Monday, March 4, 2024

Farm Bankruptcy; Sovereign Immunity; Farm Lease and Pipeline Damages

Introduction

Farmers and ranchers face numerous legal issues on a regular basis.  The variety is vast from contract issues to income tax, estate and business planning, to real estate-related issues.  Other issues come up with water, criminal matters, and environmental law.  Then there are frequent issues with federal and state administrative agencies. 

With today’s article I look at some recent cases that illustrate issues with farm bankruptcy, sovereign immunity, farm lease law and damages from an alleged leaking pipeline.

A potpourri of legal issues facing farmers and ranchers – it’s the topic of today’s post.

Farm Bankruptcy

This first case from Kansas demonstrates that a Chapter 12 bankruptcy debtor must have a legitimate basis for seeking a modification of the Chapter 12 reorganization plan.  A mere hope in getting financing is not a change in circumstances that would justify reimposing the automatic stay (stopping creditors from acting).  The farm debtor must be able to put a feasible plan together for paying debts.  Here, the plan had been approved, but then the farm debtor couldn’t make the payments. 

Debtors Lacked Reasonable Likelihood of Putting Re-Tooled Chapter 12 Plan Together

In re Sis, No. 21-10123, 2024 Bankr. LEXIS 124 (Bankr. D. Kan. Jan. 18, 2024)

The debtors Chapter 12 plan was confirmed in early 2022, but the debtors soon had trouble making plan payments. They managed to make an annual payment to a creditor (bank) but failed to do so the next year.  The Chapter 12 trustee filed a motion to dismiss the case in late 2023, and another creditor filed a motion for relief from the automatic stay.   The debtors sought to re-impose the automatic stay to get more time to modify their Chapter 12 plan and make payments to a creditor to avoid the bank foreclosing on their farm.    The bankruptcy court denied the debtors’ motion.  The court noted the debtors’ genuine efforts to secure financing and sell assets but determined that the debtors had little likelihood of success in modifying their reorganization plan in a manner allowing them to make plan payments.  The court also determined that the debtors had not endured a substantial change in circumstances to support modifying their Chapter 12 plan.  The debtors merely had a hope of obtaining financing was not a change in circumstances.  As a result, the court denied the debtors’ motion for a temporary restraining order because the debtors had not shown a substantial likelihood of prevailing on the merits or any extraordinary circumstances that would justify reimposition of the automatic stay. In late 2023, the court dismissed the debtors’ Chapter 12 case.  Therefore, the court the court directed the debtors to either voluntarily dismiss the adversary proceeding or provide reasons why it should not be dismissed.  The court noted that failure to file a voluntary dismissal or a statement showing cause, within fourteen days of the court’s order in this case would result in the court dismissal of the case. 

Suing the Government – Sovereign Immunity

Recently, the U.S. Supreme Court noted the exception to the general rule that the federal government can’t be sued for damages. 

Fair Credit Reporting Act Waives Sovereign Immunity 

United States Department of Agriculture Rural Development Housing Service v. Kirtz, No. 22-

846, 2024 U.S. LEXIS 589 (U.S. Feb. 8, 2024)

 The defendant received a loan from the plaintiff, a division of the U.S. Department of Agriculture, which was repaid in full by mid-2018.  However, the USDA repeatedly informed a consumer credit reporting company that the defendant’s account was past due.  As a result, thedefendant’s credit score was damaged and his ability to secure future loans at affordable rates was threatened.  The defendant notified the company of the error and the company, in turn, notified the USDA.  However, the USDA did not correct its records and the defendant sued for either a negligent or willful violation on the Fair Credit Reporting Act (FCRA).  The USDA moved to dismiss the case based on sovereign immunity.  The trial court dismissed the case, the appellate court reversed on the basis that the Congress had amended the FCRA to authorize suits for damages against “any person” who violates the FCRA and that “person” includes any governmental agency.  The Supreme Court agreed to hear the case to clear up contrary conclusions reached by the Third, Seventh and D.C. Circuits (holding that the FCRA authorizes suits against government agencies) and the Fourth and Ninth Circuits (holding that the FCRA bars consumer suits against federal agencies). 

The Supreme Court noted that a U.S. is generally immune from suits seeking money damages unless the Congress waived that immunity by making a clear legislative statement.  Here, the Court unanimously determined that the FCRA clearly waived sovereign immunity by applying its provisions to persons who furnish information to consumer reporting agencies, and that no separate provision addressing sovereign immunity was required.  The Court also noted that its holding would not make the States susceptible to consumer suits for money damages because the FCRA was enacted pursuant to the Commerce Clause and, as such, does not give the Congress the power to abrogate state sovereign immunity.  

Farm Lease Law

The law governing farm leases differs from state-to-state.  The following case from Kansas makes a couple of points.  First, if the lease is in writing, the written terms control.  Second, when leased land is sold, the buyer takes the land subject to the existing lease.  Those are two key points that will apply in every state. 

Interpretation of Farm Lease at Issue

Cure Land, LLC v. Ihrig, No. 125,709, 2023 Kan. App. Unpub. LEXIS 479 (Kan. Ct. App. Dec. 1, 2023)

The parties entered into a cash farm lease for the calendar year 2020.  The lease specified that the defendant (tenant) was allowed to harvest any wheat crop planted in the fall of 2020 (or in the fall thereafter if the lease was renewed) by the following summer.  The lease also stated that the crops planted during the term of the lease was to be planted on a rotational basis rather than in a continuous crop fashion unless adequate moisture was present, and the landlord consented.  The lease also stated that continuous cropping was normal on the irrigated ground.  The lease renewed for 2021 and notice to terminate was given on August 27, 2021.  The ownership of the leased ground then changed hands, and the tenant notified the new landlord of the tenant’s intent to plant wheat on the irrigated ground and harvest it in 2022.  The prior owned informed the defendant that planting wheat was not permitted in the fall of 2021, as did the new owner a few days later.  In October of 2021, the defendant harvested corn from the irrigated ground while it was still “high moisture corn,” a practice the tenant had not previously engaged in and planted wheat the next day.  The defendant paid the 2021 lease obligation through the end of 2021 and paid the balance on June 22, 2022.  The plaintiff (the new landlord) sued for breach of contract and unjust enrichment.  The trial court ruled in favor of the new landlord, finding that the lease did not permit the defendant to plant fall 2021 wheat. The trial court interpreted the lease provisions, considering the distinction between wheat ground and irrigated ground, and concluded that the defendant’s interpretation would result in an unintended windfall. Additionally, the court found that the purchaser of the leased land had the right to enforce its terms.  The appellate court affirmed. 

The Proof and Computation of Property Damage

When you incur damage to your property being able to prove those damages and the amount of the loss is critical.  A recent case involving a pipeline under an Oklahoma ranch illustrates these principles.

Cattle Ranch’s Lawsuit Against Energy Company for Pipeline Leak Revived

Lazy S Ranch Properties, LLC v. Valero Terminaling & Distribution Co., No. 23-7001, 2024 U.S. App. LEXIS 3397 (10th Cir. Feb. 13, 2024)

The plaintiff, an Oklahoma cattle ranch noticed a diesel fuel odor coming from a cave.  The ranch hired experts to test the soil, surface water and groundwater for possible hydrocarbon contamination.  The tests found trace amounts of refined petroleum products.  The plaintiff sued the defendant energy company in late 2019 alleging claims of negligence, negligence per se, trespass, unjust enrichment, private nuisance and public nuisance.  The defendant moved for summary judgment on the basis that its pipeline carrying gasoline and diesel fuel beneath the ranch was not leaking and that the plaintiff failed to show any injury from the de minimis presence of hydrocarbons. 

The trial court analyzed the plaintiff’s various tort claims together which required a minimum level of contamination to be present so as to establish injury for each claim.  Ultimately, the trial court granted summary judgment to the defendant.  On appeal, the appellate court held that the trial court’s combining of the plaintiff’s tort claims under legal injury confused the analysis because “what constitutes a legal injury will be different based on the elements of each tort.”  On the two nuisance-based claims, the appellate court noted the plaintiff owners’ testimony that they discontinued their use of the land, in part, due to an odor that induced headaches, stopped water sales, and barred others from recreational activities on the ranch.  The appellate court viewed this as sufficient evidence to warrant trial on whether the defendant had committed a nuisance.  On the negligence issue, the appellate court determined that the plaintiff had presented sufficient evidence to create a genuine issue of material fact concerning legal injury and causation on the private and public nuisance as well as the negligence per se claim.  However, the appellate court affirmed the trial court on the plaintiff’s constructive fraud and trespass claims citing a lack of evidence that the defendant had any intent to commit a trespass or knew that its pipeline was leaking or overlooked the leak or failed to tell the plaintiff about a leak in the pipeline. 

March 4, 2024 in Bankruptcy, Civil Liabilities, Contracts, Real Property | Permalink | Comments (0)

Monday, February 26, 2024

Animal Ag Facilities and Free Speech – Does the Constitution Protect Saboteurs? (An Update)

Overview

In response to attempts to shut down animal confinement operations by activist groups, legislatures in several states have enacted laws designed to protect these businesses by limiting access. A common approach is for the law to criminalize the use of deception to access a confined livestock facility or meatpacking plant with the intent to cause physical harm, economic harm or some other type of injury to the business. But the laws have generally been struck down on free speech and equal protection grounds.  Is there a way for states to provide legal protection to confinement livestock facilities? 

What can these facilities do to protect themselves?  I wrote about this issue last spring and since that time the U.S. Court of Appeals for the Eighth Circuit has issued a significant opinion.  That makes an update in order.

Laws designed to protect confined animal livestock facilities from those intended to do them harm – it’s the topic of today’s post.

General Statutory Construct

The basic idea of state legislatures that have attempted to provide a level of protection to livestock facilities is to bar access to an animal production facility under false pretenses.  At their core, the laws attempt to prohibit a person having the intent to harm a livestock production facility from gaining access to the facility (such as via employment) to then commit illegal acts on the premises.  See, e.g., Iowa Code §717A.3A.  Laws that bar lying and trespass coupled with the intent to do physical harm to an animal production facility should not be constitutionally deficient.  Laws that go beyond those confines may be. 

The Iowa provisions.  Iowa legislation is a common example of how states have attempted to address the issue.  The Iowa legislature has made two attempts at crafting a state law that would withstand a constitutional challenge.  The initial version, enacted in 2012, criminalized “agricultural production facility fraud” if a person willfully obtained access to such a facility by false pretenses (the “access” provision) or made a false statement or representation as part of an application or agreement to be employed at the facility (the “employment” provision).  The law also required the person to know that the statement was false when made and that it was made with an intent to commit a knowingly unauthorized act.  Iowa Code §717A.3A.  This initial statutory version was challenged and the employment provision was deemed unconstitutional.

The Iowa legislature then modified the law with a second version that described an agricultural production facility trespass as occurring when a person uses deception “on a matter that would reasonably result in a denial of access to an agricultural production facility that is not open to the public, and, through such deception, gains access to [the facility], with the intent to cause physical or economic harm or other injury to the [facility’s] operations, agricultural animals, crop, owner, personnel, equipment, building, premises, business interest, or customer [the “access” provision].”  Iowa Code §717.3B.  The revised law also criminalizes the use of deception “on a matter that would reasonably result in a denial of an opportunity to be employed  at [a facility] that is not open to the public, and, through such deception, is so employed, with the intent to cause physical or economic harm or other injury to the [facility’s] operations, agricultural animals, crop, owner, personnel, equipment, building, premises, business interest, or customer [the “employment” provision].

Note:  In other words, the Iowa provisions criminalize the use of lies to either gain access or employment at an ag production facility where the use is coupled with the intent to do harm. 

Recent Court Opinions

North Carolina.  In 2017, a challenge to the North Carolina statutory provision was dismissed for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017). The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act.  They claimed that the law unconstitutionally stifled their ability to investigate North Carolina employers for illegal or unethical conduct and restricted the flow of information those investigations provide.  As noted, the court dismissed the case for lack of standing. On appeal, however, the appellate court reversed.  PETA, Inc. v. Stein, 737 Fed. Appx. 122 (4th Cir. 2018).  The appellate court determined that the plaintiffs had standing to challenge the law through its “chilling effect” on their First Amendment rights to investigate and publicize actions on private property.  They also alleged a reasonable fear that the law would be enforced against them. 

On the merits, the trial court then held that the challenged provisions of the law were unconstitutional under the First Amendment as a violation of the plaintiffs’ free speech rights. There was a direct implication of speech, the court reasoned, because recordings and image capture constituted speech and the Act was unconstitutional under intermediate scrutiny.  People for the Ethical Treatment of Animals, Inc. v. Stein, 466 F. Supp. 3d 547 (M.D.  N.C. 2020).

On further review, the appellate court affirmed in part and reversed in part.  People for the Ethical Treatment of Animals, Inc. v. North Carolina Farm Bureau Federation, Inc., 60 F.4th 815 (4th Cir. 2023).  The appellate court determined that the First Amendment protects the right to surreptitiously record in an "employer's nonpublic areas as part of newsgathering" and that, therefore, the Act was unconstitutional when it was applied to bar the undercover activities that the plaintiff wanted to conduct on private property. 

Note:  The Attorney General of North Carolina sought the U.S. Supreme Court's review, but the Court declined.  North Carolina Farm Bureau Federation, Inc. v. People for the Ethical Treatment of Animals, Inc., 144 S. Ct. 325 (2023).  

Utah.  The Utah law was also deemed unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017). At issue was Utah Code §76-6-112 which criminalizes the entering of a private agricultural livestock facility under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility.  While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist.”  For those reasons, the court determined that the Act was unconstitutional. 

A Wyoming law experienced a similar fate. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" included numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection of resource data. 

Note:  The appellate court remanded the case to the trial court for a determination of the appropriate level of scrutiny and whether the statutes survived review.   Ultimately, the trial court granted the plaintiffs’ motion for summary judgment, finding that the statutes were content based and, as such failed to withstand constitutional strict scrutiny review on the basis that the laws were not narrowly tailored.  Western Watersheds Project v. Michael, 353 F. Supp. 3d 1176 (D. Wyo. 2018). 

Ninth Circuit.  In early 2018, the U.S. Circuit Court of Appeals for the Ninth Circuit issued a detailed opinion involving the Idaho statutory provision.  Animal Legal Defense Fund v. Wasden, 878 F.3d 1184 (9th Cir. 2018).  The Ninth Circuit’s opinion provides a roadmap for state lawmakers to follow to provide at least a minimal level of protection to animal production facilities from those that would intend to do them economic harm.  According to the Ninth Circuit, state legislation can bar entry to a facility by force, threat or trespass.  Likewise, the acquisition of economic data by misrepresentation can be prohibited.  Similarly, criminalizing the obtaining of employment by false pretenses coupled with the intent to cause harm to the animal production facility is not constitutionally deficient.  However, provisions that criminalize audiovisual recordings are suspect. 

The Iowa experience.  In 2021, the U.S. Court of Appeals for the Eighth Circuit construed the 2012 version of the Iowa law and upheld the portion of it providing for criminal penalties for gaining access to a covered facility by false pretenses.  Animal Legal Defense Fund v. Reynolds, 8 F.4th 781 (8th Cir. 2021).  This is the first time that any federal circuit court of appeals has upheld a provision that makes illegal the gaining of access to a covered facility by lying.   

Conversely, the court held that the employment provision of the law (knowingly making a false statement to obtain employment) violated the First Amendment because the law was not limited to false claims that were made to gain an offer of employment.  Instead, the provision provided for prosecution of persons who made false statements that were incapable of influencing an offer of employment.  A prohibition on immaterial falsehoods was not necessary to protect the State’s interest – such as false exaggerations made to impress the job interviewer.  The court determined that barring only false statements that were material to a hiring decision was a less restrictive means to achieve the State’s interest. 

Note.  The day before the Eighth Circuit issued its opinion concerning the Iowa law, it determined that plaintiffs challenging a comparable Arkansas law had standing the bring the case.  Animal Legal Defense Fund v. Vaught, 8 F.4th 714 (8th Cir. 2021).  The court later denied a petition for rehearing.   Animal Legal Defense Fund v. Vaught, No. 20-1538, 2021 U.S. App. LEXIS 27712 (8th Cir. Sept. 15, 2021). 

In late 2019, the plaintiffs in the Iowa case filed suit to enjoin the second version of the Iowa law – Iowa Code §717A.3B.  The trial court agreed and preliminary enjoined the revised law.  The plaintiffs then filed a motion for summary judgment in early 2020 and the state filed a cross motion for summary judgment, and the case was continued while the appellate court was considering the case involving the initial version of the Iowa law.  As noted above, the appellate court ultimately upheld the access provision but not the employment provision.  The trial court, in the current case upheld the plaintiffs’ motion for summary judgment, finding that the revised statutory language had been slightly modified, but was substantially similar to the initial version.  As such, the trial court determined that the revised statute discriminated based on content and viewpoint and was unconstitutional under a strict scrutiny analysis.  Animal Legal Defense Fund v. Reynolds, No. 4:19-cv-00124-SMR-HCA, 2022 U.S. Dist. LEXIS 48142 (S.D. Iowa Mar. 14, 2022). 

Iowa also has another law that bears on the issue.  Iowa Code § 727.8A makes it a crime for “a person committing a trespass as defined in section 716.7 to knowingly place or use a camera or electronic surveillance device that transmits or records images or data while the device is on the trespassed property.” 

Iowa Code §716.7 defines a trespass as follows:

  1. a. “Trespass” shall mean one or more of the following acts:

(1) Entering upon or in property without the express permission of the owner, lessee, or person in lawful possession with the intent to commit a public offense, to use, remove therefrom, alter, damage, harass, or place thereon or therein anything animate or inanimate,….

(2) Entering or remaining upon or in property without justification after being notified or requested to abstain from entering or to remove or vacate therefrom by the owner, lessee, or person in lawful possession, or the agent or employee of the owner, lessee, or person in lawful possession, or by any peace officer, magistrate, or public employee whose duty it is to supervise the use or maintenance of the property. A person has been notified or requested to abstain from entering or remaining upon or in property within the meaning of this subparagraph (2) if any of the following is applicable:

(a) The person has been notified to abstain from entering or remaining upon or in property personally, either orally or in writing, including by a valid court order under chapter 236.

(b) A printed or written notice forbidding such entry has been conspicuously posted or exhibited at the main entrance to the property or the forbidden part of the property.

(3) Entering upon or in property for the purpose or with the effect of unduly interfering with the lawful use of the property by others.

(4) Being upon or in property and wrongfully using, removing therefrom, altering, damaging, harassing, or placing thereon or therein anything animate or inanimate, without the implied or actual permission of the owner, lessee, or person in lawful possession.

Note:  An initial conviction for violation of Iowa Code § 727.8A is an aggravated misdemeanor and a second conviction is a class “D” felony.

In Animal Legal Defense Fund, et al. v. Reynolds, et al., 630 F. Supp.3d 1105 (S.D. Iowa. 2022), the plaintiffs (animal rights activist groups) claimed the statute violated their First Amendment rights by hindering them from gaining access to farms and dairies under false pretenses of seeking a job to be able to take pictures and/or videos without the property owner’s consent.  The defendants asserted that the case should be dismissed for lack of standing and lack of ripeness.

The trial court (the same Obama-appointed judge that ruled earlier in 2022 on another variant of the Iowa laws) held that the plaintiffs had standing because their organizational objectives would be hindered, and that an arrest is not required before a criminal statute can be challenged.  The trial court noted that the statute prohibited video recordings (which the court asserted was protected “speech”) while trespassing which the plaintiffs considered important to broadcasting their negative messages about animal agriculture to the public.  More specifically, the court determined that the statute singled out conduct (that the plaintiffs contemplated) by expanding the penalty for conduct already prohibited by law and was not limited to specific uses of a camera.  Accordingly, the court determined that the statute was an unconstitutional restriction on the free speech rights of trespassers apparently on the basis that regulating free speech on private property would create a “slippery slope” for not allowing people to record politicians or express views about the Government.   In addition, any recording, production, editing, and publication of the videos is protected speech.  The court granted summary judgment to the plaintiffs. 

The trial court’s view, made it practically impossible for farmers to protect their farming operations from those intending to inflict harm via protected “speech.” Is the trial court saying that there is a constitutional right to trespass?  If so, that is flatly contrary to the U.S. Supreme Court opinion of Cedar Point Nursery, et al. v. Hassid, et al., 141 S. Ct. 2063 (2021).   

Note:  Interestingly (and hypocritically) the Iowa federal district court’s website contains the following information: “To be admitted into the courthouse, you must present a government issued photo identification.  Please be aware the following items are NOT allowed in the courthouse: cell phones, cameras, other electronic devices (including Apple watches), recording devices,…”.

Note:  Iowa Code §716.7A, the Food Operation Trespass Law, remains in effect.  That law, effective on June 20, 2020, treats as an aggravated misdemeanor a first offense of entering or remaining on the property of a food operation without the consent of a person who has real or apparent authority to allow the person to enter or remain on the property.  A subsequent offense is a Class D felony.  This statutory provision was upheld as constitutional by an Iowa county district court judge in early 2022. 

In early 2024, the U.S. Court of Appeals for the Eighth Circuit reversed.  Animal Legal Defense Fund v. Reynolds, 89 F.4th 1071 (8th Cir. 2024).  The appellate court concluded that while false or deceptive speech is not per se unprotected, Iowa had the constitutional right to bar intentionally false speech that is used to cause a legal harm to someone else or their business.  The Iowa law, the appellate court concluded, focused on the intent to inflict a legally recognizable harm rather than on the content of what was being said.  Accordingly, both the trespass and employment provisions of the law constitutionally barred false statements that result in a harm the law would recognize.  It was the law’s reference to the content of the speech (i.e., false statements) that made the law constitutional.  The intent requirement did not distinguish among speakers based on their viewpoints.  The appellate court succinctly stated that the Iowa law filtered out trespassers who are “relatively innocuous,” and focuses the criminal law on conduct that inflicts greater harms on victims and society.  Thus, the Iowa law was not a viewpoint-based restriction on speech, but was a permissible restriction on intentionally false speech undertaken to accomplish a legally cognizable harm. 

Kansas and the Tenth Circuit.  In Animal Legal Defense Fund, et al. v. Kelly, 9 F.4th 1219 (10th Cir. 2021), pet. for cert. filed, (U.S. Sup. Ct. Nov. 17, 2021), the court construed the Kansas provision that makes it a crime to take pictures or record videos at a covered facility “without the effective consent of the owner and with the intent to damage the enterprise.”  The plaintiffs claimed that the law violated their First Amendment free speech rights.  The State claimed that what was being barred was conduct rather than speech and that, therefore, the First Amendment didn’t apply.  But, the court tied conduct together with speech to find a constitutional violation – it was necessary to lie to gain access to a covered facility and consent to film activities.  As such, the law regulated protected speech (lying with intent to cause harm to a business) and was unconstitutional.  The court determined that the State failed to prove that the law narrowly tailored to a compelling state interest in suppressing the “speech” involved.  The dissent pointed out (correctly and consistently with the Eighth Circuit) that “lies uttered to obtain consent to enter the premises of an agricultural facility are not protected speech.” The First Amendment does not protect a fraudulently obtained consent to enter someone else’s property. 

Note:  On April 25, 2022, the U.S. Supreme Court declined to hear the case.  Kelly v. Animal Legal Defense Fund, cert. den., 142 S. Ct. 2647 (2022). 

As a result of the Eighth Circuit’s opinion in Reynolds in early 2024, legislation was introduced into the Kansas Senate that would amend the Farm Animal and Field Crop Act and Research Facilities Protection Act.  Among other things, the legislation would criminalize the making of false statements on an employment application to gain access to an animal facility.  The legislation stalled in the Senate.  Identical legislation was introduced into the Kansas House. 

A Different Approach?

The appellate courts generally holding (except for the Eighth Circuit) that the right to free speech protects false factual statements that inflict real harm and serve no legitimate interest runs contrary to an established line of U.S. Supreme Court precedent, at least until the Court’s decision in United States v. Alvarez, 567 U.S. 709 (2012).  See, e.g., Bill Johnson’s Restaurants, Inc. v. NLRB, 461 U.S. 731 (1983); Brown v. Hartlage, 456 U.S. 45 (1982); Herbert v. Lando, 441 U.S. 153 (1979); Garrison v. Louisiana, 379 U.S. 64 (1964).  The current split between the Eighth, Ninth and Tenth Circuits on the constitutionality of the Iowa, Idaho and Kansas laws with respect to the issue of gaining access to a covered facility by lying could warrant a Supreme Court review. 

Indiana trespass law.  Short of a Supreme Court review of a state statute is there another approach that a state might take to provide protection for agricultural livestock facilities?  The state of Indiana’s approach might be the answer.  In 2014, the Indiana legislature passed, and the Governor signed into law the “Indiana Trespass Law.”  Ind. Code 35-43-2-2.  Under the statute, “trespass” is defined as being on a property after being denied entry by the property owner, court order or by a posted sign (or purple paint).  If the trespass involves a dwelling (including an ag operation), the landowner need not deny entry for a trespass to be established.  The law also sets various thresholds for criminal violations. 

Note:  The Iowa Food Operation Trespass Law appears to be similar to the Indiana law.

The Indiana law appears to base property entry on the legal property interest of that of a license.  A license is a term that covers a wide range of permissive land uses which, unless permitted, would be trespasses.  For example, a hunter who is on the premises with permission is a licensee.  The hunter has a license for the limited purpose of hunting only.  If the hunter were to videotape any activity on the premises, that would constitute a trespass as exceeding the scope of the license.  An unlawful entry.  This would be the same result for a farm employee.  Video recording would be outside the scope of employment. By focusing on the property interest of a license and that of a trespass for unauthorized entry, a claim of a possible free speech violation is eliminated.

Hiring Practices

Considering activists that wish to harm animal agriculture, ag animal facilities should utilize common sense steps to minimize potential problems.  Of course, not mistreating animals should always be the standard.  Proper hiring practices are also very important.  A well drafted employment agreement should be used for workers hired to work in an ag animal facility to  help screen potential hires.  The agreement should specify in detail the job requirements and what is not permitted to occur on the premises and inside buildings.  The agreement should give the employer the right to search every employee for devices that could be used to record activities on the farm and in farm buildings.  Also, employee training should be provided and documented.  Also, it’s critical that employee conduct be closely monitored to ensure that employees are acting within the scope of their employment and that animals are being treated appropriately. 

Conclusion

It’s unfortunate that groups exist dedicated to damage and/or eliminate certain aspects of animal agriculture, and that they will use lies and deception to become employed and gain access.  It’s even more frustrating that many of the courts are willing to use the First Amendment as a shield to protect those intending to commit criminal activities to harm animal agriculture.  But, until state laws are drafted in a way that will be found constitutional, the only recourse for livestock operations is to adopt hiring and business practices that will minimize potential harm.

The Eighth Circuit’s decision in Reynolds is refreshing.  It is an important decision for agriculture in general and the confinement livestock industry in particular.  For example, in the Iowa situation, approximately one-third of the nation’s hog production occurs in Iowa. 

February 26, 2024 in Criminal Liabilities, Regulatory Law | Permalink | Comments (0)

Tuesday, February 20, 2024

Dicamba Update

Overview

My blog article of February 11 discussed the Arizona federal district court opinion vacating the registrations of three Dicamba products.  Since then, the EPA made an “existing stocks” ruling that will help some producers through the 2024 growing season.  That makes an update in order.

Updated Dicamba information – it’s the topic of today’s post.

Background

Farmers have used Dicamba for decades on broadleaf plants and, more recently, have used it to control weeds that have become glyphosate-tolerant.  However, until 2016 the use of Dicamba was used only as a pre-emergent herbicide.  It was then that the Environmental Protection Agency (EPA) registered certain low-volatility forms of Dicamba that had a low likelihood of drift problems for over-the-top usage on growing soybean and cotton crops resulting from Dicamba-resistant seeds.  The EPA was sued on the basis that the registration process violated the Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA) as well as the Endangered Species Act (ESA).  The case became moot by the expiration of the registration, but when the EPA again registered Dicamba for over-the-top use in 2018, a new case was filed.  In 2020, the U.S. Court of Appeals for the Ninth Circuit vacated the registrations for XtendiMax, Engenia and FeXapan.  National Family Farm Coalition v. United States Environmental Protection Agency, 960 F.3d 1120 (9th Cir. 2020).  The court determined that the EPA had failed to follow the procedural rules of the Administrative Procedure Act, the FIFRA and the ESA.  Those statutes require the EPA to provide public notice and a chance for the public to make comments and attend a hearing on the registration issue.  The court also said that the EPA failed to assess risks and costs for non-users of over-the-top Dicamba. 

The EPA again issued another registration for over-the-top Dicamba use for the 2020 and 2021 growing seasons and made further amendments in 2022 and 2023 along with approval for new uses.

2024 Court Decision

On February 6, 2024, a federal district court vacated the registrations of three Dicamba products (XtendiMax, Engenia, and Tavium) that EPA had approved for over-the-top applications.  Center for Biological Diversity v. United States Environmental Protection Agency, No. CV-20-00555-TUC-DCB, 2024 U.S. Dist. LEXIS 20307 (D. Ariz. Feb. 6, 2024).  The decision came at a time when many soybean and cotton farmers have already purchased seed and chemicals and will soon be planting the 2024 crop.  The court said the EPA didn’t follow the notice and comment provisions of the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA) when it issued the registrations and also violated the Administrative Procedure Act (APA) (and the Endangered Species Act) by not allowing public input on whether over-the-top Dicamba has unreasonable adverse effects on the environment. 

The ruling canceled any benefits of planting Dicamba seeds, with the concern that there might not be enough supply of other traits to replace the Dicamba market share.  The immediate impact of the ruling was that it could force farmers to plant Dicamba trait soybeans or cotton without the correct chemical to utilize the gene, resulting in the likely use of alternatives.  Those alternatives could, in turn, magnify the known issues of the Dicamba chemical problems.   

Comment:  While the timing of the court’s decision was awful, the result is good overall in that it held the “feet” of the EPA to the “fire” of the administrative process.  It also raised the question of whether the EPA deliberately violated the public notice and comment procedures that are clearly established in the law.  It’s difficult to believe that the EPA lawyers, particularly after losing in the Ninth Circuit on virtually the same issue in 2020, didn’t know that failing to follow the procedural rules for approving the registrations would lead to the registrations being invalidated. 

EPA reaction.  On February 14, the EPA issued an order to allow existing stocks of XtendiMax, Engenia, and Tavium to be applied directly onto crops so long as the pesticides were “labeled, packaged, and released for shipment” before the court’s decision. The order will allow these products purchased before February 6 to be used this growing season.  The EPA order also provides instructions for how to dispose of unwanted or unused dicamba products.

The Future

What does the future hold for over-the-top Dicamba?  Of course, the EPA could appeal the court’s decision, but any appeal would be to the Ninth Circuit.  Going back to the same court on the same shortcomings as in the 2020 decision probably wouldn’t end well for the EPA.  Perhaps a better idea is for the EPA to re-register over-the-top use of Dicamba by actually following the law’s requirements for providing public notice and comment, and giving the public the opportunity to attend a hearing on the registration.  

February 20, 2024 in Environmental Law, Regulatory Law | Permalink | Comments (0)

Monday, February 19, 2024

New Tax Legislation Proposed

Introduction

On January 31, the U.S. House overwhelmingly passed tax legislation containing provisions of importance to farmers and ranchers in particular and many taxpayers in general.  H.R. 7024, known as the “Tax Relief for American Families and Workers Act of 2024,” is scored at nearly $78 billion and contains some retroactive provisions.  Some of the key provisions modify the employee retention credit (ERC), widen eligibility for the child tax credit (CTC), reinstate expensing for research and experimental (R&E) costs; increase expense method depreciation; and reinstate bonus depreciation to 100 percent for 2023. 

The legislation is currently before the U.S. Senate where it appears to have bipartisan support, if not immediate space on the Senate calendar. 

Pending tax legislation – it’s the topic of today’s post.

Details

ERC.  The IRS has been making significant efforts to eliminate abuses of the ERC.  The Congress constructed the ERC poorly which made it ripe for promoters to scam businesses, including farm businesses into thinking that they were eligible for the credit or eligible for more than what was appropriate.  The bill prevents additional ERC claims as of January 31, 2024 – moving up the current April 15, 2025, deadline. 

Note:  To put the cost of the ERC in perspective, the Joint Committee on Taxation says sunsetting the ERC as of January 31, 2024, would save $77.1 billion in spending. 

The bill makes several changes relevant to the ERC with respect to a “COVID-ERTC promoter.”  That’s a person who “aids, assists, or advises on an affidavit, refund, claim, or other document related to the ERC” if the person charges fees based on the amount of the credit or meets a gross receipts test.

The bill also makes other changes to the ERC relevant to a “COVID-ERTC promoter” as follows:

  • Extends the statute of limitations for the IRS to audit ERC claims from the current five years from the date of the claim to six years for claims involving a COVID-ERTC promoter.
  • Increases the penalty for aiding and abetting the understatement of a tax liability to the greater of $200,000 ($10,000 in the case of a natural person) or 75 percent of the promoter’s gross income derived (or to be derived) from providing aid, assistance, or advice with respect to a return or claim for ERC refund or a document relating to the return or claim.
  • Requires a promoter to comply with due-diligence requirements (similar to the due-diligence requirements applying to paid tax return preparers) with respect to a taxpayer's eligibility for (or the amount of) an ERC.  Each failure to comply comes with a $1,000 penalty. 
  • Require a promoter to file return disclosures and provide lists of clients to the IRS on request similar to those that “material advisers” are required to provide with respect to listed transactions.

CTC

The bill makes the following changes to the CTC:

  • An increase in the maximum refundable amount per child to $1,800 in tax year 2023 from $1,600. That amount then increases to $1,900 in 2024 and $2,000 in 2025.  Inflation adjustments also apply for 2024 and 2025.   
  • For tax years 2023-2025, the CTC is to be computed by multiplying a taxpayer’s earned income exceeding $2,500 by 15 percent, with the resulting amount multiplied by the number of qualifying children.
  • For 2024 and 2025, a taxpayer would be able to use the taxpayer’s earned income from the prior tax year to compute the maximum child credit, but only if the taxpayer’s earned income in the prior year was higher than the current year.

R&E costs.  The bill would amend I.R.C. §174 to reverse (at least temporarily) the impact of the Tax Cuts and Jobs Act (TCJA) provision requiring amortization of domestic R&E costs.  That change under the TCJA requires amortization over a five-year period effective for tax years beginning after 2021. The bill would maintain current deductible through 2025.   

Business interest.   For tax years beginning before 2018, business interest (such as is paid on loans for farmland, machinery, buildings, operating lines, etc.) was fully deductible.  For tax years beginning after 2017 and before 2022, deductible business interest is limited to business income plus 30 percent of the taxpayer’s adjusted taxable income (ATI) for the tax year that is not less than zero.  The computation of ATI is determined without regard to any deduction allowable for depreciation, amortization, or depletion (i.e., earnings before interest, taxes, depreciation, and amortization (EBITDA)).

The bill specifies that, for taxable years beginning after December 31, 2021, and before January 1, 2024, ATI is computed with regard to deductions allowable for depreciation, amortization, or depletion (i.e., earnings before interest and taxes (EBIT)). However, ATI may be computed as EBITDA, if elected, for such taxable years. For taxable years beginning after December 31, 2023, and before January 1, 2026, ATI is computed as EBITDA. For taxable years beginning after December 31, 2025, ATI is computed as EBIT.

Note:  The limit is computed at the entity level with any disallowed amounts carried over to the succeeding year.

The otherwise existing rules would continue to apply.  That means that any disallowed amount is treated as paid or accrued in the succeeding tax year.  However, businesses entitled to use cash accounting (i.e., those with average annual gross receipts not exceeding $30 million for 2024) are not subject to the limitation.  Special rules apply to excess business interest of partnerships. In addition, a farming business may elect out of the limitation.  I.R.C. §163(j)(7)(C).

Bonus depreciation. The bill would retroactively extend I.R.C. §168 bonus depreciation for qualified property at 100 percent for property placed in service after Dec. 31, 2022, and before Jan. 1, 2026 (Jan. 1, 2027, for longer production period property and certain aircraft) and for specified plants planted or grafted after Dec. 31, 2022, and before Jan. 1, 2026.   Under current law, bonus depreciation was capped at 80 percent for 2023 and is 60 percent for 2024. 

Note:  The retroactive nature of this provision could cause numerous issues.  Many farm assets are 20-year or less MACRS property and have uniquely benefitted from bonus depreciation.  This is particularly true because the personal property trade provisions of the TCJA can cause large machinery purchases that exceed the I.R.C. §179 threshold which then causes taxpayers to utilize bonus depreciation.   

Sec. 179 expensing. The bill would also increase the I.R.C. §179 maximum deductible amount to $1.29 million for 2024 (up from $1.22 million), reduced by the amount by which the cost of the qualifying property exceeds $3.22 million (up from $3.05 million). Those amounts would be adjusted for inflation after 2024.

Other provisions.  The bill also includes an increase in the threshold for information reporting on Forms 1099-NEC, Nonemployee Compensation, and 1099-MISC from $600 to $1,000, effective for payments made after 2023. 

Conclusion

Will the bill pass the Senate?  Probably.  But that won’t likely occur before March 1.  Of course, that’s the date that many farmers use for filing returns.  As a result, for those that have already made decisions concerning depreciation, the CTC, and, perhaps, the deductibility of interest, amended returns will need to be filed.  Will IRS waive the penalties if farm returns (for those that didn’t pay estimated tax) are filed after March 1?  That may not be known until very late in February.  This all increases the chance for errors on returns.  In addition, IRS forms and tax preparation software will need to be revised which will create anxiety due to pending deadlines.  Retroactive tax legislation is rarely a good idea from a return preparation standpoint.

February 19, 2024 in Income Tax | Permalink | Comments (0)

Sunday, February 11, 2024

The Big Issues for 2024

Introduction

What are likely to be the most prominent issues in agricultural law and tax in 2024?  I have just finished looking back at 2023 as to what I viewed as the top issues of 2023, so it’s time to take a look forward to what might be the key issues in law and tax that will impact ag producers and the sector as a whole. 

Looking ahead at what might be the biggest issues in ag law and tax in 2024 – it’s the topic of today’s post.

Important “Takings” Case at the Supreme Court

DeVillier v. Texas, 63 F.4th 416 (5th Cir. 2023)

What are likely to be the big issues in ag law and tax in 2024?  One involves a case currently at the U.S. Supreme Court with the matter concerning the government’s taking of private property and the requirement under the Fifth Amendment that the government pay for what it takes.  The case involves a Texas farmer and was argued last month.

The family involved in a case has farmed the same land for a century.  There was no problem with flooding until the State renovated a highway and changed the surface water drainage.  In essence, the renovation turned the highway into a dam and when tropical storms occurred, the water no longer drained into the Gulf of Mexico.  Instead, the farm was left flooded for days, destroying crops and killing cattle.  In essence, the farm had been turned into a retention pond. 

The farmer sued the State to get paid for the taking.  Once the case got to federal court, the appellate court dismissed it, saying he couldn’t sue under the Fifth Amendment – only State officials can because Congress hadn’t passed a law saying a private citizen could sue the state.  But the appellate court’s opinion is out-of-step with other court opinions on the issue.  The Fifth Amendment contains a remedy when the government takes your property – you get paid for it. The Constitution matters.

The outcome will be an important one for agriculture. 

Taxing Wealth and the U.S. Supreme Court

Moore v. United States, 36 F.4th 930 (9th Cir. 2022)

This year the U.S. Supreme Court will decide a case on whether the Congress can tax a person’s wealth without a tax realization event such as a sale.  It’s a huge issue for agriculture. 

A case presently before the U.S. Supreme Court involves the question of whether the Congress can tax wealth without a tax realization event.  The taxpayers in the case owned 11 percent of a corporation in India that is more than 50 percent controlled by U.S. persons.  It doesn’t pay dividends but reinvests its earnings into its business of making tools for sale to farmers.  Under the 2017 tax law in the U.S., the company was subjected to a tax that year on its undistributed earnings and profits from 1986 to 2017 which became the obligation of the taxpayers to the extent of their ownership.  They got a $15,000 tax bill from the IRS. 

They sued because they hadn’t sold any stock or done anything to trigger the tax.  They lost and the Supreme Court heard arguments in early December.  If the law is upheld it’s estimated it will bring in $340 billion in revenues.  And it would open the door for the Congress to tax your unrealized gains that could wipe out the stepped-up basis rule at death.  That would be a tough result for many farming operations.

USDA’s “Climate Smart Projects”

Another big issue in 2024 will likely involve the USDA’s attempts to manipulate producers’ behavior by providing taxpayer funding for what it calls “Climate-Smart Agriculture.”  Presently, USDA has poured about $3 billion tax dollars into getting farmers to enroll in projects such as those designed to reduce methane emissions and sequester carbon.  It’s termed the USDA’s “Partnership for Climate Smart Commodities Projects,” and flows from the SEC’s plans that were announced in 2022 to force all publicly traded companies to submit an Environmental, Social, Governance” (ESG) report.  Five months later the USDA’s project was announced.  It’s not just farmers that are on the take.  So far, $90 million has been paid to agricultural giant Archer Daniels Midland; $95 million to the Iowa Soybean Association; and $40 million dollars to Farm Journal.  27 universities have also received various amounts (all in the millions of dollars each). 

But with the funding comes a loss of freedom.  Just ask a Dutch, Polish, Irish, French, German or Sri Lankan farmer how such an agenda has worked for them.  The USDA’s expressed goal is to get farmers and ranchers to calculate greenhouse gas emissions.  In the USDA’s words, “implementation and monitoring of climate smart practices.”  Indeed, USDA has worked with Colorado State University to develop a “planner tool” to be able to measure conservation practices on farms. Pilot projects focused on reducing methane emissions, improving soil quality and carbon sequestration.  Once the emissions from a farm become measurable, they will be regulated.  With regulation comes a loss of freedom and a further loss of smaller farming and ranching operations that are least likely to be able to bear the compliance cost. 

Consumers will also be harmed.  A new study published by the Economic Research Center at the Buckeye Institute finds that, as a result of the USDA’s climate agenda, a typical family of four will have to spend an extra $1,300 annually for food.  This is on top of the double-digit inflation consumers have faced since 2021.  The study also explains that the USDA’s climate agenda will result in much higher costs for diesel, propane, fertilizer and other ag production inputs.  The authors of the study note that, “Federal policymakers are pursuing expensive climate-control and emissions policies that have largely failed in Europe.”  The study can be accessed here:  https://www.buckeyeinstitute.org/library/docLib/2024-02-07-Net-Zero-Climate-Control-Policies-Will-Fail-the-Farm-policy-report.pdf

In 2024, will questions arise concerning the premise underlying the USDA’s efforts?  Also expect further questions to be raised about the funding.  The Ag Secretary says he can use the CCC to fund the climate agenda for agriculture.  Some in Congress don’t agree. 

But one thing’s for sure, the current political climate surrounding agriculture is seeking greater restrictions on farming practices.  That will assuredly increase the cost of farming and make it more difficult for smaller operations to survive.

Farm Bill Developments

An issue on the radar in ag law and tax in 2024 will be the continued discussions about a new Farm Bill.  The 2018 Farm Bill is set to expire at the end of September.  Cost will be an issue.  The CBO projects that continuing the current Farm Bill for ten years would cost more than $1.4 trillion with 84 percent of that going into nutrition programs.  Given increasing budget deficits, the debt ceiling and budget battles, the cost of the Farm Bill will be a big discussion point in 2024. 

Crop reference prices will be on the table as will whether nutrition spending should be meshed with farm income and ag conservation.  Other key issues will likely involve the amount of crop insurance premium subsidies, the amount of acreage in the CRP and eligibility for SNAP benefits. 

All of this depends on the political process.  Possibly, the Congress will view the Farm Bill as a way to compromise on a bill critical to rural economies.  Or the opposite could occur, and agreements reached only when they absolutely must be.  If that happens, that will cause uncertainty for markets, consumers, ag retailers and producers in general.

The Farm Bill debate will be an issue to monitor throughout 2024.

SCOTUS on Chevron Deference

Relentless, Inc. v. United States Department of Commerce, 62 F.4th 621 (1st Cir. 2023)

Loper Bright Enterprises v. Raimondo, 45 F.4th 359 (D.C. Cir. 2022)

A big issue in the world of ag law and tax in 2024 will involve the issue of government administrative agency deference. The U.S. Supreme Court is considering two cases involving the issue of how much deference should be given administrative agency rules such as those of the USDA or the EPA, for example. 

The two cases involve whether the National Marine Fisheries Service can require the herring industry to bear the costs of observers on fishing boats who monitor conservation and management practices.  The lower courts simply deferred to the determination of the fishery service that the industry should pay the costs.  That’s the typical outcome – you lose a dispute with the USDA, for example, and once you get to court the court simply defers to the agency unless the agency was completely out of bounds with its interpretation of the law.  If the agency’s interpretation was reasonable, the agency wins.  That’s the standard the Court established in 1984 in its Chevron decision. 

In 2022, the Supreme Court limited the deferential standard (it completely ignored Chevron in another 2022 case) when a question of national economic policy is involved, but now the court has an opportunity to lower the deferential standard on a broader scope.  If it does, farmers and ranchers may have better luck in disputes with government agencies and be able to more frequently overcome the presumption that the government is almost always right when Congress hasn’t written a clear statute.

Court Vacates Dicamba Registrations

Center for Biological Diversity v. United States Environmental Protection Agency, No. CV-20-00555-TUC-DCB, 2024 U.S. Dist. LEXIS 20307 (D. Ariz. Feb. 6, 2024)

Recently, a federal court vacated the registrations of three Dicamba products that EPA had approved for over-the-top applications.  The decision comes at a time when many soybean and cotton farmers have already purchased seed and chemicals and will soon be planting the 2024 crop. 

The court said the EPA didn’t follow the notice and comment provisions of the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA) when it issued the registrations and also violated the Administrative Procedure Act (APA) (and the Endangered Species Act) by not allowing public input on whether over-the-top Dicamba has unreasonable adverse effects on the environment. 

In 2020 a federal appellate court vacated the registrations finding that the EPA failed to assess risks and costs for non-users of over-the-top Dicamba.  National Family Farm Coalition v. United States Environmental Protection Agency, 960 F.3d 1120 (9th Cir. 2020).  The EPA made amendments in 2022 and 2023 and approved new uses which the court has now said were approved improperly.

The ruling cancels any benefits of planting Dicamba seeds, and there may not be enough supply of other traits to replace the Dicamba market share.  If farmers are forced to plant Dicamba trait soybeans or cotton without the correct chemical to utilize the gene, they will likely use alternatives that will, in turn, magnify the known issues of the Dicamba chemical problems.   

Comment:  While the timing of the court’s decision is awful, the result is good overall in that it holds the “feet” of the EPA to the “fire” of the administrative process.  It also raises the question of whether the EPA deliberately violated the public notice and comment procedures that are clearly established in the law.  It’s difficult to believe that the EPA lawyers, particularly after losing in the Ninth Circuit on virtually the same issue in 2020, didn’t know that failing to follow the procedural rules for approving the registrations would lead to the registrations being invalidated. 

Perhaps the judge in the case will stay the ruling until the next crop year to reduce the potential for even more harm from a herbicide that should never have been allowed to be used. 

Certainly, this issue will be one that stays on the “front burner” for some time. 

Conclusion

That’s what I see as being the biggest issues in law and tax facing agriculture in 2024.  Only time will tell, but I suspect some of these will end up on my 2024 “Top Ten” list next January.

February 11, 2024 in Environmental Law, Income Tax, Regulatory Law | Permalink | Comments (0)

Friday, February 2, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Seven): No. 1 - SCOTUS and the Definition of a “Water of the United States”

Overview

Today’s article is the seventh and final in a series concerning the Top Ten ag law and tax developments of 2023.  To recap, here’s the list of the top developments so far:

  • 10 - Court orders removal of wind farm.
  • 9 – Reporting Rules for Foreign Bank Accounts
  • 8 – New Business Information Reporting Requirements
  • 7 – “Renewable” Fuel Tax Scam
  • 6 – Limited Partners and Self-Employment Tax
  • 5 – COE Mismanagement of Missouri River Water Levels
  • 4 – The Employee Retention Credit
  • 3 – California’s Proposition 12 and the Dormant Commerce Clause
  • 2 – Foreign Ownership of Agricultural Land

That brings me to what I view as the most important development in ag law and tax in 2023. It’s an issue that has bedeviled agriculture, the Congress the courts and certain administrative agencies for decades – the definition of “Waters of the United States.”  In 2023, the U.S. Supreme Court decided a case involving the definition and, perhaps, narrowed the scope of the federal government’s control of land use under the Clean Water Act (CWA) wetland provisions.   The Court’s decision restores the original understanding of the wetland rules contained in the 1972 CWA amendments, and essentially restores the Trump-era National Water Protection Rule (NWPR).  The Court’s decision in Sackett v. Environmental Protection Agency is an important one for agricultural producers and landowners in general. 

Background

Sackett v. Environmental Protection Agency, 598 U.S. 651 (2023)

Background 

The scope of the federal government’s regulatory authority over wet areas on private land, streams and rivers under the Clean Water Act (CWA) has been controversial for more than 40 years.  As part of its interstate commerce power, the Congress has long regulated the navigable waters of the United States.  The improvement of navigable waters is the domain of the U.S. Army Corps of Engineers (COE) pursuant to the Rivers and Harbors Act of 1890 (and an 1899 amendment banning private deposits of refuse into navigable waters without a permit).  In 1972, under the CWA Amendments of that year, used the concept of “navigable waters” to address water pollution.  By attaching federal jurisdiction (vested in the Environmental Protection Agency (EPA)) over water pollution to the concept of navigation, that gave the federal government control upstream to cover not only waters that are navigable, but waters that can impact waters that are navigable.  This meant that the concept of pollution was integrated with that of navigation into a single definition that barred the discharge of a “pollutant” (which includes cellar dust) into the navigable waters of the United States.  The concept of preserving wetlands was not in mind when the Congress wrote the definition of “a discharge into a navigable water.”  Thus, the parameters of the definition became the task of the EPA and the COE.  Originally, those parameters were narrow in scope.  The COE regulatory position was that a discharge permit was require only if a discharge was into waters that were truly navigable, and that didn’t include wetlands as well as shallow or isolated wetlands.   

However, environmental activists sued, and many court opinions have been filed attempting to define the scope of the government’s jurisdiction. Ultimately, the courts sided with the environmentalists and the COE and EPA changed their rules to give themselves jurisdiction over streams, mud flats, prairie potholes, or ponds, “the use, degradation, or destruction of which could affect interstate commerce.”  The regulatory reach became so broad that in 1985 the EPA’s general counsel approved a regulatory guidance letter stating that a migrating bird flying across state lines that contemplated landing and did land in an isolated wetland was enough to confer jurisdiction!  While that interpretation was eventually negated by the courts, the matter led to several high-profile criminal cases leading to incarceration of individuals for polluting navigable waters as a result of depositing dirt on dry ground.

On two occasions, the U.S. Supreme Court attempted to clarify the 1986 regulatory definition of a WOTUS, but in the process of rejecting the regulatory definitions of a WOTUS developed by the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE), the Court didn’t provide clear direction for the lower courts.  See Solid Waste Agency of Northern Cook County v. United States Army Corps of Engineers, 531 U.S. 159 (2001); Rapanos v. United States, 547 U.S. 175 (2006).  The lower courts have also had immense difficulties in applying the standards set forth by the U.S. Supreme Court. 

The “Clean Water Rule” 

The Obama Administration attempted take advantage of the lack of clear guidance on the scope of federally jurisdictional wetland by issuing an expansive WOTUS rule.  The EPA/COE regulation was deeply opposed by the farming/ranching and rural landowning communities and triggered many legal challenges.   The courts were, in general, highly critical of the regulation, invalidating it in 28 states by 2019. The CWR became a primary target of the Trump Administration.

The “NWPR Rule” 

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

Another Revised Rule 

On December 7, 2021, the EPA and the COE published a proposed rule redefining a WOTUS in accordance with the pre-2015 definition of the term. 86 FR 69372 (Dec. 7, 2021).  The proposed rule was finalized effective March 20, 2023, with the EPA clearly wanting to restore “significant nexus” via “adjacency” test for jurisdiction.   This represented a big change in the definition of “adjacency.”  It doesn’t mean simply “abutting.”  Instead, “adjacent” includes a “significant nexus” and a “significant nexus” can be established by “shallow hydrologic subsurface connections” to the “waters of the United States.  A “shallow subsurface connection,” the Final Rule states, may be found below the ordinary root zone (below 12 inches), where other wetland delineation factors may not be present.  Frankly, that means farm field drain tile.      

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

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

Ditches and drainage devices.  The Final Rule is vague enough to give the government regulatory authority over non-navigable ponds, ditches, and potholes.

The Sackett Litigation

During 2021 another significant case with WOTUS-related issues continued to wind its way through the court system.  In Sackett v. Environmental Protection Agency, 8 F.4th 1075 (9th Cir. 2021), the plaintiffs bought a .63-acre lot in 2004 on which they intended to build a home. The lot is near numerous wetlands the water from which flows from a tributary to a creek, and eventually runs into a lake approximately 100 yards from the lot. The lake is 19 miles long and is a WOTUS subject to the CWA which bars the discharge of a pollutant, including rocks and sand into it. The plaintiffs began construction of their home, and the EPA issued a compliance order notifying the plaintiffs that their lot contained wetlands due to adjacency to the lake and that continuing to backfill sand and gravel on the lot would trigger penalties of $40,000 per day. The plaintiff sued and the EPA claimed that its administrative orders weren’t subject to judicial review. Ultimately the U.S. Supreme Court unanimously rejected the EPA’s argument and remanded the case to the trial court for further proceedings. The EPA withdrew the initial compliance order and issued an amended compliance order which the trial court held was not arbitrary or capricious. The plaintiffs appealed and the EPA declined to enforce the order, withdrew it and moved to dismiss the case. However, the EPA still maintained the lot was a jurisdictional wetland subject to the CWA and reserved the right to bring enforcement actions in the future. In 2019, the plaintiffs resisted the EPA’s motion and sought a ruling on the motion to bring finality to the matter. The EPA claimed that the case was moot, but the appellate court disagreed, noting that the withdrawal of the compliance order did not give the plaintiffs final and full relief. On the merits, the appellate court concluded that the lot contained wetlands 30 feet from the tributary, and that under the “significant nexus” test of Rapanos v. United States, 547 U.S. 715 (2006), the lot was a regulable wetland under the CWA as being adjacent to a navigable water of the United States (the lake).  On September 22, 2021, the plaintiffs filed a petition with the U.S. Supreme court asking the Court to review the case.  The Supreme Court agreed to hear the case and oral argument occurred in early October of 2022. 

Supreme Court opinion.  On May 25, 2023, the Court unanimously agreed that the Sackett’s lot was not a wetland subject to the CWA.  All of the Justices rejected the “significant nexus” test when determining EPA/COE regulatory authority over wetlands.  The majority (Alito, Roberts, Thomas, Gorsuch and Barrett), then paired back the expansive EPA regulatory authority under the CWA.  They replaced the “significant nexus” test with a new standard – the Scalia standard set forth in the plurality opinion of Rapanos in 2006.  They said that the term “waters” in the statute refers only to geological features that are “streams, oceans, rivers and lakes” and to adjacent wetlands that are indistinguishable from those bodies of water due to a continuous surface connection.  For the EPA/Corps to successfully assert jurisdiction, it must: 1) establish that the adjacent water body is a relatively permanent body of water connected to interstate navigable water; and 2) that the wet area has a continuous surface connection with that water making it difficult to determine where the water ends, and the wetland begins.  Justices Kavanaugh, Sotomayor, Kagan and Jackson disagreed on the basis that the majority's approach was too narrow. 

As for the 2023 WOTUS rule, the Supreme Court said it was "inconsistent with the text and structure of the CWA" and that EPA has "no statutory basis to impose a significant nexus test."  A redo is in order.  With the opinion, the Court restored the original position of the EPA in the 1970s – the CWA only applies to waters traditionally recognized as navigable – those subject to the tide; used for transportation, and natural river meanders.  Isolated wetlands were excluded where fill would not affect boats. 

What about agency deference?  Interestingly, there wasn’t a single mention of deference by any of the Justices (other than Justice Kavanaugh’s retort about the agencies being consistent about “adjacency”).  The Court in essence said that the scope of an agency’s authority is not the type of question that courts should defer to the agencies.  This sets the Court up for another case (Loper, Bright) that is coming next term on the issue of Chevron deference.

Water quality.  The Court’s decision will not likely have any discernable effect on water quality.  While the decision does set forth a narrower interpretation of “the waters of the United States” for purposes of the entire CWA, the matter of pollution control is a separate issue.  As noted above, navigation and pollution control are two separate issues which the Court’s opinion more clearly distinguishes.  Any negative impact on water quality is minimized (if not negated) because of the Supreme Court’s decision in a case from Hawaii in 2020.  In that case, the Court held that a “pollutant” that reaches navigable waters after traveling through groundwater requires a federal permit if the discharge into the navigable water is the “functional equivalent’ of a direct discharge from the actual point source into navigable waters.  Hawai’i Wildlife Fund, et al. v. County of Maui, 886 F.3d 737 (2018), vac’d and rem’d. by County of Maui v. Hawaii Wildlife Fund, et al., 140 S. Ct. 1462 (2020).  That is a broad interpretation of “discharge of pollutants” creating the distinct possibility that a contamination of federal jurisdictional waters could result from activities on land that is not subject to the CWA under the Sackett Court’s definition of a “wetland.” 

In addition, the Court’s decision in Sackett applies only to the federal CWA.  It has no application to existing state and local regulations.  Indeed, many of those rules were already in place before the CWA amendments of 1972, and many of them are significant. 

Implications for agriculture.  The Sackett opinion has significant ramifications for agriculture.  This really solidifies the National Water Protection Rule of 2019 as the correct approach.  That rule limited federal jurisdiction to traditional navigable waters and their tributaries.  Now streams and ditches and private waters that don’t have a continuous surface connection to navigable waters won’t be subject to the CWA.  It will make it more difficult for the EPA or COE to assert regulatory control over private land under the CWA.  This eliminates federal control under the CWA over private ponds, as well as ditches and streams where there is no continues flow into a WOTUS. 

Also, farmers that are in the farm programs are subject to the Swampbuster rules.  A “wetland” is defined differently under Swampbuster.  There are two separate definitions.  The one at issue in Sackett involves "waters of the United States" contained in 33 U.S.C. Sec. 1362(7) which a "navigable water" must be.  To have jurisdiction over those waters the Court is saying that the government must 1) establish that an adjacent water body is a relatively permanent body of water connected to interstate navigable water; and 2) such area has a continuous surface connection with that water making it difficult to determine where the water ends, and the wetland begins.  

Swampbuster involves the definition of a wetland contained in 16 U.S.C. 3801(27).  So, there are two different definitions of a "wetland" - one for CWA purposes - which ties into the "navigable waters of the United States" definition, and the other one for Swampbuster.  This all means that a farmer may not have a wetland that the EPA/COE can regulate under the CWA, but might have a wetland that can’t be farmed without losing farm program benefits. 

Conclusion

The Sackett decision is a victory for property rights without any likely discernable impact on water quality.  Ironically, if not for the EPA’s belligerence in insisting on its position against the Sacketts and forcing the couple into a lawsuit, the “significant nexus” test would remain. That test has now been unanimously rejected.  For once agriculture says, “thanks, EPA”!

February 2, 2024 in Environmental Law | Permalink | Comments (0)

Saturday, January 27, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Six): Foreign Ownership of Agricultural Land

Overview

Today’s article is the sixth in a series concerning the Top Ten ag law and tax developments of 2023.  To recap, here’s the list of the top developments so far:

  • 10 - Court orders removal of wind farm.
  • 9 – Reporting Rules for Foreign Bank Accounts
  • 8 – New Business Information Reporting Requirements
  • 7 – “Renewable” Fuel Tax Scam
  • 6 – Limited Partners and Self-Employment Tax
  • 5 – COE Mismanagement of Missouri River Water Levels
  • 4 – The Employee Retention Credit
  • 3 – California’s Proposition 12 and the Dormant Commerce Clause

I am now up to what I view as the second most significant development in ag law and tax in 2023.  It’s an issue that received attention in numerous state legislatures as well as at the federal level.  It’s the issue of foreign ownership of agricultural land – and it’s the topic of today’ post.

Background

The issue of foreign ownership of agricultural land received a lot of attention in 2023 – both at the federal as well as at the state level in numerous states.  It’s not a new issue.  It’s an issue that’s been around for centuries. Under the English common law, aliens could not acquire title to land except with the King's approval.  The King understood that control and ownership of the land was critical to national security and the food supply and did not want disloyal subjects owning or acquiring an interest in land.  As a result, the notion of limiting alien ownership of agricultural land was well imbedded in United States jurisprudence. 

Federal law.  In the 1970s, the issue of foreign investment in and ownership of agricultural land received additional attention because of several large purchases by foreigners and the suspicion that the build-up in liquidity in the oil exporting countries would likely lead to more land purchases by nonresident aliens.  The lack of data concerning the number of acres actually owned by foreigners contributed to fears that foreign ownership was an important and rapidly spreading phenomenon. 

    AFIDA.  As a result of the scant data available on foreign investment in agricultural land, the Congress enacted the Agricultural Foreign Investment Disclosure Act (AFIDA).  7 U.S.C. §3501 et seq. Under AFIDA, the USDA obtains information on U.S. agricultural holdings of foreign individuals and businesses.  In essence, AFIDA is a reporting statute rather than a regulatory statute.  The information provided in reports by the AFIDA helps serve as the basis for any future action Congress may take in establishing direct controls or limits on foreign investment in agricultural land and provides useful information to states considering limitations on foreign investment. The Act requires that foreign persons report to the Secretary of Agriculture their agricultural land holdings or acquisitions.  The Secretary assembles and analyzes the information contained in the report, passes it on the respective states for their action and reports periodically to the Congress and the President.

During 2023, legislation was proposed in the Congress that would increase oversight and restrict foreign investments in and acquisitions of land located within the U.S.

Note:  On January 18, 2024, the U.S. Government Accountability Office (GAO) issued a report that reviews foreign investments in U.S. farmland and evaluates the effectiveness (or lack thereof) of the USDA’s procedures for obtaining and disseminating the data on foreign investment that it receives via the AFIDA.  The GAO also provided recommendations to the USDA on how it can improve the reliability of the data it collects and how it can improve its procedures in distributing the collected information to other federal agencies. 

    FSA request for public comments.  In early 2024, the USDA’s Farm Service Agency (FSA) announced that it was seeking public comments on the AFIDA reporting Form (FSA-153).  Comments are being solicited concerning how the Form can be improved to gather AFIDA-required reporting information.  FSA proposes to update Form FSA-153 to gather information on long-term leases, the impact of foreign investment on ag producers and rural communities, and certain geographic information.  FSA asserts the updated Form will provide the government with “precise and meaningful” data under the AFIDA.   

State action.  Recently, the issue of restricting foreign investment in and/or ownership of agricultural land has been raised in Alabama, Arizona, Arkansas, California, Florida, Indiana, Iowa, Mississippi, Missouri, Montana, North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Washington, and Wyoming. Each of these states have proposed, or planned to propose, legislation restricting foreign ownership and/or investment in agricultural land to varying degrees.  Several high-profile events have spurred this renewed interest including a Chinese-owned company acquiring over 130,000 acres near an Air Force base in Texas and a 300-acre purchase by another Chinese company near a different Air Force base in North Dakota.  Also, the China-originated virus in late 2019, the slow “fly-over” of a Chinese spy balloon from Alaska to South Carolina in 2023, as well as mysterious damages to many food processing facilities, pipelines and rail transportation have contributed to the growing interest in national security and restrictions on ownership of U.S. farm and ranchland by “known adversaries.”

State Enactments in 2023

Arkansas.  Senate Bill 383, enacted in 2023, restricts investors from certain countries, including China, from acquiring an interest in land within the state.  In October, Arkansas became the first in the nation to enforce a state foreign ownership law when the Arkansas Attorney General ordered a subsidiary of Syngenta Seeds, a company owned by an arm of the Chinese communist party, to divest its ownership interest in farmland it owned within the state.  

Florida.  S.B. 264 was signed into law on May 8, 2023, and is codified at Fla. Stat. Ann. §§ 692.201-205.  The new law limits landownership rights of certain noncitizens that are domiciled either in China or other countries that are a “foreign country of concern” (FCOC).  Fla. Stat. §§692.201-.204.   The countries considered as a FCOC under the law include China; Russia; Iran; North Korea; Cuba; Venezuela’s Nicolás Maduro regime; and Syria.

The law was almost immediately challenged in court. Shen v. Simpson, No. 4:23-cv-208 (N.D. Fla., filed May 22, 2023).  Four Chinese citizens living in Florida, along with a real estate brokerage firm, claimed that the law violated their equal protection rights because it restricts their ability to purchase real property due to their race. They also claimed that the law violated the Due Process Clause and the Supremacy Clause of the Constitution and the Fair Housing Act (FHA). Under the law, Chinese investors that are not U.S. citizens that hold or acquire and interest in real property in Florida on or after July 1, 2023, must report their interests to the state or be potentially fined $1,000 per day the report is late.  Chinese acquisitions after July 1, 2023, are subject to forfeiture to the state with such acquisitions constituting a third-degree felony.  The seller commits a first-degree misdemeanor for knowingly violating the law.  The plaintiffs sought an injunction against the implementation of the law before it went into effect on July 1, 2023.  However, the law went into effect on July 1, with the litigation pending.

On August 17, the court denied the plaintiffs’ motion for an injunction.   Shen v. Simpson, No. 4:23-cv-208-AW-HAF, 2023 U.S. Dist. LEXIS 152425 (N.D. Fla. Aug. 17, 2023).  The court determined that the Florida provision classified persons by alienage (status of an alien) rather than by race because it barred landownership by persons who are not lawful, permanent residents and who are domiciled in a “country of concern” while exempting noncitizens domiciled in countries that were not “countries of concern.”  Thus, the restriction was not race-based (it applied equally to anyone domiciled in China, for example, regardless of race) and was not subject to strict scrutiny analysis which would have required the State of Florida to prove that the law advanced a compelling state interest narrowly tailored to achieve that compelling interest.  Strict scrutiny, the court noted only applies to laws affecting lawful permanent aliens, and the Florida provision exempts nonresidents who are lawfully permitted to reside in the U.S.  Thus, the law was to be reviewed under the “rational basis” test.  See, e.g., Terrace v. Thompson, 263 U.S. 197 (1923).

The court held that the State of Florida did have a rational basis for enacting the ownership restrictions – public safety and to “insulate [the state’s] food supply and…make sure that foreign influences…will not pose a threat to it.”  This satisfied the rational basis test for purposes of the plaintiffs’ equal protection challenge and the FHA challenge (because the law didn’t discriminate based on race) and also meant that the court would not enjoin the law because the plaintiffs’ challenge on this basis was unlikely to succeed. 

The Florida law, the court concluded, also defined “critical military infrastructure” and “military installation” in detail which gave the plaintiffs sufficient notice that they couldn’t own ag land or acquire an interest in ag land within 10 miles of a military installation or “critical infrastructure facility,” or within five miles of a “military installation” by an individual Chinese investor.  Thus, the court determined that the plaintiffs’ due process claim would fail. 

The plaintiffs also made a Supremacy Clause challenge claiming that federal law trumped the Florida law because the Florida law conflicted with the manner in which land purchases were regulated at the federal level.  They claimed that federal law established a procedure to review certain foreign investments and acquisitions for purposes of determining a threat to national security.  The court disagreed, noting the “history of state regulation” of alien ownership” and that the Congress would have preempted state foreign ownership laws conflicting with the federal review procedure. 

North Dakota.  S.B. 2371, effective through July 31, 2025, was enacted in 2023.  The legislation gives counties and municipalities the power to prohibit local development by a foreign adversary.  County commissions, city commissions, or city council may not authorize a development agreement with a foreign adversary whether individual or government. Any ordinance contrary to this section is void.  During 2023, North Dakota also enacted H.B. 1135 and H.B. 1371, primarily dealing with existing law concerning ag business structures. 

Oklahoma.  S.B. 212 was enacted in 2023.  The law specifies that no person who is not a US citizen shall acquire title to land either directly through a business entity or trust. These requirements don’t apply to a business entity that has legally operated in the US for at least 20 years.  Any deed recorded with a county clerk shall include proof that the person or entity obtaining the land is in compliance.  No application to lands now owned by aliens so long as they are held by the present owners nor to any alien who shall take up bona fide resident of the state or any lawfully recognized business entity.  It is the duty of the attorney general or district attorney to institute a suit on behalf of the state if they have reason to believe any lands are being held contrary to the Act.  The law also creates a citizen land ownership unit to enforce the provisions of the act within the office of the attorney general.

Other states.  In 2023, in addition to the above-mentioned states, the following states also enacted various types of legislation designed to address foreign ownership/investment of agricultural land:

  • Alabama (H.B. 379, enacted on May 24, 2023)
  • Idaho (H.B. 173, enacted on April 3, 2024)
  • Louisiana (H.B. 537, enacted on June 27, 2023)
  • Mississippi (H.B. 280, enacted on March 22, 2023). This bill merely creates a committee to study the ownership of agricultural land in the state by a foreign government.
  • Montana (S.B. 203, enacted on May 4, 2023)
  • South Dakota (H.B. 1189, enacted on March 9, 2023). This bill is a reporting requirement only.
  • Tennessee (H.B. 40, enacted on May 11, 2023)
  • Utah (H.B. 186, enacted on March 13, 2023)
  • Virginia (S.B. 1438, enacted on May 12, 2023)

Conclusion

Expect the foreign ownership of agricultural land issue to remain a big issue in 2024.  As of January 26, 2024, bills addressing foreign ownership/investment in agricultural land have been filed in the following states:

  • Alaska (HB 252)
  • Arizona (HB 2407 and HB 2439)
  • Florida (HB 1455),
  • Hawaii (SB 2617; SB 2624; HB 2541; HB 2542; HB 2594)
  • Maryland (SB 392)
  • Mississippi (SB 2025; HB 348)
  • Nebraska (LB 1301)
  • New Jersey (A 191)
  • Oklahoma (SB 1705; SB 1773; SB 1953; SB 2002; HB 3077; HB 3125)
  • Tennessee (SB 1950)
  • Washington (SB 6290)

January 27, 2024 in Real Property, Regulatory Law | Permalink | Comments (0)

Tuesday, January 23, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Five): California’s Proposition 12 and the U.S. Supreme Court

Overview

Today’s article is fifth in a series concerning the Top Ten ag law and tax developments of 2023.  To recap, here’s the list of the top developments so far:

  • 10 - Court orders removal of wind farm.
  • 9 – Reporting Rules for Foreign Bank Accounts
  • 8 – New Business Information Reporting Requirements
  • 7 – “Renewable” Fuel Tax Scam
  • 6 – Limited Partners and Self-Employment Tax
  • 5 – COE Mismanagement of Missouri River Water Levels
  • 4 – The Employee Retention Credit

That brings me to the third most important development in ag law and tax of 2023 – it’s the topic of today’s post.

California’s Proposition 12 at the U.S. Supreme Court

North American Meat Institute v. Bonta, 141 S. Ct. 2854 (2021)

In a huge blow to pork producers (and consumers of pork products) nationwide, the Supreme Court of the United States (Court) upheld California’s Proposition 12 against a constitutional challenge.  Proposition 12 requires any pork sold in California to be raised in accordance with California’s housing requirements for hogs.  This means that U.S. hog producers must ensure that their production facilities satisfy California’s requirements for the resulting pork products to be sold to California consumers.

Involved in the case was a claim involving the judicially created doctrine known as the “dormant Commerce Clause.”  A bit of background is in order.

The Commerce Clause.  Article I Section 8 of the U.S. Constitution provides in part, “the Congress shall have Power...To regulate Commerce with foreign Nations and among the several states, and with the Indian Tribes.”  The Commerce Clause, on its face, does not impose any restrictions on states in the absence of congressional action.  However, the U.S. Supreme Court has interpreted the Commerce Clause as implicitly preempting state laws that regulate commerce in a manner that disrupts the national economy.  This is the judicially created doctrine known as the “dormant” Commerce Clause. 

The “dormant” Commerce Clause.  The dormant Commerce Clause is a constitutional law doctrine (that is not in the text of the Constitution) that says Congress's power to "regulate Commerce ... among the several States" implicitly restricts state power over the same area.  In general, the Commerce Clause places two main restrictions on state power – (1) Congress can preempt state law merely by exercising its Commerce Clause power by means of the Supremacy Clause of Article VI, Clause 2 of the Constitution; and (2) the Commerce Clause itself--absent action by Congress--restricts state power.  In other words, the grant of federal power implies a corresponding restriction of state power.  This second limitation has come to be known as the "dormant" Commerce Clause because it restricts state power even though Congress's commerce power lies dormant. Willson v. Black Bird Creek Marsh Co., 27 U.S. 245 (1829).  The label of “dormant Commerce Clause” is really not accurate – the doctrine applies when the Congress is dormant, not the Commerce Clause itself.

The rationale behind the Commerce Clause is to protect the national economic market from opportunistic behavior by the states - to identify protectionist actions by state governments that are hostile to other states.  Generally, the dormant Commerce Clause doctrine prohibits states from unduly interfering with interstate commerce.  State regulations cannot intentionally discriminate against interstate commerce.  If they do, the regulations are per se invalid.  See, e.g., City of Philadelphia v. New Jersey, 437 U.S. 617 (1978).  Also, state regulations cannot impose undue burdens on interstate commerce.  See, e.g., Kassel v. Consolidated Freightways Corp., 450 U.S. 662 (1981).  Under the “undue burden” test, state laws that regulate evenhandedly to effectuate a local public interest are upheld unless the burden imposed on commerce is clearly excessive in relation to the local benefits.     

The Court has never held that discrimination between in-state and out-of-state commerce, without more, violates the dormant Commerce Clause.  Instead, the Court has explained that the dormant Commerce Clause is concerned with state laws that both discriminate between in-state and out-of-state actors that compete with one another, and harm the welfare of the national economy.  Thus, a discriminatory state law that harms the national economy is permissible if in-state and out-of-state commerce do not compete.  See, e.g., General Motors Corp. v. Tracy, 117 S. Ct. 811, 824-26 (1997).  Conversely, a state law that discriminates between in-state and out-of-state competitors is permissible if it does not harm the national economy. H.P. Hood & Sons, Inc. v. Du Mond, 336 U.S. 525 (1949). 

Proposition 12.  In 2018, California voters passed Proposition 12.  Proposition 12 bans the sale of whole pork meat (no matter where produced) from animals confined in a manner inconsistent with California’s regulatory standards.  Proposition 12 established minimum requirements on farmers to provide more space for egg-laying hens, breeding pigs, and calves raised for veal. Specifically, the law requires that covered animals be housed in confinement systems that comply with specific standards for freedom of movement, cage-free design, and minimum floor space. The law identifies covered animals to include veal calves, breeding pigs and egg-laying hens. The implementing regulations prohibit a farm owner or operator from knowingly causing any covered animal to be confined in a cruel manner, as specified, and prohibits a business owner or operator from knowingly engaging in the sale within the state of shell eggs, liquid eggs, whole pork meat or whole veal meat, as defined, from animals housed in a “cruel manner.”  In addition to general requirements that prohibit animals from being confined in a manner that prevents lying down, standing up, fully extending limbs, or turning around freely, the measure added detailed confinement space standards for farms subject to the law. The alleged reason for the law was to protect the health and safety of California consumers and decrease the risk of foodborne illness and the negative fiscal impact on California. 

In late 2019, several national farm organizations challenged Proposition 12 and sought a declaratory judgment that the law was unconstitutional under the dormant Commerce Clause.  The plaintiffs also sought a permanent injunction preventing Proposition 12 from taking effect.  The plaintiffs claimed that Proposition 12 impermissibly regulated out-of-state conduct by compelling non-California producers to change their operations to meet California’s standards.  The plaintiffs also alleged that Proposition 12 imposed excessive burdens on interstate commerce without advancing any legitimate local interest by significantly increasing operation costs without any connection to human health or foodborne illness.  The trial court dismissed the plaintiffs’ complaint.  National Pork Producers Council, et al. v. Ross, 456 F. Supp. 3d 1201 (S.D. Cal. 2020). 

On appeal, the plaintiffs focused their argument on the allegation that Proposition 12 has an impermissible extraterritorial effect of regulating prices in other states and, as such, is per se unconstitutional.  This was a tactical mistake for the plaintiffs.  The appellate court noted that existing Supreme Court precedent on the extraterritorial principle applied only to state laws that are “price control or price affirmation statutes.”  National Pork Producers Council, et al. v. Ross, 6 F.4th 1021 (9th Cir. 2021).  Thus, the extraterritorial principle does not apply to a state law that does not dictate the price of a product and does not tie the price of its in-state products to out-of-state prices.  Because Proposition 12 was neither a price control nor a price-affirmation statute (it didn’t dictate the price of pork products or tie the price of pork products sold in California to out-of-state prices) the law didn’t have the extraterritorial effect of regulating prices in other states. 

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

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

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

U.S. Supreme Court

On May 11, 2023, the Court issued a 5-4 plurality opinion dismissing the case for failure to state a claim.  While the Court did not address the merits of the case, the Court did issue a total of five opinions (including a dissent) that can provide guidance for future cases alleging a dormant commerce clause violation. 

Plurality opinion.  The controlling plurality opinion (Justices Gorsuch, Thomas, Barrett, Sotomayor and Kagan) pointed out that the Congress has the power to regulate interstate commerce (Article I, Section 8), but hadn’t enacted any statute that would displace Proposition 12.  So, the Court noted, the pork producers were claiming that the dormant Commerce Clause should be utilized to negate Proposition 12.  As noted, the pork producers didn’t allege any purposeful discrimination by California, instead relying on the “extraterritoriality doctrine,” with the result that, because price discrimination was not involved, the Court rejected adopting a “per se” rule under the dormant Commerce Clause that would strike down state legislation that only has an impact beyond that state’s borders.  Indeed, the Court said, “This argument falters out of the gate.” 

The fallback argument of balancing under Pike v. Bruce Church, Inc., 397 U.S. 137 (1970) was rejected by Justices Gorsuch, Thomas and Barrett on the basis that balancing state interests was a policy decision to be left up to the Congress. 

Note:  In Pike, the Court held that the power of the states to enact laws that interfere with interstate commerce is limited when the law poses and undue burden on business transactions.  “Undue burden is to be determined based on a balancing test which depends on the facts of each particular situation.

Indeed, Justice Barrett concluded that the benefits and burdens of Proposition 12 were impossible to measure, but that the complaint plausibly alleged a substantial burden on interstate commerce that would be felt almost exclusively outside California.  Justices Sotomayor and Kagan would have engaged in balancing but because the pork producers failed to plausibly allege a substantial burden on interstate commerce (which is a requirement under Pike), the Court said it had no way to weigh the costs of Proposition 12 against California’s “moral and health interests.”  Again, the Court said the matter was a policy choice to be left up to the Congress and that the Commerce Clause does not protect a particular structure or method of business operation – “That goes for pigs no less than gas stations.” 

Dissenting opinion.  Chief Justice Roberts wrote a dissenting opinion that was joined by Justices Alito, Kavanaugh and Jackson.  The dissent concluded that a substantial burden on interstate commerce was present because Proposition 12 impacted practically the entire U.S. hog industry due to the interconnected nature of the nationwide pork industry which would require the compliance of the vast majority of hog producers.  It was more than a cost of compliance issue.  The question was then, in the words of the dissent, whether the burden of Proposition 12 was clearly excessive in relation to the “putative local benefits.”  This determination needed to be made by the lower courts, the dissent argued.

Separate opinion.  Justice Kavanaugh wrote separately to point out that California was regulating hog production in other states and that other states had good reason for allowing hogs to be raised in a manner the California found offensive.  He also noted that it would be virtually impossible for hog farmers and pork processors to segregate individual hogs based on their ultimate destination, and that each state has its own rules for health and safety as applied to hog production.  Justice Kavanaugh stated, “California’s approach undermines federalism and the authority of individual States by forcing individuals and businesses in one State to conduct their farming, manufacturing and production practices in a manner required by the laws of a different State.”  If Proposition 12 were to be upheld, a “blueprint” could be provided for other states.  Justice Kavanaugh also stated that California’s approach could also be challenged under the Privileges and Immunities Clause, the Import-Export Clause and the Full Faith and Credit Clause.  He concluded with a biting criticism of the lawyers for the pork producers by stating, “It appears, therefore, that properly pled dormant Commerce Clause challenges under Pike to laws like California’s Proposition 12 (or even to Proposition 12 itself) could succeed in the future – or at least survive past the motion-to-dismiss stage.”

Conclusion

Historically, the Court has been careless in applying the anti-discrimination test, and in many cases, neither of the two requirements--interstate competition or harm to the national economy--is ever mentioned.  See, e.g., Hughes v. Oklahoma, 441 U.S. 322 (1979). The reason interstate competition goes unstated is obvious – in most cases the in-state and out-of-state actors compete in the same market.  But, the reason that the second requirement, harm to the national economy, goes unstated is because the Court simply assumes the issue away.

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

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

Clearly a majority of the Justices said such matters as Proposition 12 is up to the Congress.  On that point, since 2015 legislation has been introduced in the U.S. House on multiple occasions to address interstate commerce cannibalization by a state.  On two occasions, the legislation passed the House but only to die in the U.S. Senate and not get included in a Farm Bill.  The legislation, was entitled the “Protect Interstate Commerce Act” and would have barred a state from imposing a standard or condition on the production or manufacture of agricultural products sold or offered for sale in interstate commerce if (1) the production or manufacture occurs in another state, and (2) the standard or condition adds to standards or conditions applicable under Federal law and the laws of the state in which the production or manufacture occurs. More recently, the legislation was later introduced in the U.S. Senate under a different title.    

Note:  Certainly, congressional action can resolve questions about the constitutionality of agricultural regulations under the Commerce Clause.  For example, a Vermont “genetically modified organism” labelling law was challenged through litigation, but Congress reached a nationwide solution by creating a uniform national standard.  In the current situation, The Congress could set a specific standard for cage sizes that preempts state laws or, as the proposed legislation attempts, set a general rule for state regulation of products in interstate commerce.

The dormant commerce clause is one of those legal theories “floating” around out there that can have a real impact in the lives of farmers, ranchers and consumers, and how economic activity is conducted.  But a case challenging a state law on dormant Commerce Clause grounds must be plead and argued properly for a court to hear it.  That didn’t happen in the present situation. 

January 23, 2024 in Regulatory Law | Permalink | Comments (0)

Monday, January 22, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Four): The Employee Retention Credit

Overview

Today’s article is fourth in a series concerning the Top Ten ag law and tax developments of 2023.  To recap, here’s the list of the top developments so far:

  • 10 - Court orders removal of wind farm.
  • 9 – Reporting Rules for Foreign Bank Accounts
  • 8 – New Business Information Reporting Requirements
  • 7 – “Renewable” Fuel Tax Scam
  • 6 – Limited Partners and Self-Employment Tax
  • 5 – COE Mismanagement of Missouri River Water Levels

That brings me to the fourth most important development in ag law and tax of 2023 – it’s the topic of today’s post.

Employee Retention Credit (ERC)

BackgroundThe ERC is a refundable tax credit enacted in 2020 to provide an incentive for qualified businesses to keep employees on the payroll.  While 2021 legislation eliminated most employers’ ability to claim the ERC for wages paid beginning with the fourth quarter of 2021, it remains possible that some business may still qualify.  An eligible business that didn’t claim the credit when the original employment tax return was field can claim the ERC by filing an adjusted employment tax return.  That Form, Form 941-X (943-X for farm businesses) can be filed up to three years after initially filing or two years after paying, whichever is later.  Thus, claims can be filed with respect to unclaimed credits for 2020 until April 15, 2024, and until April 15, 2025, for 2021 unclaimed credits. 

Note:  Pending legislation (the Tax Relief for American Families and Workers Act) would bar filing any ERC claims as of January 31, 2024.  If a claim is finalized and ready to mail before January 31, 2024, it should be sent via certified mail

The ERC is complex, which led to confusion and opened a door for potential fraud.  One area of confusion concerned the modifications for various periods of time.  For the timeframe March 13, 2020, through the end of 2020 eligible trades or businesses were those that were partially or fully suspended due to orders from a government authority, or sustained a decline in gross receipts of at least 50 percent for the same calendar quarter in 2019.  Of course, farm and ranch operations were not shut down during the virus years, and the virus years tended to correspond to strong commodity price years such that many farm and ranch businesses did not experience a drop in gross receipts. 

Note:  The definition of “gross receipts” for ERC purposes contained complicated parent/sub rules, common ownership rules, as well as deemed ownership rules.  A farmer could not determine the ERC by simply looking at the Schedule F.  

Self-employed persons weren’t eligible for the 2020 ERC for their own wages, but the ERC could be claimed on wages paid to other employees.  For the first three quarters of 2021, an eligible business was one that either sustained partial or full suspension of business activities by action of the government or experienced a decline of at least 20 percent of gross receipts for the same calendar quarter in 2019.  For businesses that didn’t exist in 2019, 2020 could be used as a comparison.  The same rule as before applied to self-employed persons. 

Note:  The ERC was ended as of Sept. 30, 2021, except for “startup recovery businesses” that could claim the credit on wages paid for the balance of 2021.

The credit was tied to the number of employees a business hired, and different rules applied to full-time as compared to part-time employees.  Again, the rules changed on this computation for 2020 and 2021.  In addition, not all wages counted for ERC purposes. 

For 2020, the amount of the credit was equal to 50 percent of up to $10,000 in qualified wages per employee (including amounts paid toward health insurance) for all eligible calendar quarters beginning March 13, 2020, and ending Dec. 31,

For 2021, the credit was equal to 70 percent of up to $10,000 in qualified wages per employee (including amounts paid toward health insurance) for each eligible calendar quarter beginning Jan. 1, 2021, and ending Sep. 30, 2021.

Fraud.  The IRS announced that it had received 3.6 million claims as of September 2023, But, on Sept. 14, 2023, the IRS announced "an immediate moratorium through at least the end of the year" on processing new ERC claims.  IRS said it was taking the action because of fraud concerns, in particular involving businesses that had been "pressured and scammed by aggressive promoters and marketing" into filing questionable claims.

Note:  The moratorium impacted legitimate claims by farm businesses (and other businesses) that were counting on receipt of the credit amounts. 

In October, the IRS announced a "special withdrawal process" for business owners who had filed a possibly ineligible claim, but not yet received the money, allowing them to withdraw it without facing penalties or interest.  IRS also made allowance for businesses that had received the ERC but later learned it shouldn’t have.  By the end of 2023, the IRS reported that pending applicants had withdrawn claims amounting to more than $100 million.

Note:  The lucrative nature of the ERC combined with the complex rules attracted “mills” that perpetrated ERC fraud.  For instance, many orchards and other types of labor-intensive ag business easily qualified for six-figure ERC amounts for each quarter in 2021. 

Many ERC promoters claimed that supply chain issues during the virus years automatically qualified a business for the ERC.  IRS issued guidance on this issue that wasn’t clear, but then later stated that the supply chain issues do not automatically qualify a business for the ERC.  Indeed, IRS stated that only wages paid during the suspension or shutdown qualify.  This again caused tax preparers in many situations to consider amending payroll and income tax returns to make corrections before IRS discovered the matter and issued a notice for taxes, interest and penalties. 

In late 2023, the IRS announced a voluntary disclosure program letting employers who received questionable ERCs pay them back at a discounted rate.  This amnesty program was also part of the agency’s efforts to combat ERC fraud.  Under the program, IRS will provide amnesty if 80 percent of the improperly received ERC is paid back.  Doing so removes the possibility of interest and penalties and provides a greater avenue for businesses to return the improperly received ERC having already lost some of it to a bogus ERC promoter.  Businesses must apply to the voluntary disclosure program by March 22, 2024.  Certain qualifications must be satisfied for a business to participate in the program.    

Note:  Pending legislation (the Tax Relief for American Families and Workers Act) includes substantial fines for those involved in erroneous or false claims.  

Conclusion

Normally a tax credit would not make the “top ten” list.  However, the magnitude of the problems associated with the ERC and the frequency with which tax preparers representing farmers and ranchers had to deal with it throughout 2023 (and continuing into 2024) pushed it to the upper half of the top ten list.

Three more developments to go.  What do you think are the top three?

January 22, 2024 in Income Tax | Permalink | Comments (0)

Friday, January 19, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Three)

Overview

Today’s article is third in a series concerning the Top Ten ag law and tax developments of 2023.  So far, I’ve looked at a court-ordered removal of an entire wind farm, the reporting of foreign bank accounts, new business information reporting requirements, a massive “renewable” fuel tax scam, and a significant Tax Court case concerning self-employment tax on distributions to limited partners.  That brings me to the remaining ‘top five’ developments in today’s post. 

Development number 5 – it’s the topic of today’s post. 

  1. Corps of Engineers Mismanages Water Levels in Missouri River

Ideker Farms, Inc. et al. v. United States, 71 F.4 th 964 (Fed. Cir. 2023), afn'g. in part, vacn'g. in part and remanding, 151 Fed Cl. 560 (Fed. Cl. 2020).

In 2023, the U.S. Court of Appeals for the Federal Circuit largely affirming a lower court ruling that the U.S. Army Corps of Engineers (COE) unconstitutionally violated the property rights of certain farmers along the Missouri River.  The case stemmed from changed in the COE’s manual for managing waters levels in the river.  The court’s decision is not only very important for the particular farmer’s involved but is also an important victory for private property rights in general.

Background facts.  In 2014, almost 400 farmers along the Missouri River from Kansas to North Dakota sued the federal government claiming that the actions of the U.S. Army Corps of Engineers (COE) led to and caused repeated flooding of their farmland along the Missouri River.  The farmers alleged that flooding in 2007-2008, 2010-2011, and 2013-2014 constituted a taking requiring that compensation be paid to them under the Fifth Amendment.  The litigation was divided into two phases – liability and compensation for an unconstitutional taking of theirs farms. 

The liability phase was decided in early 2018 when the court determined that some of the 44 landowners selected as bellwether plaintiffs had established the COE’s liability.  In that decision, the court held that the COE, in its attempt to balance flood control and its responsibilities under the Endangered Species Act, had released water from reservoirs “during periods of high river flows with the knowledge that flooding was taking place or likely to soon occur.”  The court, in that case, noted that the COE had made changes to its “Master Manual” in 2004 and made other changes after 2004 to reengineer the Missouri River and reestablish more “natural environments” to facilitate species recovery.  Those changes led to unprecedented releases from Gavins Point Dam in South Dakota after heavy spring rains and snowmelt in Montana during early 2011.  The large volume of water released caused riverbank destabilization which led to flooding and destroyed all of the levees along the lead plaintiff’s farm and an estimated $2 billion in damages.  The COE claimed it acted appropriately to manage the excess water.  Ultimately, the court, in the earlier litigation, determined that 28 of the 44 landowners had proven the elements of a takings claim – causation, foreseeability and severity.  The claims of the other 16 landowners were dismissed for failure to prove causation. The court also determined that flooding in 2011 could not be tied to the COE’s actions and dismissed the claims for that year. 

Damages.  Subsequent litigation involved a determination of the plaintiffs’ losses and whether the federal government had a viable defense against the plaintiffs’ claims.  The trial court found that the “increased frequency, severity, and duration of flooding post MRRP [Missouri River Recovery Program] changed the character of the representative tracts of land.”  The trial court also stated that, “ [i]t cannot be the case that land that experiences a new and ongoing pattern of increased flooding does not undergo a change in character.”  The trial court determined that three representative plaintiffs, farming operations in northwest Missouri, southwest Iowa and northeast Kansas, were collectively owed more than $10 million for the devaluation of their land due to the establishment of a “permanent flowage easement” that the COE acquired along with repairs to a levee.  The easement and levee damage constituted a compensable taking under the Fifth Amendment.  However, the trial court determined that the COE need not compensate the plaintiffs for property and crop losses, and that flooding from 2011 was not compensable. The impact of the trial court’s ruling meant that hundreds of landowners affected by flooding in six states would likely be entitled to compensation for the loss of property value due to the new flood patterns that the COE created as part of its MRRP. Both parties appealed.  The Corps claimed that the trial court lacked jurisdiction and that the plaintiffs’ claims accrued in 2007.  As such those claims, the COE argued, were barred by a six-year statute of limitations. The Corps also claimed the trial court’s December 31, 2014, accrual date was arbitrary. The Federal Circuit rejected both arguments.

Appellate decision.  The appellate court determined that the plaintiffs’ claims were not time-barred and that the accrual date of December 31, 2014, was not arbitrary.  The appellate court affirmed on the compensable taking issue but determined that the trial court erred by excluding crop damages occurring between 2007 and 2014 from the damage calculation.  Thus, the appellate court vacated the trial court determination not to award compensation for crop and property damage for those years and remanded for a determination of the amount of the crop damage to both mature and immature crops. 

The compensable taking was for both a flowage easement and crop damage because the appellate court concluded that a per se taking had occurred – it was foreseeable that the COE’s 2004 changes would cause intermittent flooding into the future.  This meant that the permanent flowage easement was not simply a trespass.  It was a per se taking. The appellate court also determined that the trial court failed to consider whether the actions of the COE actions in accordance with its Master Manual changes increased the severity or duration of the 2011 flooding compared to what was attributable to the record rainfall that year.   

On the damages issue, the appellate court concluded that lost profit and the cost of moving into new facilities are not compensable under the Fifth Amendment, but that destroyed crops are.  Crop damage, both mature and immature must be compensated because they were taken as a direct result of the COE’s permanent flowage easement. The appellate court remanded the case to the trial court to determine the value of the immature crops the COE’s action unconstitutionally took.

Implications.  As noted above, the appellate court held that not only had a Taking occurred, but that the farmers in the case had to be paid for all of the crops that were destroyed over the seven-year period at issue (2007-2014).  The appellate court’s opinion is important for the fact that it establishes that the government must pay for the damages it causes when it floods farmland and destroys crops.  Certainly, the government has the power to “take” property that it wants.  The Constitution ensures that the government pays for what it takes.  That principle was appropriately applied in this instance. 

January 19, 2024 in Environmental Law, Regulatory Law | Permalink | Comments (0)

Monday, January 15, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part Two)

Overview

With the immediately previous blog article I started the journey through what I believe are the Top Ten developments in ag law and tax of 2023.  In that article I wrote about developments ten, nine and eight.  Today, it’s the seventh and sixth most important ones.   Again, all of these make my Top Ten list because of their significance on a national level to farmers, ranchers, rural landowners and agribusiness in general.

Developments seven and six of 2023 – that’s the topic of today’s post.

  1. Prison Sentences for Five People Involved in Billion Dollar Biofuel Tax Fraud Conspiracy (i.e., the Dermen/Kingston Conspiracy)

Number seven on my list topped the IRS Criminal Investigation Divisions case list for 2023.  Involved is one of the largest tax fraud schemes in the history of the United States and it ultimately led in 2023 to the sentencing of five individuals for their roles in a $1 billion biofuel tax conspiracy.  The conspiracy occurred from 2010 to 2018 and involved money laundering, mail fraud and the fraudulent claiming of more than $1 billion in refundable renewable fuel tax credits.

At the foundation of the criminal activity was the Renewable Fuel Standard (RFS) created in 2005 and expanded in 2007.  Under the RFS, the government offers lucrative subsidies and tax credits to companies that convert crops such as soybeans and corn, as well as other products, into “renewable” fuels – the most common of which is corn ethanol.  Included in the RFS are biofuel production incentives known as renewable identification numbers (RINs).  Under EPA rules, a 38-digit number designed to track each gallon of ethanol or biodiesel from the producer to the point of sale.  Ethanol RINs remain with the fuel until it is pumped by a consumer at the gas station.  However, biodiesel RINs can be sold separately as credits that can be traded.  This allows oil refiners who failed to blend the government-mandated amount of biodiesel to buy RINs to make up the difference without paying a fine.  However, it also allowed for the possibility that a RIN price could be negotiated by a biofuel company with an oil refiner with the company using a fake 38-digit number.  The RIN buyer would then claim to have shipped the biofuel to be refined.  No fuel was actually bought or sold, and both the buyer and seller were in on the scam. 

Note:  Estimates are that the blending government mandate has resulted in about 40 percent of U.S. corn production being converted into ethanol annually.  The estimated taxpayer subsidies of corn farmers have exceeded $71 billion since 2005. 

The biggest RFS scam ever involved the parties mixed-up in this development.  The perpetrators created the appearance of biodiesel production and sale to claim the tax credits.  IRS actually paid out more than $511 million in credits to their biodiesel company that then distributed the proceeds among them as the company’s owners.  After pleading guilty, one conspirator was sentenced to 40 years in prison plus over $1 million in restitution and personal financial liability.  Another got 18 years in prison plus over $500 million in restitution and another $338 million in personal financial liability.  Three others were sentenced to 12, 7 and six years in prison and ordered to pay over $500 million in restitution combined. 

The IRS said the case, “has been one of unprecedented fraud against the United States and its citizens and is one of the most egregious examples of tax fraud in U.S. history.”   

     6. Self-Employment Tax and Limited Partners

Soroban Capital Partners LP v. Comr., 161 T.C. No. 12 (2023)

A question in self-employment tax planning is whether an LLC member is a limited partner.  In 1997 the IRS/Treasury issued a proposed regulation to address the issue, but it has never been finalized.  The regulation establishes a fact-based analysis based on participation in management to determine limited partner status.  A limited partner doesn’t participate in management.    For businesses other than those providing professional services, characterization of an LLC member’s interest is determinative of whether the member has self-employment tax liability on amounts distributed to the member (other than guaranteed payments).  That means that proper structuring of the entity matters as does the drafting of the LLC operating agreement and the conduct of the members. 

Here's what it might look like for a farming operation:

A married couple operates a farming business as an LLC.  The wife works full-time off the farm and does not participate in the farming operation.  But she holds a 49 percent non-manager ownership interest in the LLC.  The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest.  But, the husband, as the farmer, also holds a 2 percent manager interest.  The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC.  The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.  The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives.  This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC. 

In late 2023, the U.S. Tax Court issued a fully reported opinion confirming that state law classifications of a partner’s interest is not conclusive on the self-employment tax issue.  ordinary income to its limited partners. However, the petitioner excluded distributions of ordinary income to its limited partners from its computation of net earnings from self-employment.  Its basis for doing so was that the limited partners’ interest conformed to state law.  The IRS disagreed asserting that wasn’t enough and that the functions and roles of the limited partners also had to be analyzed for self-employment tax purposes. The Tax Court agreed with the IRS.

At issue was the definition of a “limited partner” for purpose of the exception from s.e. tax under I.R.C. §1402(a)(13).  The Tax Court noted that the proposed regulations provided a definition, that the Congress froze the finalization of the regulation for six months and has said very little about the issue since the freeze was lifted and has not provided a definition.  The Tax Court noted that it had applied a “functional analysis” test in Renkemeyer, Campbell & Weaver, LLP, 136 T.C 137 (2011), but that this was the first time the Tax Court was asked to determine the self-employment tax status of limited partner in a state law limited partnership (having passed on the issue in a 2020 case). 

The Tax Court determined that the functional analysis test applied based largely on statutory construction of I.R.C. §1402(a)(13) which excludes from self-employment tax “the distributive share of any item of income or loss of a limited partner, as such.”  The Court concluded that the “as such” language meant that there wasn’t a blanket exclusion for a limited partner.  Instead, the statute only applies to a limited partner that is acting as a limited partner.  If a limited partner is anything more than merely an investor, self-employment tax applies to the partner’s distributive share. 

Note:  The Tax Court noted that the petitioner cited legislative history in an attempt to support its position, but that the legislative history actually supported the position of the IRS.  The Tax Court also noted that the petitioner put forth “myriad other arguments” none of which were persuasive.  The petitioner even cited language in the instructions for Form 1065 which it claimed defined a limited partner, but the Tax Court noted that the definition did not purport to define a limited partner. 

The Tax Court held that a functional inquiry into the roles and activities of the petitioner’s individual partners under I.R.C. §1402(a)(13) “involves factual determinations that are necessary to determine Soroban’s aggregate amount of net earnings from self-employment.”  Accordingly, the Tax Court denied the petitioner’s motion for summary judgment and set forth the rule going forward in evaluating the application of self-employment tax for limited partners in professional service businesses.

The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships.  For those that are, the S corporation is the business form to use to achieve a better tax result.  For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free.  But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.   

Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan.  Other non-tax considerations may carry more weight in a particular situation.  But for some, this strategy can be quite beneficial.

Soroban Capital Partners LP lays down the rule that it’s not enough to simply hold a limited partnership interest under state law (in the context of a professional service business).  A limited partner must truly be acting as an investor and no more. 

Proper structuring of the LLC and careful drafting of the operating agreement is important. 

Conclusion

I will continue the trek through the “Top Ten” of 2023 in the next post.

January 15, 2024 in Criminal Liabilities, Income Tax | Permalink | Comments (0)

Friday, January 12, 2024

Top Ten Developments in Agricultural Law and Taxation in 2023 – (Part One)

Overview

With my two prior blog articles I started looking at some of the most significant developments in agricultural law and taxation during 2023.  With today’s article I begin the look at what I view as the ten most significant developments in 2023.  These make my Top Ten list because of their significance on a national level to farmers, ranchers, rural landowners and agribusiness in general.

Developments ten through eight of 2023 – that’s the topic of today’s post.

  1. Entire Commercial Wind Development Ordered Removed

United States v. Osage Wind, LLC, No. 4:14-cv-00704-CG-JFJ,

2023 U.S. Dist. LEXIS 226386 (N.D. Okla. Dec. 20, 2023)

In late 2023, a federal court ordered the removal of an entire commercial wind energy development (150-megawatt) in Oklahoma and set a trial for damages.  The litigation had been ongoing since 2011 and was the longest-running legal battle concerning wind energy in U.S. history.  The ruling follows a 2017 lower court decision concluding that construction of the development constituted “mining” and required a mining lease from a tribal mineral council which the developers failed to acquire.  United States v. Osage Wind, LLC, 871 F.3d 1078 (10th Cir. 2017).  The court’s ruling granted the United States, the Osage Nation and the Osage Minerals Council permanent injunctive relief via “ejectment of the wind turbine farm for continuing trespass.”

The wind energy development includes 84 towers spread across 8,400 acres of the Tallgrass Prairie involving leased surface rights, underground lines, overhead transmission lines, meteorological towers and access roads.  Removal costs are estimated at $300 million.  In 2017, the U.S. Circuit Court of Appeals for the Tenth Circuit held that the wind energy company’s extraction, sorting, crushing and use of minerals as part of its excavation work constituted mineral development that required a federally approved lease.  The company never received one.  The Osage Nation owns the rights to the subsurface minerals that it purchased from the Cherokee Nation in the late 1800s pursuant to the Osage Allotment Act of 1906.  The mineral rights include oil, natural gas and the rocks that were mined and crushed in the process of developing the project. 

In its decision to order removal of the towers, the court weighed several factors but ultimately concluded that the public interest in private entities abiding by the law and respecting government sovereignty and the decision of courts was paramount.  The court pointed out that the defendant’s continued refusal to obtain a lease constituted interference with the sovereignty of the Osage Nation and “is sufficient to constitute irreparable injury.” 

Note:  The lengthy litigation resulting in the court’s decision is representative of the increasing opposition in rural areas to wind energy production grounded in damage to the viewshed, landscape and wildlife.  During 2023, including the court’s opinion in this case, there were 51 restrictions or rejections of wind energy projects and 68 rejections of solar energy projects.  See, Renewable Rejection Database, https://robertbryce.com/renewable-rejection-database/

9.         Reporting Foreign Income

Bittner v. United States, 598 U.S. 85 (2023)

The Bank Secrecy Act of 1970 requires U.S. financial institutions to assist U.S. government agencies in detecting and preventing money laundering by, among other things, maintaining records of cash purchases of negotiable instruments, filing currency transaction reports for cash transactions exceeding $10,000 in a single business day, and reporting suspicious activities that might denote money laundering, tax evasion and other crimes.  The law also requires a U.S. citizen or resident with foreign accounts exceeding $10,000 to report those account to the IRS by filing FinCEN Form 114 (FBAR) by the due date for the federal tax return.  The failure to disclose foreign accounts properly or in a timely manner can result in substantial penalties. 

In this case, the plaintiff was a dual citizen of Romania and the United States.  He emigrated to the United States in 1982, became a U.S. citizen, and lived in the United States until 1990 when he moved back to Romania.  He had various Romania investments amounting to over $70 million.  He had 272 foreign accounts with high balances exceeding $10,000.  He was not aware of the FBAR filing requirement for his non-U.S. accounts until May of 2012.  The initial FBARs that he filed did not accurately report all of his accounts.  In 2013, amended FBARs were filed properly reporting all of his foreign accounts.  The IRS audited and, in 2017, computed the plaintiff’s civil penalties at $2,720,000 for a non-willful violation of failing to timely disclose his 272 foreign account for five years 2007-2011.

The plaintiff denied liability based on a reasonable cause exception.  He also claimed that the penalty under Section 5321 of the Bank Secrecy Act applied based on the failure to file an annual FBAR reporting the foreign accounts, and that the penalty was not to be computed on a per account basis. 

The trial court denied the plaintiff’s reasonable cause defense and held him liable for violations of the Bank Secrecy Act.  The trial court determined that the penalty should be computed on a per form basis and not on a per account basis.  Thus, the trial court computed the penalty at $50,000 ($10,000 per year for five years).  On appeal, the appellate court affirmed on the plaintiff’s liability (i.e., rejected the reasonable cause defense), but determined that the penalty was much higher because it was to be computed on a per account basis. 

On further review, the U.S. Supreme Court (in a 5-4 decision) determined that the penalty was to be computed on a per form basis and not a per account basis.  The Court’s holding effectively reduced the plaintiff’s potential penalty from $2.72 million to $50,000.  The majority relied on the text, IRS guidance, as well as the drafting history of this penalty provision in the Bank Secrecy Act.  The Court did not address the question of where the line is to be drawn between willful and non-willful conduct for FBAR purposes. 

Note:  The Supreme Court’s decision was a major taxpayer victory.  However, the point remains that foreign bank accounts with a balance of at least $10,000 at any point during the year must be reported.  This is an important point for U.S. citizen farmers and ranchers with farming interests in other countries. 

  1. New Corporate Reporting Requirements

            Corporate Transparency Act (CTA), P.L. 116-283

Overview.  The Corporate Transparency Act (CTA), P.L. 116-283, enacted on January 1, 2021 (as the result of a veto override), as part of the National Defense Authorization Act, was passed to enhance transparency in entity structures and ownership to combat money laundering, tax fraud and other illicit activities. In short, it’s an anti-money laundering initiative designed to catch those that are using shell corporations to avoid tax.  It is designed to capture more information about the ownership of specific entities operating in or accessing the U.S. market.  The effective date of the CTA is January 1, 2024.   

Who needs to report?  The CTA breaks down the reporting requirement of “beneficial ownership information” between “domestic reporting companies” and “foreign reporting companies.”  A domestic reporting company is a corporation, limited liability company (LLC), limited liability partnership (LLP) or any other entity that is created by filing of a document with a Secretary of State or any similar office under the law of a state or Indian Tribe.  A foreign reporting company is a corporation, LLC or other foreign entity that is formed under the law of a foreign country that is registered to do business in any state or tribal jurisdiction by the filing of a document with a Secretary of State or any similar office. 

Note:  Sole proprietorships that don’t use a single-member LLC are not considered to be a reporting company. 

Reporting companies typically include LLPs, LLLPs, business trusts, and most limited partnerships and other entities are generally created by a filing with a Secretary of State or similar office. 

Exemptions.  Exemptions from the reporting requirement apply for securities issuers, domestic governmental authorities, insurance companies, credit unions, accounting firms, tax-exempt entities, public utility companies, banks, and other entities that don’t fall into specified categories.  In total there are 23 exemptions including an exemption for businesses with 20 or more full-time U.S. employees, report at least $5 million on the latest filed tax return and have a physical presence in the U.S.   But, for example, otherwise exempt businesses (including farms and ranches) that have other businesses such as an equipment or land LLC or any other related entity will have to file a report detailing the required beneficial ownership information.  Having one large entity won’t exempt the other entities. 

What is a “Beneficial Owner”?  A beneficial owner can fall into one of two categories defined as any individual who, directly or indirectly, either:

  • Exercises substantial control over a reporting company, or
  • Owns or controls at least 25 percent of the ownership interests of a reporting company

Note:  Beneficial ownership is categorized as those with ownership interests reflected through capital and profit interests in the company.

What must a beneficial owner do?  Beneficial owners must report to the Financial Crimes Enforcement Network (FinCEN).  FinCEN is a bureau of the U.S. Department of the Treasury that collects and analyzes information about financial transactions to combat domestic and international money laundering, terrorist financing and other international crimes.  Beneficial owners must report their name, date of birth, current residential or business street address, and unique identifier number from a recognized issuing jurisdiction and a photo of that document.  Company applicants can only be the individual who directly files the document that creates the entity, or the document that first registers the entity to do business in the U.S.  A company applicant may also be the individual who is primarily responsible for directing or controlling the filing of the relevant document by someone else. This last point makes it critical for professional advisors to carefully define the scope ot engagement for advisory services with clients.

Note:  If an individual files their information directly with FinCEN, they may be issued a “FinCEN Identifier” directly, which can be provided on a BOI report instead of the required information.

Filing deadlines.  Reporting companies created or registered in 2024 have 90 days from being registered with the state to file initial reports disclosing the persons that own or control the business. NPRM (RIN 1506-AB62) (Sept 28, 2023). If a business was created or registered to do business before 2024, the business has until January 1 of 2025 to file the initial report.  Businesses formed after 2024 must file within 30 days of formation.  Reports must be updated within 30 days of a change to the beneficial ownership of the business, or 30 days from when the beneficial owner becomes aware of or has reason to know of inaccurate information that was previously filed. 

Note:  FinCEN estimates about 32.6 million BOI reports will be filed in 2024, and about 14.5 million such reports will be filed annually in 2025 and beyond. The total five-year average of expected BOI update reports is almost 12.9 million.

Penalties.  The penalty for not filing is steep and can carry the possibility of imprisonment.  Specifically, noncompliance can result in escalating fines ranging from $500 per day up to $10,000 total and prison time of up to two years.    

State issues.  A state is required to notify filers upon initial formation/registration of the requirement to provide beneficial ownership information to the FinCEN.  In addition, states must provide filers with the appropriate reporting company Form.

How to report.  Businesses required to file a report are to do so electronically using FinCEN’s filing system obtaining on its BOI e-filing website which is accessible at https://boiefiling.fincen.gov

Note:  On December 22, 2023, FinCEN published a rule that governing access to and protection of beneficial ownership information. Beneficial ownership information reported to FinCEN is to be stored in a secure, non-public database using rigorous information security methods and controls typically used in the Federal government to protect non-classified yet sensitive information systems at the highest security level. FinCEN states that it will work closely with those authorized to access beneficial ownership information to ensure that they understand their roles and responsibilities in using the reported information only for authorized purposes and handling in a way that protects its security and confidentiality.

Conclusion

I will continue the trek through the “Top Ten” of 2023 in the next post.

January 12, 2024 in Business Planning, Income Tax, Regulatory Law | Permalink | Comments (0)

Friday, January 5, 2024

2023 in Review – Ag Law and Tax Developments (Part 2)

Overview

Today’s article is the second in a series discussing the top developments in agricultural law and taxation during 2023.  As I work my way through the series, I will end up with the top ten developments from last year.  But I am not there yet.  There still some significant developments to discuss that didn’t make the top ten list.

Significant developments in ag law and tax during 2023, but not quite the top ten – it’s the topic of today’s post.

Scope of the Dealer Trust

In re McClain Feed Yard, Inc., et al., Nos., 23-20084; 23-20885; 23-20886 (Bankr. N.D. Tex. 2023)

The Packers and Stockyards Act of 1921 (PSA) (7 U.S.C. §§ 181 et seq.), applies to transactions in livestock or poultry in interstate commerce involving a covered a packer, dealer, market agency, swine contractor, or live poultry dealer.  The PSA creates statutory trusts and requires bonds of market participants which may provide funds to reduce losses incurred by unpaid cash sellers of livestock or poultry.  A similar provision applies for perishable commodities created by the Perishable Agricultural Commodity Act. 7 U.S.C. § 499e(c).

Historically, there have been numerous attempts to amend the PSA to create a “Dealer Trust” that would establish a statutory trust similar to the Packer Trust created by the PSA at 7 U.S.C. § 196. These efforts succeeded with legislation signed into law on December 27, 2020, that adds new Section 318 to the PSA.  Codified at 7 U.S.C. § 217b.

The Dealer Trust’s purpose is to protect unpaid cash sellers of livestock from the bankruptcy of feeders, brokers and small processors.  The new law puts unpaid cash sellers of livestock ahead of prior perfected security interest holders.  It’s a provision like the trust that exists for unpaid cash sellers of grain to a covered grain buyer.  The first case testing the scope of the Dealer Trust Act is winding its way through the courts.

A case involving the new Dealer Trust Act hit the courts in 2023.  Over 100 livestock producers have $122 million in unpaid claims against three defunct cattle operations, and a lender says one of the feedyards sold about 78,000 cattle and didn’t pay on the loans.  The problems stem from a $175 million Ponzi and check-kiting scheme that the debtors were engaged in.

One issue is what the trust contains for the unpaid livestock sellers.  Is it all assets of the debtors?  It could be – for feedyards and cattle operations, practically all the income is from cattle sales.  So far, USDA has approved for payment only $2.69 million of claims for cash sellers of livestock, claiming that the balance is owed to non-cash sellers not covered by the law. 

The law is new, so it’s not clear yet what is a trust asset for the benefit of the cash livestock sellers, and what assets, if any, are in the debtors’ bankruptcy estates.  We should learn the answer to those questions in 2024. 

Equity Theft

Tyler v. Hennepin County, 598 U.S. 631 (2023)

Equity that a homeowner has in their home/farm is the difference between the value of the home or farm and the remaining mortgage balance.  It’s a primary source of wealth for many owners.  Indeed, the largest asset value for a farm or ranch family is in the equity wrapped up in the land.  In the non-farm sector, primary residences account for 26 percent of the average household’s assets.  Certainly, the government has the constitutional power to tax property and seize property to pay delinquent taxes on that property.  But is it constitutional for the government to retain the proceeds of the sale of forfeited property after the tax debt has been paid?  That was a question presented to the U.S. Supreme Court in 2023.

In this case, Hennepin County. Minnesota followed the statutory forfeiture procedure, and the homeowner didn’t redeem her condominium within the allotted timeframe.  The state ultimately sold the property and bagged the proceeds – including the homeowner’s equity in the property.    

She sued, claiming that the county violated the Constitution’s Takings Clause (federal and state) by failing to remit the equity she had in her home.  She also claimed that the county’s actions amounted to an unconstitutional excessive fine, violated her due process and constituted an unjust enrichment under state law.  The trial court dismissed the case and the Eighth Circuit affirmed finding that she lacked any recognizable property interest in the surplus equity in her home.  On further review, the U.S. Supreme Court unanimously reversed.  The Court held that an unconstitutional taking had occurred. 

All states have similar forfeiture procedures, but only about a dozen allow the state to keep any equity that the owner has built up over time.  Now, those states will have to revise their statutory

forfeiture procedures.

Customer Loyalty Rewards

Hyatt Hotels Corporation & Subsidiaries v. Comr., T.C. Memo. 2023-122

Many companies, including agribusiness retailers, utilize customer loyalty programs as a means of attracting and keeping customers.  Under the typical program, each time a customer or “member” buys a product or service, the customer earns “reward points.”  The reward points accumulate and are computed as a percentage of the customer’s purchases.  When accumulated points reach a designated threshold, they can then be used to buy an item from the retailer or can be used as a discount on a subsequent purchase (e.g., cents per gallon of off a fuel purchase).  Some programs make be structured such that a reward card is given to the customer after purchases have reached the threshold amount.  The reward card typically has no cash value and expires within a year of being issued.  A “loyalty rewards” program is a cost to the retailer and a benefit to the customer, triggering tax issues for both. 

In Hyatt, the petitioner established a “Gold Passport” rewards program in 1987 that provided its customers with reward points redeemable for free future stays at its hotels (the petitioner own about 25 percent of its branded hotels with the balance owned by third parties who license the petitioner’s IP and/or management services).   Under the program, the petitioner required hotel owners to make payments into an operating fund (Fund) when a customer earned “points.”  The petitioner was the custodian of the Fund and compensated a hotel owner out of the Fund when a guest redeemed reward points for free stays.  The petitioner determined the rate of compensation. The petitioner invested portions of the Fund's unused balance in marketable securities which generated gains and interest.  In 2011, the petitioner changed the compensation formula to increase the amount it could hold for investment.  The petitioner also used the Fund to pay administrative and advertising expenses that it determined were related to the rewards program. 

The points could not be redeemed for cash and were not transferrable.  In addition, any particular member hotel could not get the payments to the Fund back except by providing free stays to members.  The Fund allocated from 46-61 percent to reward point redemptions.  Fund statements described the funds as belonging to the hotel owners that paid into the Fund.  The petitioner’s Form 10-K filed with the SEC treated the Fund as a “variable interest entity” eligible for consolidated reporting.  When the petitioner provided management services to member hotels, payments into the Fund were reported as “expenses.” 

The petitioner did not report the Fund’s revenue into gross income with respect to the hotels it did not own and did not claim any deductions for expenses paid on the basis that petitioner was a mere trustee, agent or conduit for hotel owners rather than a true owner of the Fund.  But, the petitioner did claim deductions for its share of program expenses associated with the 25 percent of hotels that it owned.  The petitioner reported Fund assets and liabilities on a consolidated basis on Schedule L.  The petitioner’s Form 1120 did not state that it was using the trading stamp method or include any statement concerning Treas. Reg. §1.451-4.  The petitioner’s position was that third-party owners should make their own decision about tax treatment of the money they paid to the Fund.  

The IRS audited and took the position that the petitioner was using an improper accounting method which triggered an I.R.C. §481 adjustment requiring the including in the petitioner’s income the cumulative amounts from 1987 (Fund revenue less expenditures).  The IRS asserted an adjustment of $222.5 million and additional adjustments in 2010 and 2011.  The petitioner disagreed and filed a Tax Court petition. 

The Tax Court determined that the amounts the petitioner received related to the customer reward program (i.e., Fund revenue) were revenue includible in gross income because of the petitioner’s significant control over the Fund.  That control indicated that the petitioner had retained a beneficial interest in the Fund, and the exception under the “trust fund” doctrine established in Seven-Up Co. v. Comr., 14 T.C. 965 (1950), acq., 1950-2 C.B. 4, did not apply. 

Hyatt lays down a good “marker” for tax advisers with clients that offer loyalty reward programs to customers. Retail businesses that offer such programs will want to ensure that their program is structured in a manner that can fit within the trust fund doctrine’s exception for excluding program funds from gross income.

Basis of Assets Contained in an Intentionally Defective Grantor Trust (IDGT)

Rev. Rul. 2023-2, 2023-16 I.R.B. 658

An IDGT is an irrevocable trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. Normally, an irrevocable trust is a tax entity distinct from the grantor and has its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return. But there is language included in an IDGT that causes the income to be taxed to the grantor.  So, a separate return need not be prepared for the trust, but you still get the trust assets excluded from the grantor’s estate at death.  It also allows the grantor to move more asset value to the beneficiaries because the grantor is paying the tax.

Note:  The term “intentionally defective grantor trust” refers to the language in the trust that cause the trust to be defective for income tax purposes (the trust grantor is treated as the owner of the trust for income tax purposes) but still be effective for estate tax purposes (the trust assets are not included in the grantor’s gross estate). 

This structure allows the IDGT’s income and appreciation to accumulate inside the trust free of gift tax and free of generation-skipping transfer tax, and the trust property is not in the decedent’s estate at death.  This will be an even bigger deal is the federal estate tax exemption is reduced in the future from its present level of $13.61 million.  Another benefit of an IDGT is that it allows the value of assets in the trust to be “frozen.” 

A question has been whether the assets in an IDGT receive a stepped-up basis (to fair market value) when the IDGT grantor dies.  Over the years, the IRS has flip-flopped on the issue but in 2023 the IRS issued a Revenue Ruling taking the formal position that the trust assets do not get a stepped-up basis at death under I.R.C. §1014 because the trust assets, upon the grantor’s death, were not acquired or passed from a decedent as defined in I.R.C. §1014(b).  So, the basis of the trust assets in the hands of the beneficiaries will be the same as the basis in the hands of the grantor. 

Not getting a stepped-up basis at death for the assets in an IDGT is an important consideration for those with large estates looking for a mechanism to keep assets in the family over multiple generations at least tax cost.  An irrevocable trust may still be appropriate for various reasons such as asset protection and overall estate tax planning.  But, the IRS ruling does point out that it’s important to understand all of the potential consequences of various estate planning options.

January 5, 2024 in Estate Planning, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Tuesday, January 2, 2024

2023 in Review – Ag Law and Tax

Overview

As 2024 begins, it’s good to look back at the most important developments in agricultural law and tax from 2023.  Looking at things in retrospect provides a reminder of the issues that were in the courts last year as well as the positions that the IRS was taking that could impact your farming/ranching operation.  Over the next couple of weeks, I’ll be working my way through the biggest developments of last year, eventually ending up with what I view as the Top Ten developments in ag law and tax last year.

The start of the review of the most important ag law and tax developments of 2023 – it’s the topic of today’s post.

Labor Disputes in Agriculture

Glacier Northwest, Inc. v. International Brotherhood of Teamsters Local Union No. 174, 143 S. Ct. 1404 (2023)

In 2023, the U.S. Supreme Court ruled that an employer can sidestep federal administrative agency procedures of the National Labor Relations Board and go straight to court when striking workers damage the company’s property rather than merely cause economic harm.  The case involved a concrete company that filed a lawsuit for damages against the labor union representing its drivers.  The workers filled mixer trucks with concrete ready to pour knowing they were going to walk away.  The company sued for damage to their property – something that’s not protected under federal labor law.  The Union claimed that the matter had to go through federal administrative channels first. 

The Court said the case was more like an ordinary tort lawsuit than a federal labor dispute, so the company could go straight to court.  Walking away was inconsistent with accepting a perishable commodity. 

There’s an important ag angle to the Court’s decision.  Where there are labor disputes in agriculture, they are often timed to damage perishable food products such as fruit and vegetables.  Based on the Court’s 8-1 opinion, merely timing a work stoppage during harvest might not be enough to be deemed economic damage, unless the Union has a contract.  But striking after a sorting line has begun would seem to be enough.

Swampbuster

Foster v. United States Department of Agriculture, 68 F. 4th 372 (8th Cir. 2023)

Another 2023 development involved the application of the Swampbuster rules on a South Dakota farm.  In 1936, the farmer’s father planted a tree belt to prevent erosion. The tree belt grew over the years and collects deep snow drifts in the winter. As the weather warms, the melting snow collects in a low spot in the middle of a field before soaking into the ground or evaporating.  In 2011, the USDA called the puddle a wetland subject to the Swampbuster rules that couldn’t be farmed, and it refused to reconsider its determination even though it had a legal obligation to do so when the farmer presented new evidence countering the USDA’s position.

The farmer challenged the determination in court as well as the USDA’s unwillingness to reconsider but lost.  This seems incorrect and what’s involved is statutory language on appeal rights under the Swampbuster program. The Constitution limits what the government can regulate, including water that doesn’t drain anywhere.  In addition, the U.S. Supreme Court has said the government cannot force people to waive a constitutional right as a condition of getting federal benefits such as federal farm program payments. 

We’ll have to wait and see whether the Supreme Court will hear the case.

Railbanking

Behrens v. United States, 59 F. 4th 1339 (Fed. Cir. 2023)

Abandoned rail lines that are converted to recreational trails have been controversial.  There are issues with trespassers accessing adjacent farmland and fence maintenance and trash cleanup.  But perhaps a bigger issue involves property rights when a line is abandoned. A federal court opinion in 2023 provided some guidance on that issue. 

In 2023, a federal court clarified that a Fifth Amendment taking occurs in Rail-to-Trail cases when the trail is considered outside the scope of the original railway easement. That determination requires an interpretation of the deed to the railroad and state law.  Under the Missouri statute involved in the case the court said the railroad grant only allowed the railroad to construct, maintain and accommodate the line.  Once the easement was no longer used for railroad purposes, the easement ceased to exist.  Trail use was not a railroad purpose. The removal of rail ties and tracks showed there would be no realistic railroad use of the easement and trail use was unrelated to the operation of a railway.

The government’s claim that the trail would be used to save the easement and that the railway might function in the future was rejected, and the court ruled that the grant was not designed to last longer than current or planned railroad operation.  As a result, a taking had occurred. 

CAFO Rules

Dakota Rural Action, et al. v. United States Department of Agriculture, No. 18-2852 (CKK), 2023 U.S. Dist. LEXIS 58678 (D. D.C. Apr. 4, 2023)

In 2023, USDA’s 2016 rule exempting medium-sized CAFOs from environmental review for FSA loans was invalidated.  A medium-sized CAFO can house up to 700 dairy cows, 2,500 55-pound hogs or up to 125,000 chickens.  The rule was challenged as being implemented improperly without considering the impact on the environment in general.  The USDA claimed that it didn’t need to make any analysis because its proposed action would not individually or cumulatively have a significant effect on the human environment.  So, the agency categorically exempted medium-sized CAFOs from environmental review.  

But the court disagreed with the USDA and vacated the rule.  The FSA conceded that it made no finding as to environmental impact.  The court determined that to be fatal, along with providing no public notice that it was going to categorically exempt all loan actions to medium-sized CAFOs. 

Don’t expect this issue to be over.  In 2024, it’s likely that the agency will try again to exempt medium-sized CAFOs from environmental review for FSA loan purposes.

Charitable Remainder Annuity Trust Abuse

Gerhardt v. Comr., 160 T.C. No. 9 (2023)

In 2023, the U.S. Tax Court decided another case involving fraud with respect to a charitable remainder annuity trust.  It can be a useful tax planning tool, particularly for the last harvest of a farmer that is retiring.  But a group centered in Missouri caught the attention of the criminal side of IRS. 

The fact of the case showed that farmers contributed farmland, harvested crops, a hog-finishing barn and hog equipment to Charitable Remainder Annuity Trusts.  The basic idea of a CRAT is that once property is transferred to the trust the donor claims a charitable deduction for the amount contributed with the income from the CRAT’s annuity spread over several years at anticipated lower tax brackets.  But contributing raised grain to a CRAT means you can’t claim a charitable deduction because you don’t have any income tax basis in the grain.  In addition, there are ordering rules that govern the annuity stream coming back to the donor.  Ordinary income is taxed first – which resulted from the contribution of the crops and depreciation recapture on the hog-finishing barn and equipment.  

The farmers involved got into the CRATs by reading an ad in a farm magazine.  The Department of Justice prosecuted the promoters that dished out the bad advice. 

Get good tax advice if you consider using a CRAT.  They can be a good tax planning tool but can create a mess if the rules aren’t followed.

Conclusion

This is the first pass at some of the biggest developments in ag law and tax during 2023.  In my next post, I’ll continue the journey.

January 2, 2024 in Environmental Law, Estate Planning, Income Tax, Real Property, Regulatory Law | Permalink | Comments (0)

Thursday, December 28, 2023

Tax Issues with Customer Loyalty/Reward Programs

Overview

Many companies, including agribusiness retailers, utilize customer loyalty programs as a means of attracting and keeping customers.  Under the typical program, each time a customer or “member” buys a product or service, the customer earns “reward points.”  The reward points accumulate and are computed as a percentage of the customer’s purchases.  When accumulated points reach a designated threshold, they can then be used to buy an item from the retailer or can be used as a discount on a subsequent purchase (e.g., cents per gallon of off a fuel purchase).  Some programs make be structured such that a reward card is given to the customer after purchases have reached the threshold amount.  The reward card typically has no cash value and expires within a year of being issued. 

A “loyalty rewards” program is a cost to the retailer and a benefit to the customer, triggering tax issues for both. 

Tax issues associated with customer “loyalty” programs – it’s the topic of today’s post.

Treasury Regulations – Impact on Retailers

When is economic performance?  Treasury Regulation §1.461-4(g)(3) addresses the treatment of rebates and refunds and specifies that economic performance occurs when payment is made to the person to whom the liability is owed.  The IRS position is that a retailer cannot claim a deduction until the points are actually redeemed because the event fixing the retailer’s liability occurs when a member reaches the minimum number of points for redemption and actually redeems the points. Internal Revenue Manual 4.43.1.12.6.5(5); Priv. Ltr. Rul. 200849015 (Dec. 5, 2008).   But, for an accrual basis taxpayer, the taxpayer’s liability becomes fixed (and, hence, a deduction can be claimed) when the customers earn the rewards.  Giant Eagle, Inc. v. Comr., 822 F.3d 666 (3d Cir. 2016), rev’g., T.C. Memo. 2014-146. A deduction is not deferred until the customer redeems the rewards. 

Note:   The IRS does not agree on this point and only follows the Third Circuit’s decision in cases appealable to the Third Circuit that cannot be distinguished.  A.O.D. 2016-03 (Oct. 3, 2016).

Two requirements.  Treasury Regulation §1.451-4 addresses trading stamps and premium coupons that are issued with sales and are redeemable in cash, merchandise or “other property.”  Most retailer customer loyalty programs likely satisfy both tests. The National Office of IRS, in a matter involving an accrual basis supermarket chain that had a rewards program that allowed customers to get a certain amount of gas for free depending on purchases of products, said that the supermarket could take a current deduction for the value of the gas rewards. F.S.A. 20180101F (Nov. 7, 2017).   The IRS reached that result by concluding that the gas rewards were being redeemed for “other property.” Treas. Reg. §1,451-4(a)(1).  Clearly, the rewards were issued on the basis of purchases.

Loyalty reward programs that might not satisfy the “redeemable in cash, merchandise or other property test” might be programs that provide customers with cents-off coupons.  With these programs, the IRS could argue that a customer’s right to redeem the coupon is conditioned on a future purchase and, as a result, the coupon liability should be matched to the later sale when the liability becomes fixed and determinable and economic performance occurs.  I.R.C. §461.

Timing of deduction.  The regulation provides that the estimated redemption costs of premium coupons issued in connection with the sale of merchandise is deductible in the year of the merchandise sale, even though the reserves for future estimated redemption costs are not fixed and determinable and don’t otherwise meet the economic performance rules of the all-events test.  Internal Revenue Manual 4.43.1.12.6.5(4).

Retailers with loyalty programs that satisfy the two tests of Treas. Reg. §1.451-4 may find the use of this method preferential from a tax standpoint.  For retailers that can qualify but are not presently using the Treas. Reg. §1.451-4 approach, a method change is required. The method change is achieved by using the advance consent procedures of Rev. Proc. 97-27. 1997-1 C.B. 680. If a loyalty program does not meet the requirements to use Treas. Reg. §451-4, the redemption liability is treated as a deduction and not as an exclusion from income.  Thus, the redemption liability is taken into account in the tax year in which the liability becomes fixed and determinable and economic performance occurs under I.R.C. §461.  That will, in general, be the year in which the customer redeems the loyalty rewards. 

Tax Issues for Customers

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

In 2021, the Tax Court issued an opinion providing guidance on how a taxpayer, as a user of a rewards program is to report the transactions on the taxpayer’s return, and whether the IRS “rebate rule” is applicable.  In Anikeev, the petitioners, husband and wife, spent over $6 million on their credit card between 2013 and 2014. Nearly all of these purchases were for Visa gift cards, money orders or prepaid debit card reloads that the couple later used to pay the credit card bill.  The credit card earned them five percent cash back on certain purchases after they spent $6,500 in a single calendar year. Before purchases were sufficient for them to reach the five percent level, the card earned one percent cash back on certain purchases.

Rewards were issued in the form of “rewards dollars” that could be redeemed for gift cards and statement credits.  In 2013, the petitioners redeemed $36,200 in rewards dollars from the card as statement credits in 2013 and $277,275 in 2014.  The petitioners did not report these amounts as income for either year.  The IRS audited and took the position that the earnings should have been reported as “other income” as an exception to the IRS “rebate rule.”  Under the rule, when a seller makes a payment to a customer, it’s generally seen as a “price adjustment to the basis of the property.”  It’s a purchase incentive that is not treated as income.  Instead, the incentive is treated as a reduction of the purchase price of what is purchased with the rewards or points. Thus, points and cashback earned on spending are viewed as a non-taxable purchase price adjustment.  The petitioners cited this rule, pointing out that the “manner of purchase of something…does not constitute an accession of wealth.  The IRS, however, claimed that the rewards were taxable upon receipt irrespective of how the gift cards were later used. 

The Tax Court noted that the gift cards were a “product.”  Thus, the portion of their reward dollars associated with gift card purchases weren't taxable.  However, the Tax Court held that the petitioners’ direct purchases of money orders and reloads of cash into the debit cards using their credit card was different in that the petitioners were buying “cash equivalents” rather than a rebate on a purchase.  Thus, the transaction did not involve the purchase of a product subject to a price adjustment.  The purchase of a cash equivalent was different than obtaining a product or service.  Because there was no product or service obtained in connection with direct money order purchases and cash reloads, the reward dollars associated with those purchases were for taxable cash infusions. 

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

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

Tax Issues for Retailers

Hyatt Hotels Corporation & Subsidiaries v. Comr., T.C. Memo. 2023-122

Facts of the case.  In Hyatt, the petitioner established a “Gold Passport” rewards program in 1987 that provided its customers with reward points redeemable for free future stays at its hotels (the petitioner own about 25 percent of its branded hotels with the balance owned by third parties who license the petitioner’s IP and/or management services).   Under the program, the petitioner required hotel owners to make payments into an operating fund (Fund) when a customer earned “points.”  The petitioner was the custodian of the Fund and compensated a hotel owner out of the Fund when a guest redeemed reward points for free stays.  The petitioner determined the rate of compensation. The petitioner invested portions of the Fund's unused balance in marketable securities which generated gains and interest.  In 2011, the petitioner changed the compensation formula to increase the amount it could hold for investment.  The petitioner also used the Fund to pay administrative and advertising expenses that it determined were related to the rewards program. 

The points could not be redeemed for cash and were not transferrable.  In addition, any particular member hotel could not get the payments to the Fund back except by providing free stays to members.  The Fund allocated from 46-61 percent to reward point redemptions.  Fund statements described the funds as belonging to the hotel owners that paid into the Fund.  The petitioner’s Form 10-K filed with the SEC treated the Fund as a “variable interest entity” eligible for consolidated reporting.  When the petitioner provided management services to member hotels, payments into the Fund were reported as “expenses.” 

The petitioner did not report the Fund’s revenue into gross income with respect to the hotels it did not own and did not claim any deductions for expenses paid on the basis that petitioner was a mere trustee, agent or conduit for hotel owners rather than a true owner of the Fund.  But, the petitioner did claim deductions for its share of program expenses associated with the 25 percent of hotels that it owned.  The petitioner reported Fund assets and liabilities on a consolidated basis on Schedule L.  The petitioner’s Form 1120 did not state that it was using the trading stamp method or include any statement concerning Treas. Reg. §1.451-4.  The petitioner’s position was that third-party owners should make their own decision about tax treatment of the money they paid to the Fund.   

Note:  Most third-party owners simply deducted payments to the Fund when paid regardless of whether economic performance would have occurred for expenses accrued for redemption, advertising and operating costs. 

The IRS audited and took the position that the petitioner was using an improper accounting method which triggered an I.R.C. §481 adjustment requiring the including in the petitioner’s income the cumulative amounts from 1987 (Fund revenue less expenditures).  The IRS asserted an adjustment of $222.5 million and additional adjustments in 2010 and 2011.  The petitioner disagreed and filed a Tax Court petition. 

Fund revenue includible in income.  The Tax Court determined that the amounts the petitioner received related to the customer reward program (i.e., Fund revenue) were revenue includible in gross income because of the petitioner’s significant control over the Fund.  That control indicated that the petitioner had retained a beneficial interest in the Fund, and the exception under the “trust fund” doctrine established in Seven-Up Co. v. Comr., 14 T.C. 965 (1950), acq., 1950-2 C.B. 4,  did not apply. 

Note:  The “trust fund” doctrine allows for the exclusion from gross income of funds received in trust, subject to a legally enforceable restriction that the funds be spent entirely for a specific purpose, where the taxpayer does not profit, gain or benefit from spending the funds for that purpose.  In Hyatt, the Tax Court determined that the trust fund doctrine did not apply because the petitioner: 1) mandated participation and payments into the Fund; 2) controlled the amounts of program payments to the Fund and the payments from the Fund; 3) made the decisions as to how Fund amounts were to be invested; 4) accrued interest and realized gains on investments in the Fund; and 5) decided whether Fund amounts would cover advertising and/or administrative costs.  In other words, the petitioner received more than “incidental and secondary” benefits from the Fund.

In addition, the Tax Court pointed out that the petitioner benefited directly from the Fund based, in part, on the Fund generating goodwill among customers that lead to increased bookings and royalties and fees.  Indeed, the petitioner owned approximately 25 percent of the hotels that paid into the fund which indicated a clear benefit to the petitioner’s own interests. 

No I.R.C. §481 adjustment.  However, in a major win for the petitioner, the Tax Court also determined that the petitioner’s treatment of Fund revenue and expenses did not amount to the adoption of a method of accounting.  Thus, no I.R.C. §481 adjustment was required.  The petitioner’s consistent and total exclusion of Fund revenue and expense did not involve timing and, therefore, was not a method of accounting. The petitioner had simply excluded the Fund amounts from gross income and would have continued to do so if the Fund had ended and the amounts in the Fund distributed to member hotels.   

Note:  The normal statute of limitation of I.R.C. §6501 does not apply when an accounting method change has occurred.  Had the petitioner adopted an impermissible accounting method, the IRS would not have been time-barred to make adjustments. 

Trading stamp method inapplicable.  As for the application of the “trading stamp method” of reporting income and expense, the petitioner claimed that Fund gross receipts should be offset by both the current year reward redemptions and the estimated cost of future tax year reward redemptions (i.e., an acceleration of deduction beyond actual program costs). The Tax Court disagreed on the basis that a hotel stay, which is either characterized as a license or a leasehold, would not qualify as merchandise, cash or other property as the trading stamp method required. The Tax Court also clarified that “other property” for purposes of Treas. Reg. §1.451-4 means property similar to merchandise or cash.  “Other property” is not a hotel stay.  It is, rather, tangible property.

Conclusion

The Anikeev and Hyatt cases lay down good “markers” for tax advisers with clients that offer loyalty reward programs to customers. Retail businesses that offer such programs will want to ensure that their program is structured in a manner that can fit within the trust fund doctrine’s exception for excluding program funds from gross income.  Hyatt is basically a win for the taxpayer, because most of the adjustments that IRS proposed were time-barred once the Tax Court determined that a method of accounting had not been adopted. 

For retailers with customer reward programs, conforming closely to the “trust fund doctrine” is essential to achieving the desired tax treatment. 

December 28, 2023 in Income Tax | Permalink | Comments (0)

Tuesday, December 26, 2023

More Issues in Ag Law and Tax for Farmers, Ranchers and Rural Landowners

Overview

The issues in the courts and with the IRS that are important to farmers and ranchers keep on coming.  Soon, I will be posting what I view to be the biggest developments of 2023.  For today’s post, I summarize some key matters and pose some year-end tax planning thoughts for which there still might be time to utilize for the 2023 return.

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

Important “Takings” Case at Supreme Court

DeVillier v. Texas, 63 F.4th 416 (5th Cir. 2023)

The government has the right to take your property from you if it wants it for a public use.  But, under the Fifth Amendment, the government must pay you for it.  The right to receive just compensation for property the government takes is in the Fifth Amendment.  It’s an important issue for farmers and ranchers because of how critical land ownership is to farming and ranching.  A case soon to be argued at the U.S Supreme Court involving a Texas farmer tests the limits of the government’s taking power. 

The family involved in the case has farmed the same land for a century.  There never was a problem with flooding until the State renovated a highway and changed the surface water drainage.  In essence, the renovation turned the highway into a dam and when tropical storms occurred, the water no longer drained into the Gulf of Mexico.  Instead, the farm was left flooded for days, destroying crops and killing cattle.  In essence, the farm had been turned into a retention pond. 

The farmer sued the State to get paid for the taking of his farm.  Once the case got to federal court, the appellate court dismissed it, saying that the farmer couldn’t sue under the Fifth Amendment – only State officials can.  But that seems incorrect.  The Fifth Amendment contains a remedy when the government takes your property – you get paid for it. 

The U.S. Supreme Court agreed to hear the case on Sept. 29, 2023.  The oral argument date is set for January 16, 2024.  The Court’s decision will likely be issued by the end of June.  The outcome will be an important one for agriculture. 

Tax Treatment of Income from Farm-Related Assets

Breeding fees.  If you report income from breeding fees and then later issue a refund, still report the breeding fees as income in the year received, but then take a deduction when the refund is made.

Soil, sod and other minerals.  Report the sale of soil, sod and other minerals on a regular basis as ordinary income.  For mineral deposits, the disposition could be held to be a sale reported as capital gain.  But that probably is not going to be the case in most situations because a lease was likely involved.   

Crop share or livestock share rent is included in income in the year it is reduced to money (or its equivalent), fed to livestock or donated to charity. For livestock, the amount of cash received during the tax year from the sale of livestock is included in gross income. 

Farmland and breeding stock.  Gains and losses arising from the sale of certain capital assets such as farmland and breeding livestock get a special, capital gain, tax treatment that is often at a lower rate than the seller’s individual rate.

Land trades.  If you trade land, if the trade is even in dollars there still could be ordinary gain to report unless you trade bare land for bare land.  This often comes as a surprise to farmers trading land.

Tax Strategy for Purchased Livestock

A key question for many farmers is whether livestock purchased for draft, dairy or breeding purposes should be depreciated or included in inventory.  While purchased livestock that are held primarily for sale must be included in inventory, livestock that are purchased or raised for draft, breeding or dairy purposes may be depreciated.  What’s the best tax strategy – should you include them in inventory or depreciate them?  As with many tax questions, the answer “depends.”

Depreciation is beneficial for several reasons – it’s an ordinary deduction that reduces your net and self-employment income; any depreciation recapture is not subject to self-employment tax for sole proprietors and partners in a partnership; and the amount of gain in excess of original cost can qualify to be taxed at favorable capital gains rates.

So, is this a better tax result than capitalizing livestock and holding them in inventory?  The answer turns on whether a current deduction for depreciation will outweigh subsequent capital gain treatment upon sale.  For high volume sales generating significant income, an inventory method might be better.

If you use accrual accounting, generally the livestock should be inventoried at the lowest possible value.  But carefully select the inventory method that is utilized. 

Is a “Legal” Fence a “Sufficient” Fence?

If your fence meets the state law requirements for a “legal” fence, is that enough to shield you from liability if your animals get out and cause damage?  Not necessarily.  A legal fence must also be a "sufficient" fence.  Having a legal fence does not mean that you won’t be liable for damage your animals cause if they escape. Not having a legal fence is negligence. So, having a legal fence is the minimum standard, but it is not necessarily a sufficient fence for livestock.  There are numerous cases that have involved a legal fence where the court held it was not deemed to be a sufficient fence.

This issue often comes up with animals other than cattle. But it can come up with cattle also. The situation is based on the facts, but the point is if your fence meets the requirements to be a legal fence, that's just the first step of the analysis. It still must be a sufficient fence to keep your animals in if you live in a "fence-in" jurisdiction – which is most of the country.

Don't cause issues with your neighbor by insisting that your fence meets the minimum statutory requirements. That's literally the least you can do.  You must do more under the law.

Entire Commercial Wind Development Ordered Removed

United States v. Osage Wind, LLC, No. 4:14-cv-00704-CG-JFJ,

2023 U.S. Dist. LEXIS 226386 (N.D. Okla. Dec. 20, 2023)

A federal court has now ordered the removal of an entire commercial wind energy development in Oklahoma and set a trial for damages.  The litigation has been ongoing for over 10 years.  The ruling follows a 2017 lower court decision concluding that construction of the development constituted “mining” and required a mining lease from a tribal mineral council which the developers failed to acquire. 

The wind energy development includes 84 towers spread across 8,400 acres of leased surface rights, underground lines, overhead transmission lines, meteorological towers and access roads. In 2017, the U.S. Circuit Court of Appeals for the Tenth Circuit held that the wind energy company’s extraction, sorting, crushing and use of minerals as part of its excavation work constituted mineral development that required a federally approved lease.  The company never received one.

In its decision to order removal of the towers, the court weighed several factors but ultimately concluded that the public interest in private entities abiding by the law and respecting government sovereignty and the decision of courts was paramount.

Optimizing Tax Liability

Many farmers often want to eliminate income taxes every year.  But maybe a better strategy over the long run is to optimize the amount paid each year.  That can be done in several ways, and there still might be time to use some of the techniques on your 2023 return. 

As a farmer you can file and pay income taxes by March 1 or simply pay one estimated tax payment on January 15 and then pay the balance on April 15.  To do this, the amount you need to pay by January 15 is the lesser of 100 percent of the prior year’s tax or two-thirds of this year’s tax.  With higher interest rates, the saving on deferring tax for six weeks can add up.  Do the math to figure out what the best approach is for you.

Also, you can decide to not defer grain contract income by reporting the income in 2023.  Similarly, only the portion of crop insurance payments received in 2023 that relate to yield loss is deferable.  The price loss portion is not deferable into 2024. 

For 2024, if you have children under the age of 18 that work on your farm, paying them wages won’t trigger payroll tax.  If they are older, pay them in grain to get the same result.  Also, consider gifts of grain to children to drop your tax liability and not create one for a child.

Conclusion

Just some “odds and ends” to think about this last week of December. 

December 26, 2023 in Income Tax, Real Property | Permalink | Comments (0)

Monday, December 25, 2023

Conservation Easement Valuation Upheld – Reasonable Cause Defense at Issue

Overview

The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor.  The donor can receive an income tax deduction equal to the FMV of the contributed conservation easement at the time of the donation (I.R.C. §170(h); Treas. Reg. §1.170A-14); an estate tax benefit at death by excluding the fair market value of the donated easement from the donor’s (landowner’s) gross estate (I.R.C. §2031(c)(1)-(2)); and a possible reduction in property taxes (dependent on state law).  In addition, during life, the donor retains the right to sell or transfer the property subject to the easement restrictions.

Note:  The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base).  I.R.C. §170(b)(1)(E)(iv)(I). For others, the limit is 50 percent of annual income. I.R.C. §170(b)(1)(B). 

IRS Concerns

The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property).  That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.).  This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent.  This is termed a deemed consent provision, and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction.  See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).

The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated.  For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires.  In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds.  That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii).  A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated. 

The case law also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement.  In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant.  However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied.  See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).

Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed.  If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C).  But there is an exception.  Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization.  Treas. Reg. §1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72. 

Another requirement is that the taxpayer must disclose (on Form 8283) the income tax basis in the property being subjected to a conservation easement that is donated to a qualified charity.  This is part of the substantiation requirements for non-cash charitable donations.

Recent Case

In Murfam Enterprises, LLC v. Comr., T.C. Memo. 2023-73, the petitioner was a partnership owned by the Murphy family who began a hog empire in North Carolina and is largely credited with reshaping the hog production industry into the large-scale, confinement facility, contract production structure that it is today.  In 1999, the partnership acquired a 6,171-acre tract of undeveloped rural land in North Carolina, largely covered in trees. The partnership obtained a certificate permitting it to engage in raising hogs on 1,115 acres of the property.  The certificates were a restriction that “ran with the land” subjecting any future owner to the same restriction.  The certificates authorized the raising of up to 58,752 swine in a feeder-to-finish facility, or 19,538 sows in a “farrow-to-wean” facility.  In 2007, the state of North Carolina imposed a moratorium on any new certificates, but existing certificates would remain honored.  In 2010, the family decided not to clear the land and build more hog facilities, preferring instead to use the land for recreational purposes.  The partnership then donated a permanent conservation easement on the 1,115 acres where hog production was allowed, thereby making the certificates useless.  An expert valued the easement at $5.745 million (based on the before-and-after approach).

The IRS audited the partnership return and proposed to reduce the charitable contribution to $446,000.  The IRS did not assert any penalty and did not claim that the charitable deduction should be denied based on the partnership’s failure to fully complete Form 8283.

The partnership challenged the IRS position in Tax Court.  In its answer, the IRS (for the first time) asserted a gross valuation misstatement penalty under I.R.C. §6662(e) or (h).  The IRS also, alternatively, argued for an accuracy-related penalty under I.R.C. §6662(a). 

Note:  On the penalty issue, the IRS bore the burden of proof, which also meant that the IRS had to establish that the partnership lacked reasonable cause for any errors on the return regarding the charitable deduction.    

Later, in a pretrial memo, the IRS claimed that the charitable deduction should be denied in full because of the partnership’s failure to substantiate the donation by not providing the income tax basis of the property on Form 8283. 

Tax Court agreed with the IRS that the partnership’s failure to report the basis for the land on Form 8283 did not comply with the applicable regulations, but that a deduction could still be allowed if the failure to comply with the regulation was due to reasonable cause and not a result of willful neglect.  I.R.C. §170(f)(11)(A)(ii)(II).  The Tax Court noted that the partnership relied on professional tax preparers to prepare the return and that the partnership had provided accurate and necessary information to the CPA firm to prepare the return appropriately (as testified to by the CPA firm).   

Note:  The record did not reveal whether the partnership actually provided the basis information to the CPA firm, there was also no evidence showing why it was not provided.  The IRS failure to cross examine witnesses and not claim that the partnership withheld evidence from the preparers until its reply brief was fatal to its position.

On the valuation, the Tax Court determined the value of the easement was $5.637 million rather than the $5.745 million reported on the return (and substantially more than IRS claimed).  The Tax Court also determined that the highest and best use of the property was as a farrow-to-wean operation, and that the expert report of the IRS was flawed in several respects.  

Ultimately, the partnership avoided the imposition of any penalties.  Importantly, the IRS did not assert a gross valuation misstatement penalty for which reasonable cause would not have been a defense.  See, e.g., Murphy v. Comr., T.C. Memo. 2023-72 (in a case involving the same family, a charitable deduction not disallowed due to omission on return because of reasonable reliance, but gross valuation penalty imposed because the petitioner seriously overstated the value of the donated easements). 

Conclusion

Murfam Enterprises, LLC v. Comr., T.C. Memo. 2023-73, was a big win for the partnership on the novel issue which party bears the burden of proof on the reasonable cause defense when the IRS raises the issue of noncompliance with the substantiation rules of I.R.C. §170(f)(11) as a new matter in litigation and reasonable cause for the noncompliance is at issue. 

Fortunately, the partnership hired competent professionals to prepare the return.  It was not the partnership’s fault that the CPA firm failed to follow the rules associated with preparing the return on which a large charitable deduction was claimed.  Clearly, the shift of the burden of proof to the IRS aided the partnership (along with the procedural failures of the IRS leading up to and at trial in the case). 

December 25, 2023 in Income Tax | Permalink | Comments (0)

Monday, December 11, 2023

Probate Fees - How Much are They?

Overview

One of the reasons that people give for transferring property to a revocable trust during life is to avoid probate at death.  That can be accomplished if all of the decedent’s property has been transferred to the trust before death.  To make sure that occurs, the trust is often accompanied with a pour-over will.  The property that hasn’t been retitled into the name of the trustee of the trust is “poured over” into the trust at death. 

But just how much are probate fees?  How are they determined?  That’s the topic of today’s post.

Establishing Probate Fees

The avoidance of probate is often tied to the desire to avoid probate fees and maintain privacy.  As for fees, how much can be anticipated?  The answer depends.  The more complex the estate, and/or the more issues that come up post-death, the estate can anticipate incurring more probate fees.  The converse is also true.  In some states, a flat percentage of the gross estate value can be charged as an attorney fee for the estate.  That can range anywhere from about 1.5 percent to 6 percent or even higher. 

Kansas probate fees.  In Kansas, state law specifies that, “every fiduciary shall be allowed his or her necessary expenses incurred in the execution of his or her trust and shall have such compensation for services and those of his or her attorneys as shall be just and reasonable.” Kan. Stat. Ann. §59-1717.  There is no statute in Kansas that allows for a percentage fee for handling a decedent’s estate.  It’s not specifically disallowed if the percentage amount is backed up with itemized time sheets and is ultimately deemed reasonable by the probate court.  In essence, then, probate fees are based on an hourly rate for the amount of hours reasonably spent working on the estate.  In addition, an attorney’s fee for handling a decedent’s estate is also based on the eight factors of the Kansas Rules of Professional Conduct (KRPC).  The probate court considers these eight factors when determining whether a fee is appropriate. 

The eight factors are:

  • The time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;
  • The likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;
  • The fee customarily charged in the locality for similar legal services;
  • The amount involved and the results obtained;
  • The time limitations imposed by the client or by the circumstances;
  • The nature and length of the professional relationship with the client;
  • The experience, reputation, and ability of the lawyer or lawyers performing the services; and
  • Whether the fee is fixed or contingent. KRPC 1.5(a)

Kansas case.  A recent Kansas county district court decision involved the application of the factors.  In In re Estate of Appleby, No. CQ-2023-CV-000008 (Chautauqua Co. Dist. Ct., Nov. 9, 2023), from 2014 until death in 2021, the decedent had been the subject of a conservatorship.  The person that would become the executor of the decedent’s estate was the conservator.   The attorney that represented the executor for the decedent’s eventual estate, represented the conservator during the conservatorship.  The annual billing statements submitted to the conservator for the legal work in the conservatorship were itemized and detailed. The itemized billing statements listed each date services were performed; a description of the services performed on each date; the amount of time worked on each date; the amount charged for the services performed on each date; the total amount of time worked during the billing period; and the total amount charged for work performed during the billing period.  The conservator reviewed the statements, the court approved them and the conservator paid. 

However, for estate administration work, the attorney did not provide the executor with a written representation agreement and did not communicate the basis or rate of the fee he intended to charge the estate.  The executor believed the attorney would bill his time hourly, just as he had done for the previous seven years in the conservatorship matter.

The decedent died on July 6, 2021, with a gross estate value of $4,570,521.11.  However, the attorney only first informed the executor on May 2, 2022, that a fee of three percent of the estate’s gross value would be charged.  The executor informed the attorney that the fee should be based on an hourly rate.  The attorney replied as follows:

“I feel comfortable asking for a fee based upon 3%. If you want to oppose it, that's fine. Please remember that our… service to her predates your appointment as her conservator.  [We]…did quite a bit of "off the books" work for [the decedent] during her lifetime, … and… it would all even out when we handled the estate. Honestly, that's a common approach taken by attorneys ·when they know they'll be handling an estate at a later date. So, I don't know what I can say. I respect your views and your being upfront with me, but I know what the common practice has been and what we've always done.”

Ultimately, on May 30, 2023, the attorney generated a billing statement. The billing statement included descriptions of the work performed between the date of the decedent’s death and May 2023, but the descriptions were not tied to specific dates and did not include the amount of time spent performing any task on any date.  The May 30 billing statement concludes with the application of a 3% fee to the $4,570,521.11 value of the estate assets for a total fee of $137,115.63.  The local magistrate judge awarded the fee on June 5, 2023, and the executor appealed.

On appeal, the attorney estimated that he spent between 420 and 560 hours on the estate at a rate of $240 per hour.  Only specific tasks, based on the review of the emails, amounted to 174-242 hours.  The court then applied the eight factors of Rule 1.5(a) of the KRPC to the facts of the case.  The court noted that the attorney didn’t keep time records, even though being on notice that the executor wanted to know the amount of time that was being billed.  No time records kept.  There was also no engagement letter that had been entered into with the client.  The work on the estate, the court noted, did not involve difficult issues and a paralegal performed much of the work.  The fact that the attorney had billed on a percentage basis for 40 years was severely mitigated by subsequent caselaw specifying that, “"fees which are not supported by meticulous, contemporaneous time records that show the specific tasks being billed should not be allowed."  See, e.g., In re Estate of Trembley, 220 P.3d 1114 (Kan. Ct. App. 2009).  The court also noted that the attorney had a previous 7-year relationship with executor as conservator and billed hourly for the work on the conservatorship. 

Ultimately, the court approved what it deemed to be a reasonable fee of fee of $58,080 (down from the $137,115.63 requested).  In percentage terms, the approved fee worked out to be slightly less than 1.3 percent of the estate value.  

In reaching its decision, the court noted that approving attorney fees for work on an estate is a fact-based determination.  The fees must be supported by contemporaneous time records.  If they aren’t, an “award of…fees based on a percentage of an estate is not reasonable, regardless of the local custom.” 

Note:  The court also pointed out that the attorney involved “serves on the Kansas Board of Discipline for Attorneys.”

Conclusion

The fear of large and outrageous attorney fees for handling estates in Kansas is largely not justified.  The courts operate as an effective “brake” on attorneys trying to charge unjustified fees – at least that’s been the case in Kansas since 2009.  But, that may not be true in other states.  So, for those wanting to avoid probate fees, a revocable trust (or some other type of trust) might be an appropriate estate planning tool.  But, it’s important to understand just how attorney fees in probate are established.  One wonders how many estates in Kansas have been unjustly overbilled since 2009 by the attorney involved in the case.  All it took was one well-informed executor to get the right result.

December 11, 2023 in Estate Planning | Permalink | Comments (0)

Saturday, December 9, 2023

The Importance of Proper Asset Titling

Overview

For many farmers and ranchers, the land is the most significant asset that is owned, at least in terms of value.  Land value often predominates in a farmer or rancher’s estate.  How the land is titled is important.  Holding title in the proper form facilitates estate planning in accordance with expressed goals and can ease the tax burden upon death or upon subsequent transfer of the property by the heir or heirs.  Conversely, failing to title property appropriately can undermine estate planning expectations, create family disharmony and result in a higher tax burden.

The distinction between co-tenancy and joint tenancy and why it matters – it’s the topic of today’s post.

Tenancy-In-Common

A tenant in common holds an undivided interest in property that does not terminate upon the tenant predeceasing surviving co-tenants.  Upon the death of a tenant in common, that person’s interest passes under that person’s will (or in accordance with state law if there is no will (or trust)) to heirs of the deceased cotenant.  For federal estate and state inheritance/estate tax purposes, only the portion of the property owned by the deceased tenant in common is included in the decedent’s gross estate at death and receives a fair-market basis at death.

Joint Tenancy

The distinguishing characteristic of joint tenancy is the right of survivorship, with the surviving joint tenant or tenants taking all upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.  In other words, when a joint tenant dies, the deceased joint tenant’s share in the property passes to the surviving joint tenant (or surviving joint tenants).  It does not pass to the heir of the deceased joint tenant (tenants).  Upon the death of the last of the joint tenants to die, the joint tenancy is extinguished.    

In addition, upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.  A joint tenancy is created by specific language in the conveyancing instrument.  That specific language, often referred to as “magic words of conveyance,” clearly denotes the survivorship feature of a joint tenancy.  In addition, unless the conveyancing instrument is clear in its intent to create a joint tenancy, the legal presumption is against joint tenancy and that a tenancy-in-common was created.  For example, assume that O conveys Blackacre to “A and B, husband and wife.”  The result of that language is that A and B own Blackacre as tenants in common.  To own Blackacre as joint tenants O needed to convey Blackacre as required by state law to create a joint tenancy.  The language for creating a joint tenancy is typically to “A and B as joint tenants with rights of survivorship” or to “A and B as joint tenants with right of survivorship and not as tenants in common.”

Except for husband-wife joint tenancies, the survivorship feature may generate an unacceptable property disposition pattern upon death.  However, on the death of the first of the joint tenants to die, probate may be simplified or eliminated with title obtained by the surviving joint tenant perfected by showing non-liability for taxes and by proving the death of the decedent by affidavit or death certificate.  This is possible in most (but not all) states.

When it cannot be determined that two (or more) joint tenants have died other than at the same time an interesting problem may arise.  Most states have enacted a simultaneous death statute to handle just such a situation.  Such statutes typically provide that the jointly held property is to be divided into as many equal shares as there were joint tenants and that the share allocable to each joint tenant is to be distributed as if such joint tenant had survived all of the other joint tenants.

A major estate planning limitation of the joint tenancy form of property ownership is that the survivorship right of joint tenancy precludes the use of the life estate-remainder arrangement for the nonmarital portion of the estate to reduce the death tax burden upon the survivor’s death.  The entire property, therefore, will pass to the survivor and may be taxed again in the survivor’s estate.  In addition, another problem with joint tenancy is that each joint tenant has a right to sever the joint tenancy relationship unilaterally (except for tenancies by the entirety).  As a result, a joint tenant furnishing consideration for acquisition of the property in effect grants to the other tenant a revocable interest that could be partitioned and severed at any time.  Consequently, each co-owner has the power to amend or destroy the other’s estate plan.

For marital joint tenancies, upon the death of the first spouse, one-half of the date-of-death value of the jointly held property is included in the first-spouse’s estate.  However, the full value of the jointly held property is included in the first spouse’s estate (and receives a date-of-death income tax basis in the hands of the surviving spouse) if the marital joint tenancy was established before 1977 and the spouse that bought the property died after 1981 (Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992)). 

Joint tenancy is not a cure-all for tax planning but, depending upon the circumstances, it may be a convenient means of owning and passing property.  For total estates of each of the husband and wife under $22.8 million (for 2019), there is no federal estate tax liability.  Therefore, joint ownership may serve a useful purpose as a will substitute in the first estate for estates that are not potentially subject to federal estate tax.  However, since it is not known which joint tenant will die first, the estate of the surviving joint tenant will be subject to probate as an intestate estate (where death occurs without a will), unless the survivor prepares a will or otherwise disposes of the property.  For combined spousal estates exceeding $22.8 million (for 2019) in value, joint tenancy ownership may expose a portion of the total estate of the surviving joint tenant to additional taxes, causing an otherwise unnecessary reduction of the estate assets passing to the heirs or other beneficiaries.

Recent Case

A recent case from Texas illustrates the difference between tenancy-in-common and joint tenancy.  It also illustrates how misunderstandings about how property is titled can create family problems.  In Wagenschein v. Ehlinger, 581 S.W.3d 851 (Tex. Ct. App. 2019), a married couple had seven children.  The parents also owned a tract of land.  Upon the last of the parents to die, each child held an undivided one-seventh interest as tenants in common in the tract.  In 1989, the heirs sold the land but executed a deed reserving a royalty interest.  The deed reservation read as follows:  “THERE IS HEREBY RESERVED AND EXCEPTED from this conveyance for Grantors and the survivor of Grantors, a reservation until the survivor's death, of an undivided one-half (1/2) of the royalty interest in all the oil, gas and other minerals that are in and under the property and that may be produced from it. Grantors and Grantors' successors will not participate in the making of any oil, gas and mineral lease covering the property, but will be entitled to one-half (1/2) of any bonus paid for any such lease and one-half (1/2) of any royalty, rental or shut-in gas well royalty paid under any such lease. The reservation contained in this paragraph will continue until the death of the last survivor of the seven (7) individuals referred to as Grantors in this deed.” 

An oil and gas company drilled a producing well in 2010 and began paying royalties to the heirs. As each heir died, the credited their royalty interest to the surviving heirs of each deceased heir.  That had the effect of increasing the respective royalty payments of the surviving heirs.  There were no problems until 2015.  In 2015, a child of a deceased heir sued claiming that the deed crediting the royalty reservation to “Grantors and Grantors’ successors created a “tenancy in common” and not a “joint tenancy”.  If the deed created a tenancy in common, the children of the deceased heirs, rather than the surviving heirs, would inherit their parents’ royalty interests.  The trial court disagreed, noting that while the deed used “successor”, it only did so once and clearly and unambiguously reserved the royalty interest to the heirs and the “survivor[s]” of the heirs, rather than their “successors”, “heirs” or “beneficiaries.”  As such, the trial court concluded that the deed unambiguously created a joint tenancy with the right of survivorship, rather than a tenancy in common that the children of the deceased heirs could inherit.   Thus, as each heir died, their interest in the tract passed to the surviving siblings, not their children.  On appeal, the appellate court affirmed.  Further review was denied.

Conclusion

Properly titling property is important for various reasons – not the least of which is to fulfill expectations on property passage.  In the Texas case, confusion over how property was titled resulted in a family lawsuit.  Regardless of how the case would have been decided, some in the family would not be pleased.   

December 9, 2023 in Estate Planning, Income Tax | Permalink | Comments (0)

Friday, December 1, 2023

Funding a Buy-Sell Agreement with Corporate Owned Life Insurance – Will Corporate Value Be Enhanced?

Overview

In part one of this series (published back on July 3), I discussed buy-sell agreements in general and noted how beneficial they can be in the intergenerational transfer of a farm or ranch where keeping the business in the family is the key goal.  There I covered buy-sell agreements in general, the various types of agreements and common triggering events. 

With today’s article I dive deeper into other issues associated with buy-sell agreements -valuation rules and funding approaches.  A recent court opinion points out the importance of following the valuation procedures set forth in the buy-sell agreement.

Part two of a two-part series on buy-sell agreements – it’s the topic of today’s post.

Valuation 

While very few farming and ranching operations (and small businesses in general) are subject to the federal estate tax because of the current level of the exemption, some are.  For those that are, in addition to providing a market for closely held shares at a determinable price, the buy-sell agreement can serve as a mechanism for establishing the value of the interest for estate tax purposes – or otherwise establish value of the decedent’s interest at death.

General rule.  In general, the value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property.  I.R.C. §2703(a).

Exception – statutory requirements.  A buy-sell agreement can establish the value of a deceased owner’s interest if six basic requirements are satisfied.  Three of the requirements are statutory and three have been judicially created.  The statutory requirements are found at I.R.C. §2703(b). 

The statutory requirements specify that the buy-sell agreement must:

  • Be a bona fide business arrangement; I.R.C. §2703(b)(1)
  • Not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; I.R.C. §2703(b)(2) and
  • Contain terms that are comparable to other arrangements entered into by persons in arms’ length transactions.  I.R.C. §2703(b)(3)

A buy-sell agreement must satisfy each of the three statutory requirements if family members own 50 percent or more of the property subject to the restriction.  An agreement is deemed to satisfy all three of the statutory requirements if more than 50 percent of the value of the property subject to the restriction is owned directly or indirectly by individuals who are not members of the transferor’s family.  The interests owned by the nonfamily members must be subject to the same restrictions as the property owned by the transferor.  Treas. Reg. §25.2703-1(b)(3). 

Exception – caselaw requirements.  Judicial opinions have created three additional requirements that a buy-sell agreement must satisfy to be effective to establish the value of a decedent’s interest.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982).  Based on these cases, the agreement must also: contain a purchase price that is fixed and determinable under the agreement; be legally binding during life and after death; and have been entered into for a bona fide business reason and not be a substitute for a testamentary disposition for full and adequate consideration. To establish the purchase price with certainty an appropriate valuation method must be established. An independent party valuation will not only satisfy the requirements of I.R.C. §2703 but also provide an estimate of the potential funding obligation and the liquidity expectations of the seller/estate. See Rev Rul. 59-60 as amplified by Rev. Rul. 83-120,1983-2 CB 170.

The courts have indicated that preserving a business with family control for purposes of continuity and management can serve as a bona fide business arrangement.  See St. Louis County Bank v. United States, 674 F.2d 1207 (8th Cir. 1982); Estate of Lauder v. Comr., T.C. Memo. 1992-736; Estate of Gloeckner v. Comr., 152 F.3d 208 (2nd Cir. 1998).  This includes planning for the future liquidity needs of the decedent’s estate.  Estate of Amlie v. Comr., T.C. Memo. 2006-76.  But an entity that consists only of marketable securities is not a bona fide business arrangement.  Holman v. Comr., 601 F.3d 763 (8th Cir. 2010).  The long-established position of the IRS is that, “It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts to determine whether the agreement represents a bona fide business arrangement or a device to pass the decedent’s shares to the natural objects of his bounty for less than an adequate and full consideration in money or money’s worth.”  Rev.Rul 59-60, 1959-1 CB 137. See also Estate of True v. Comr., T.C. Memo 2001-167, aff’d., 390 F.3d 1210 (2004); Estate of Blount v. Comr., T.C. Memo. 2004-116.  

Note:  The business reasons for executing the buy-sell agreement should be documented.   

The buy-sell agreement must not simply be a device to reduce estate tax value.  This requires more than expressing a desire to maintain family control of the business.  See, e.g., Estate of True v. Comr., 390 F.3d 1210 (10th Cir. 2004); Estate of Lauder v. Comr., T.C. Memo. 1992-736.  In addition, a buy-sell agreement must have terms that are comparable to other buy-sell agreements that are entered into at arms-length. This requirement is satisfied if the agreement is one that unrelated parties in the same line of business could have reached in an arms’ length transaction.  Treas. Reg. §25.2703-1(b)(4).  This fair bargain standard is typically based on expert opinion testimony. 

Funding Approaches

To be operational, the parties to the agreement must have funds available to buy the stock at the time the agreement is triggered.  It is possible to use accumulated earnings of the business to fund a redemption. But such a strategy may not be treated as a “reasonable need of the business” with the result that the business (if it is a C corporation) could be subject to the accumulated earnings tax. I.R.C. §531. However, corporate accumulations used to pay off a note given a stockholder for a redemption is a reasonable need of the business, as a debt retirement cost. But see Smoot Sand & Gravel Corp. v. Comr., 274 F.2d 495 (4th Cir. 1960), cert. denied, 362 U.S. 976 (1960).

The use of life insurance.  Typically, life insurance is purchased for each business owner to cover the total purchase price (or at least the down payment). However, the premiums on such policies are not deductible (see I.R.C. §264) and can create a substantial ongoing expense.

Corporate-owned.  One approach is for the corporation to buy a life insurance policy on the life of each stockholder, with the corporation as the policy owner, premium payor, and beneficiary of these policies. The corporation would then use the life insurance to finance the purchase if, at the end of the first option period, the corporation buys the deceased stockholder’s interest. Or the corporation could lend the insurance proceeds to the stockholders if, at the end of the corporate option period, it is decided that the surviving stockholders should be the buyers (or to the extent stock remained to be purchased after the corporation’s option expires). Investment payments would be deductible to the stockholders and income to the corporation.

Shareholder-owned.  An alternative approach is for each shareholder to buy, pay for, own, and be the beneficiary of a life insurance policy for each of the other shareholders. The surviving shareholders would then receive the proceeds when one shareholder dies, and, if a cross-purchase is indicated and appropriate, use the proceeds as the necessary funds to carry out the buy-sell agreement. The surviving shareholders could also lend the proceeds to the corporation if a redemption agreement is utilized, to enable the corporation to buy additional shares, or the surviving shareholders could make capital contributions which would have the effect of increasing each shareholder’s stock basis.

Note:  The cash value of a permanent life insurance policy may be withdrawn by loan or surrender of the policy, but the value may be a very small percentage of the death benefit, inadequate to finance the buy-out. Disability insurance may be used to finance a purchase occasioned by an owner’s disability, but it can be quite expensive, and cannot be applied toward the purchase of an interest of an owner who is retiring or used to prevent the sale of an interest in the business to a buyer outside the family unit.

Other Approaches

A combination of the above approaches could also be used for funding the wait-and-see buy-sell agreement. For example, the corporation could own cash value life insurance and the owners could own term insurance. Also, the parties could have a split-dollar arrangement whereby the corporation pays for the cash value portion of the premiums and the shareholders own the policy and pay for the term portion of the premiums, with the proceeds split between them.

Potential Problem of Life-Insurance Funding

One potential problem of a corporation being the beneficiary of a life insurance policy designed to fund the buy-out of a deceased shareholder is that the IRS could argue that the policy proceeds are included in the corporate value.  In Estate of Blount v. Comr., T.C. Memo. 2004-116, the issue was whether the insurance proceeds contractually deduction to the redemption of corporate shares being valued be treated as corporate property for valuation purposes.  The decedent owned 83 percent of the stock in a corporation at death.  There was a life insurance policy owned by the company that provided some $3.1 million to pay off the mandated buyout of the shares under a buy-sell agreement providing for a fixed value of the decedent shares. The buy-sell agreement value was held not to be controlling for estate tax purposes, mainly because the deceased owned 83 percent of the stock and could have changed the agreement at any time. Furthermore, the court determined that the buy-sell agreement was not similar to those involved in arm’s length transactions.

The 11th circuit reversed on the basis that the redemption obligation of the buy-sell agreement was a liability that offset the value of the death benefits used to fund the redemption. Estate of Blount v. Comr., 428 F.3d 1338 (11th Cir. 2005).  Thus, even if the death benefits were included in the corporate value, there was a corresponding offsetting liability that would be accounted for by a “reasonably competent business person interested in acquiring the company.”  Id. 

Note:  In a decision preceding the Tax Court’s decision in Blount, the Ninth Circuit court deducted the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout.  Cartwright v. Comr., 183 F.3d 1034 (9th Cir. 1999).   

The issue in Blount and Cartwright resurfaced in Connelly v. United States, No. 4:19-cv-01410-SRC, 2021 U.S. Dist. LEXIS 179745 (E.D. Mo. Sept. 21, 2021). In Connelly, two brothers were the only shareholders of a closely-held family roofing and siding materials business.  They entered into a stock purchase agreement that required the company to buy back shares of the first brother to die.  The company then purchased about $3.5 million in life insurance coverage to ensure it had enough cash to redeem the stock.  The brother holding the majority of the company’s shares (77.18 percent) died on October 1, 2013.  The company received $3.5 million in insurance proceeds.  The surviving brother chose not to buy his shares, so the company used a portion of the proceeds to buy the deceased brother’s shares from his estate for $3 million pursuant to a Sale and Purchase Agreement.  Under the agreement the estate received $3 million, and the decedent’s son received a three-year option to buy company stock from the surviving brother.  If the surviving brother sold the company within 10 years, the brother and decedent’s son would split evenly any gains from the sale. 

The estate valued the decedent’s stock at $3 million and included that amount in the taxable estate.  Upon audit the IRS asserted that the fair market value of the decedent’s corporate stock should have factored-in the $3 million in life-insurance proceeds used to redeem the shares which, in turn, resulted in a higher value of the decedent’s stock than was reported.  The IRS assessed over $1 million in additional estate tax.  The estate paid the deficiency and filed a refund claim in federal district court. 

The district court noted that a stock-purchase agreement is respected when determining the fair market value of stock for estate tax purposes upon satisfying the requirements of I.R.C. §2703(b) (as noted above), and the additional judicially created requirements (also noted above).    The IRS expert claimed that the insurance proceeds should be included in the company’s value as a non-operating asset, and that allowing the redemption obligation to offset the insurance proceeds undervalued the company’s equity and the decedent’s equity interest in the company, and would create a windfall for a potential buyer that a willing seller would not accept.  The IRS expert concluded that the fair market value of the company was $6.86 million rather than $3.86 million.  The IRS also claimed that the stock purchase agreement failed to control the value of the company.  The estate claimed that the company sold the decedent’s shares at fair market value and that the shares had been properly valued.  Thus, according to the estate, the $3 million in life insurance proceeds were properly excluded from the decedent’s estate based on the appellate opinion in Blount.  The estate claimed that the stock purchase agreement provided a sufficient basis for the court to accept the estate’s valuation as the proper estate-tax value of the decedent’s shares.  On that point, the IRS claimed that the stock purchase agreement was not a bona fide business arrangement and, as such, didn’t control the value of the decedent’s stock.  The IRS position was that the stated estate planning objectives of the stock purchase of continued family ownership of the company were insufficient to make it a bona fide business arrangement, particularly because the brothers did not follow it by disregarding the agreement’s pricing mechanisms. 

The district court did not rule on the bona fide business arrangement issue because it determined that the estate had failed to show that the stock purchase agreement was not a device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration.  The process that the surviving brother and the estate used in selecting the redemption price bolstered the court’s conclusion that the stock purchase agreement was a testamentary device.  They also did not obtain an outside appraisal or professional advice on setting the redemption price, thereby disregarding the appraisal requirement set forth in the agreement.  The district court also noted that the agreement didn’t provide for a minority interest discount for the surviving brother’s shares or a lack of control premium for the decedent’s shares with the result that the decedent’s shares were undervalued.  This also, according to the district court, demonstrated that the stock purchase agreement was a testamentary device to transfer wealth to the decedent’s family members for less than full-and-adequate consideration and was not comparable to similar agreements negotiated at arms’ length. 

On the issue of whether the life insurance proceeds should be included in corporate value, the court rejected the appellate court’s approach in Blount, finding it to be analytically flawed.  The court concluded that the appellate court in Blount had misread Treas. Reg. §20.2031-2(f)(2), and that the regulation specifically requires consideration to be given to non-operating assets including life insurance proceeds, “to the extent such nonoperating assets have not been taken into account in the determination of net worth.”  The district court concluded that the text of the regulation does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been “taken into account in the determination of a company’s net worth.”  The district court concluded that, “by its plain terms, the regulation means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company’s stock…. And…a redemption obligation is not the same as an ordinary corporate liability.”  There is a difference, the court noted, between a redemption obligation that simply buys shares of stock, and one that also compensates for a shareholder’s past work.  One that only buys stock is not an ordinary corporate liability – it doesn’t change the value of the corporation as a whole before the shares are redeemed.  It involves a change in the ownership structure with a shareholder essentially “cashing out.”  The court noted that the parties had stipulated that the decedent’s shares were worth $3.1 million, aside from the life insurance proceeds.  The insurance proceeds were not offset by the company’s redemption obligation and, accordingly, the company’s fair market value and the decedent’s shares included all of the insurance proceeds, and the IRS position was upheld. 

On appeal the U.S Court of Appeals for the Eighth Circuit affirmed.  Connelly v. United States, 70 F.4th 412 (8th Cir. 2023).  The appellate court held that the stock purchase agreement requiring the redemption of a deceased shareholder’s shares did not affect the value of the shares for estate tax purposes under I.R.C. §2703 because it did not provide for a fixed price or a formula for arriving at one. Instead, the agreement merely laid out two mechanisms by which the brothers might agree on a price - mutual agreement or appraisal. As for the appraisal approach, there was nothing in the agreement that fixed or prescribed a formula or measure for determining the price that the appraisers would reach. Thus, neither mechanism constituted a fixed or determinable price for valuation purposes. The appellate court determined that the $3 million that the corporation actually paid for the deceased brothers shares constituted an amount determined after death that was derived by an agreement between the brothers and not by any formula in the buy-sell agreement.

As for the value of the corporation (and, hence, the deceased brother’s interest in the corporation), the appellate court determined that the life insurance proceeds were an asset that increased the shareholders’ equity and that an obligation to redeem shares is not a liability in the ordinary business sense.  Thus, the proper valuation of the corporation in accordance with I.R.C.  §§2042 and 2031 must include the life insurance proceeds without treating the obligation to redeem shares as an offsetting liability.  The court reasoned that in order for a willing buyer at the time of the brother’s death to own the stock outright, a willing buyer would account for control the life insurance proceeds and therefore would pay up to $6.86 million for the corporation, quote taking into account end quote the life insurance proceeds and then either extinguishing the agreement or redeeming the shares. Conversely, the appellate court determined that a hypothetical willing seller of the corporation would not find acceptable a price of $3.86 million with the knowledge that the company would be receiving $3 million in life insurance proceeds.

To illustrate its rationale, the appellate court explained explain that if it valued the corporation without accounting for the life insurance proceeds intended for redemption, then upon the brother’s death each share was worth $7,720 before redemption.  After redemption, the deceased brother’s interest is extinguished, with the surviving brother having full control of the corporation’s $3.86 million value.  The appellate court noted that this would essentially quadruple the value of the surviving brother’s shares, but that treating the life insurance as an offsetting liability would leave the stock value undisturbed (which was the estate’s position). The economic reality of the situation, the appellate court concluded, was that the life insurance proceeds was an asset that increased shareholders’ equity.  The buy-sell agreement thus had nothing to do with being a corporate liability. 

Note:  A separate insurance LLC could be used to fund a buy-sell agreement in light of Connelly.  The insurance LLC would collect the life insurance proceeds on the deceased owner.  The LLC’s value would not be increased by the death benefit because it is allocated to the other owners in accordance with the buy-sell agreement due to special allocations in a LLC taxed as a partnership.  See I.R.C. §704.  A formal appraisal would likely only be required if there is real estate or some other difficult to value asset that the LLC owns.  This does add a layer of complexity, but if there are more than two owners the additional complexity may be worth it.

Arguably, there is now a split on this issue between the 8th Circuit on one hand, and the 9th and 11th Circuits on the other (keep in mind the brothers in Connelly didn’t follow the buy-sell agreement).  Indeed, a petition for certiorari was filed with the U.S. Supreme Court on August 15, 2023.  Will the Supreme Court agree to hear Connelly?  Not very likely at all. 

Conclusion

A buy-sell agreement can be a very important part of a succession plan for a family farming/ranching business (or any small, family-owned business for that matter).  However, it’s critical that the agreement be drafted properly and followed by the business owners.

December 1, 2023 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)