and/or the transferee reflect the transaction as a loan; and (9) whether the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.

The court determined that the decedent did not have a reasonable expectation of repayment due to the son’s financial situation and employment history. However, a small portion of the advances made to the son while his financial situation was more favorable were loans because the decedent could expect repayment based on the son’s improved financial condition. The Tax Court noted that with respect to situations involving loans to family members, an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan. 

Conclusion

Be careful when making loans or gifts to children.  Take care to document the transaction(s) carefully and make sure to structure it with the factors listed above in mind to achieve the desired result.  Also, be mindful of another weapon the IRS might utilize in certain transactions, including those involving family members – the “step-transaction” doctrine.  This is another potential problem that can arise when the gift/loan distinction is not in issue.  For example, in Estate of Cidulka v. Comr., T.C. Memo. 1996-149, the IRS successfully utilized the doctrine to trigger gift tax liability.  The decedent had made annual gifts of stock during his life to his son, daughter-in-law and grandchildren.  He treated the transfers as gifts for gift tax purposes and kept each one at or under the applicable gift tax present interest annual exclusion (currently $15,000) so that he wouldn’t have to pay gift tax on the transfers.  Over a 14-year period, the daughter-in-law dutifully transferred her gift each year to her husband (the decedent’s son) on the exact same day her father-in-law transferred the stock to her.  The IRS didn’t have trouble picking that one apart.  It took the position that the annual gifts to her were really for her son, exceeded the annual exclusion amount and were subject to gift tax. 

Transferring funds to children can be full of traps.  Be advised.

June 9, 2020 in Estate Planning | Permalink | Comments (0)