Thursday, December 5, 2019

“Slip Slidin’ Away” – The Right of Lateral and Subjacent Support


I have published articles on this blog on prior occasions concerning easements.  In those posts, I have noted that an easement can either be affirmative (entitling the holder to do certain things upon the land subject to the easement) or negative (entitling the holder to require the owner of the land subject to the easement to either do or not do certain things with respect to the burdened land).  Negative easements are synonymous with covenantal land restrictions and are similar to certain “natural rights” that are incidents of land ownership.

One of those natural rights that is an incident of land ownership (or may come along with an easement) is the right of lateral and subjacent support.  It’s such an important right, that some states have statutes concerning it.  See, e.g., Ohio Rev. Code Ann. §§723.49-50; Idaho Code §55-310. For example, California law states that, “each coterminous owner [owners having the same or coincident boundaries] is entitled to the lateral and subjacent support which his land receives from the adjoining land…”  Cal. Civ. Code §832

The right of lateral and subjacent support is not a right that many persons are familiar with, but it is an important right to all landowners.

Lateral and subjacent support rights – it’s the topic of today’s post.

The Basics of Lateral and Subjacent Support

Lateral support.  An owner of a tract of land has the right to have the surface of the tract be supported by the land lying beneath it.  “Lateral support” exists when the adjoining lands are side-by-side. It is the right of the land to be naturally upheld by its neighboring land(s) and supported against subsidence, i.e. slippage, cave-in or landslide.  Lateral support is a common law right – it’s a right incident to the land itself.  In addition, as noted above, some states have statutory provisions governing lateral support rights.

The right of lateral support raises questions when a landowner engages in construction and/or excavation activities.  In practice, a landowner’s right of lateral support of adjoining property is subject to the right of the adjoining owner to excavate and improve his property.  But, the neighbor’s excavation/improvement activity must be conducted in a reasonable manner.  This is conceptually similar to nuisance law – a landowner can do whatever they want on their property so long as they don’t unreasonably interfere with a neighbor’s right to do what they want on their property (that’s an oversimplification, buy you get the point).  If lateral support rights are alleged to have been violated, it’s a negligence-type tort. 

So how are these mutual rights balanced?  First, it’s a good idea (and required by statute in some states) to notify potentially affected neighbors (those beyond simply the owners of coterminous lands) of the excavation project in a manner that gives them sufficient time to protect their existing structures if those structures could be impacted.  State law might require the excavating party to protect neighboring land and buildings from damage. 

Subjacent support.  A subjacent support right is the right of surface land to be supported by the land beneath it against subsidence. Subsidence is the sinking or lowering of the earth's strata caused by the removal of a substance (e.g., soil, coal, water, or some other mineral or natural resource).  Subsidence usually appears as a sinkhole, trough, or fissure.  In essence, a surface landowner has a common law right to have the surface remain in its natural state without subsidence caused by an adjacent owner as well as subsidence that the subsurface owner might create. See, e.g.,  XI Properties, Inc. v. RaceTrac Petroleum, Inc., 151 S.W.3d 443 (Tenn. 2004).  Over the past two centuries, federal and state courts have developed legal principles to deal with subsidence and a surface owner's right of subjacent support, particularly as surface and subsurface estates have been severed (such as with oil and gas development).  The basic principle is that a property owner is owed lateral and subjacent support, from an adjoining landowner; has a right to be free from unreasonable nuisances; and other similar rights that the law may require.  See, e.g., Cecola v. Ruley, 12 S.W.3d 848 (Tex. Ct. App. 2000). 

Reasonable Use

The right of lateral and subjacent support is subject to an adjacent owner’s reasonable use of their property.  For example, in Finley v. Teeter Stone, Inc, 251 Md. 428 (Md. 1968), the conducting of quarrying operations was held to be a legitimate and reasonable use of land, and there was no suggestion that quarrying was unreasonable or inappropriate under the circumstances. Consequently, the adjacent landowners were not entitled to recover damages to their farmland from sinkholes on their land created by the quarrying activity because the landowners failed to claim or prove that there was any negligence in excavating or that the quarry operation was an unreasonable use.

As for severed estates, while both a surface owner and a subsurface owner (they could be the same or different parties depending on whether the surface estate has been severed from the subsurface estate) have the right (in accordance with either state common or statutory law) to access and divert/remove water (or minerals) beneath the surface of the property that is connected with legitimate use of the land, that right cannot be exercised in an unreasonable manner that causes injury to the similar right of an adjacent owner. The rule is that in situations where the ownership of the surface of the land has been severed from the ownership of the minerals under it, the owner of the surface has an absolute right to the necessary support of the land.  However, it is possible for that right to be altered by contract or conveyance (if the deed language waiving the right is clear and unequivocal). See, e.g., Jensen v. Sheker, 231 Iowa 240 (1941); Breeding v. Koch Carbon, Inc., 726 F. Supp. 645 (W.D. Va. 1989). 

Damages – Rights and Remedies

For claims asserting damages from lateral and subjacent support, the cause of action arises upon the subsidence of the land, not its excavation. In other words, a lawsuit may be brought only once the subsidence occurs, and for each separate occurrence.  The suit can be filed by the owner of the damaged property and any disaffected tenant against the party (or parties) responsible for the damage.  It also may be possible to head-off potential subsidence filing an action that seeks an injunction if it can be shown that the suspect activity would likely create irreparable damage.   

If a landowner is negatively impacted by subsidence of the surface of their property, the landowner is entitled to proven damages from the party that caused the subsidence.  See, e.g., Platts v. Sacramento Northern Railway, 205 Cal. App. 3d 1025 (Cal. Ct. App. 1988).   It doesn’t matter whether the subsidence was the result of negligent conduct (e.g., failing to conduct mining or excavation activities, for example, in a lawfully reasonable and proper manner).  Once damages are established, the responsible party is liable – at least according to the California Court of Appeals.  Id. 

While the right of lateral and subjacent support is not dependent upon the activities that a landowner conducts on the surface of their property, the owner of the surface has a responsibility to refrain from conduct that would contribute to subsidence.  Id.  For example, the owner of the surface has a duty to support buildings and other structures which were in existence at the time of the creation of the interest in the subjacent stratum.  A person who withdraws the necessary lateral and subjacent support of land in another’s possession or the support that substitutes the naturally necessary support will be liable for a subsidence of the land to the other that was dependent upon the support withdrawn.  See, e.g., Western Indiana Coal Company v. Brown, 36 Ind. App. 44 (Ind. Ct. App. 1905).   For example, in the early 1900s case of Collins v. Gleason Coal Co., 140 Iowa 114 (Iowa 1908), the plaintiff was the owner of the surface of the land and the defendant was the owner of the coal beneath the same land.  The plaintiff farmed the surface, and also had a house, outbuildings and trees on the property.  The defendant’s coal mining operations damaged the plaintiff’s property.  The court held that each party was entitled to use their respective property interests (the plaintiff’s surface estate and the defendant’s subsurface estate) in a manner that did not interfere or deprive the rights, benefits, profits and enjoyment of the other party’s property interest.  The surface owner was entitled, the court determined, to have an enforceable support right that was the basis for recovering damages.


The right of lateral and subjacent support, while not well known by landowners, is a well-recognized property right.  It’s just another one of those issues that can arise from time-to-time for a farmer, rancher, rural landowner, and any other owner of real estate.  “You know the nearer the destination, the more you’re slip slidin’ away.”

December 5, 2019 in Real Property | Permalink | Comments (0)

Tuesday, November 26, 2019

Are Windbreaks Depreciable?


On many farms and ranches, windbreaks are used to minimize soil erosion and protect buildings and structures.  But, is a windbreak depreciable, or must its cost be capitalized and added to the basis of the land?  A depreciation deduction provides an immediate tax break, but adding the cost of a windbreak to the land basis is only beneficial upon eventual sale of the land. 

Depreciating or capitalizing windbreaks – it’s the topic of today’s post.

Depreciation Basics

Depreciation applies to property that is either tangible personal property (or is a certain type of real property) that is used in the taxpayer’s trade or business or for the production of income and has a determinable useful life of more than a year.  The depreciation rules have changed over the years, with the present system known as the Modified Cost Recovery System (MACRS).  MACRS is eight-class system that allows the cost of an asset to be depreciated or recovered over a period shorter than the asset's useful life.  All depreciable property fits into one of the eight depreciation classes with its cost recovered over 3, 5, 7, 10, 15, 20, 27 1/2 or 39 years.  Property gets assigned to these eight classes either by Congressional legislation or by the IRS.  For example, breeding hogs are classified as three-year property.  The five and seven-year categories apply generally to farm machinery and equipment. Single-purpose ag and horticultural structures along with trees and vines that produce nuts and fruits are also classified as ten-year property.  The 15-year category includes land improvements, including irrigation systems (at least the below-ground part such as wells) and some landscaping costs. 

What About Earthen Improvements?

Earthen improvements are generally not depreciable unless the taxpayer can establish that the earthen improvement is physically deteriorating and that, without maintenance, the improvement would become worthless.  See, e.g., Ekberg v. United States, No 711 W.D., 1959 U.S. Dist. LEXIS 4467 (D. S.D. Dec. 31, 1959).  In addition, expenses for maintaining such improvements should be deductible as repairs.  Common items on a farm that are included in the “land improvement” category include silage bunkers, concrete ditches, waterways, pond outlets and wells used for irrigation and livestock watering.  Relatedly, a permanent pasture (natural or seeded grassland that remains unplowed for many years) has been held to be depreciable.  See, e.g., Johnson v. Westover, No. 16527-WM, 1959 U.S. Dist. LEXIS 4249 (S.D. Cal. Mar. 19, 1955).  The court determined, based on the evidence, that the pasture should be replanted at the end of 10 years to maintain its economic usefulness.  At the time of purchase, the evidence showed that the pasture had a remaining life of five years.

But, what about a windbreak on a farm or a ranch?  Isn’t a windbreak an earthen improvement that is used in a farmer or rancher’s business?  As noted above, they are panted to reduce moisture evaporation and soil erosion.  Clearly, trees and vines that produce nuts and fruits are depreciable as ten-year property.  However, there is no specific MACRS category for trees (and bushes) planted as a windbreak that don’t also produce nuts and fruits.  In Everson v. United States, 108 F.3d 234 (9th Cir. 1997), the court ruled that the windbreak trees and bushes (Russian olive trees and Caragana bushes) that were planted in rows perpendicular to the wind by a prior owner of a 3,700-acre wheat farm were, in essence, part of the land and not depreciable because land does not have a determinable useful life – it doesn’t wear out (in theory).  See also, Blair v. Comr., 29 T.C. 1205 (1958).  The taxpayer couldn’t establish that the windbreak had a limited life or was associated with a depreciable asset.  In addition, the court noted that windbreaks are specifically listed in the definition of non-depreciable soil and water conservation expenses eligible for a deduction under I.R.C. §175.  If windbreaks were held to be depreciable, the court reasoned, the specific inclusion of windbreaks in I.R.C. §175(c) as a non-depreciable land improvement eligible for a deduction as a soil and water conservation expense would be rendered meaningless.  Thus, because the prior owner of the farm that incurred the cost of planting the windbreak could have deducted the cost of establishing the windbreak under I.R.C. §175, the taxpayer could not allocate part of the purchase price of the ranch to the windbreak and claim a depreciation deduction. 

More on Soil and Water Conservation Expense Deductibility

Soil and water conservation expenses that qualify under I.R.C. §175 must be paid or incurred for soil or water conservation purposes with respect to land used in farming, or for the prevention of erosion on farmland and be consistent with a soil conservation plan or an endangered species recovery plan. I.R.C. §§175(a); (c)(3)(A)(i).  Qualified expenses include various types of earth moving on farmland using in the business of farming (to produce crops, fruits or other ag products or the sustenance of livestock).  I.R.C. §175(c)(2)Expenses for leveling, conditioning, grading, terracing and contour furrowing are all eligible as are costs associated with the control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds.  Even the cost of eradicating brush and, as noted above, the planting of windbreaks is eligible.  I.R.C. §175(c)(1)Also included are drainage district assessments (and soil and water conservation district assessments) if such assessments would have been a deductible expense if the taxpayer had paid them directly.  I.R.C. §175 (c)(1)(B).


The IRS position is that windbreaks are inextricably associated with the land.  As such, the cost of a windbreak is to be added to the basis in the land.  In addition, a windbreak is specifically listed under I.R.C. §175 as a non-depreciable item the cost of which is eligible for deduction as a soil and water conservation expense.  An “organic” land improvement can be depreciated, however, when the taxpayer can prove that it wears out, or when it is associated with a depreciable asset in such a way that the land improvement is no longer useful to the taxpayer once the asset with which it is associated has completed its useful life.  For example, in Rudolph Investment Corp. v. Comr., T.C. Memo. 1972-129, the court allowed the taxpayer to depreciate earthen dams and earthen water storage tanks located on ranchland.  The taxpayer was able to establish that, as the result of erosion processes, the dams and storage tanks became filled-in over a period of approximately ten years, so that at the end of the ten-year period they ceased to have any ranch value.  In Everson, the taxpayer couldn’t establish a comparable situation for the windbreak.

November 26, 2019 in Income Tax | Permalink | Comments (0)

Thursday, November 21, 2019

Co-Tenancy or Joint Tenancy – Does it Really Matter?


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.


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 subject to tax. 

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 non-marital 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.

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 and 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 an 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. 


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.   

November 21, 2019 in Estate Planning, Real Property | Permalink | Comments (0)

Tuesday, November 19, 2019

Fence Law Basics


Robert Frost once said that, “Good Fences make good neighbors.”  To paraphrase G.K. Chesterton, “Whenever you remove any fence, pause long enough to consider why it was put up there in the first place.”  Both quotes are sound advice.  Of all the areas of agricultural law that I field questions concerning, outside of farm income tax and farm estate and business planning, perhaps questions concerning fences (and leases) are the most abundant.    

Most states have numerous laws concerning partition fences. Those laws involve such issues as the construction of fences; what is deemed to be a “legal” fence; liability for damages caused by livestock that escape their enclosure; the maintenance of partition fences; the role of the county officials serving as fence viewers in settling fence disputes; and rules for handling stray animals.

Fences and the legal issues for farmers, ranchers and rural landowners – it’s the topic of today’s post.

Partition Fences and Location Issues

State law commonly specifies that a partition fence is to be placed on the line between tracts of land owned by different persons, but also does allow for a partition fence to be located entirely on side of the boundary.  See, e.g., Kan. Stat. Ann. §§29-316; 317. 2 Kan. Stat. Ann. §60-503.  Having a fence located on one side of the actual property boundary may not raise an issue concerning ownership of the land that is fenced, but if such a fence has been in place for long-enough time and the adjacent landowners have, over time, come to believe that the fence marks the boundary then the fence may become the actual boundary regardless of what a deed or survey says. So, in an agricultural setting, usage of property may determine property boundaries more often than do surveys. On this point, there are two different, but related theories that may apply to determine the amount of land owned by the adjacent landowners.

Adverse possession. Under the adverse possession theory, a landowner may acquire title to property by making an open and notorious use of the property for a statutorily-prescribed timeframe that varies among the states from two to 21 years.    In general, this theory can be utilized if the adjacent parties know that the fence between their properties is not on the boundary but do know where the actual boundary is located (thus, the possession is knowingly adverse) and one party is benefited by the misplaced fence, but the other party doesn’t take any action to remedy the problem within the statutory timeframe.

Doctrine of practical location.  The doctrine of practical location can be used in situations where the parties know that the fence is not on the boundary, but don’t know where the actual boundary is located. Thus, one party has a good faith belief of ownership. Similarly, after the statutorily-prescribed timeframe of usage of a fence as the boundary, the fence can become the actual boundary between the tracts.

Building and Maintenance Issues

In general, the owners of adjoining lands are required to build and maintain in good repair all partition fences in equal shares, unless the parties agree otherwise.  The duty to maintain a partition fence confers on the landowner the privilege to lawfully enter onto the adjoining landowner’s property at reasonable times and in a reasonable manner to maintain the fence.  In practice, many adjoining landowners adopt the “right-hand” or “left-hand” rule — they face each other at the mid-point of their fence and agree to build and/or maintain the portion of the fence to either their respective right or left. Of course, adjacent landowners can execute a written fence agreement specifying the part of the fence that each party is responsible for building or maintaining. Such an agreement can be recorded and thereby become part of the land records that will bind subsequent owners of the properties.

Fence-in or fence-out?  States that are not in the western part of the United States follow the “fence-in” rule.  That means that livestock owners are required to fence their animals in.  But, as stated above, state law in these states also requires that the owners of adjoining lands build and maintain in good repair all partition fences in equal shares.  That sometimes creates problems when a livestock owner shares a partition fence with a crop farmer or other landowner who does not graze livestock and, hence, has no need for a fence. But, if an adjacent non-livestock owner does not participate in the maintenance of their share of the partition fence, and injury results to them because of the defective fence that they were required to maintain, they cannot recover for damages caused by the adjacent landowner’s stock.  Also, a non-livestock owner will be held liable to others who are damaged by the neighbor’s livestock escaping through the defective partition fence that the non-livestock owner is required to maintain.  However, there can be special rules in a particular state that might also apply in this situation.  See, e.g., Kan. Stat. Ann. §29-309. 

Procedure for Handling Fence Disputes

In some instances, adjoining landowners may come to an agreement as to how to allocate the responsibility between themselves for the building and/or maintenance of a partition fence. If an agreement is reached, it may be wise to put the agreement in writing and record it in the county Register of Deeds office in the county where the fence is located. However, if the adjoining landowners cannot reach an agreement concerning fence building and/or maintenance, most states require that the fence be called.  The fence viewers are some governmental body of elected officials (who sometimes don’t know that they have a statutory obligation to view partition fences). 

Under Kansas law, for example, the county commissioners (or their designees) in the county where the fence in question is located are the fence viewers.  Kan.Stat. Ann. § 29-201.  For partition fences that are on the boundary between counties, state law should specify the procedure to be followed to determine who is responsible for viewing the fence.  Detailed rules often apply in determining how the view is to be conducted, whether a majority vote is required for determinations, and the appeal procedure if a landowner objects to the conclusions of the viewers.  Ultimately, state law (or caselaw) will provide a mechanism to get a partition fence repaired and the proper party compensated for any work done.

What Is a Legal Fence?

State law specifies what a legal fence is in that particular state.  Sometimes, a statewide requirement applies.  In other jurisdictions, an individual county can set the legal fence requirements.  Generally, the fence viewers can require the parties to build only what is a legal fence in the county. They cannot require a higher-quality fence.   In many states, a legal fence is a barbed wire fence that meets certain specifications, but a legal fence may also be of another type such as posts and rails; post and palings; posts and planks; palisades; stone; post and wires; turf; and electric wire.  State (and/or local) law can be rather detailed on the requirements for a legal fence. 

Escaped Animals – Liability

In general.  In fence-in jurisdictions, if livestock escape through an owner’s faulty fence, the owner is liable for any resulting damages.  However, if the fence is in good shape, the livestock owner is generally not liable absent a showing of negligence.  Evidence of negligence includes such things as gates having been left open, the fence being improperly constructed or maintained, knowledge that the animals were in heat requiring a stronger enclosure or a closer watch, or knowledge that the animals were outside their enclosure and the owner made no attempt to return them. 

The same rules apply when livestock wander onto a public roadway and cause injury to a motorist. In most fence-in jurisdictions, the animal’s owner must be shown to have been negligent.  However, some fence-in jurisdictions apply the doctrine of res ipsa loquitor in livestock/automobile collision cases. The doctrine is a procedural technique that can be used to shift the burden of proof to the livestock owner. In other words, if the doctrine were applied and its elements satisfied, the animal owner would have to prove that owner was not negligent for failing to keep the animal enclosed.

Distraint. If a neighbor’s animals trespass onto an adjoining property owner’s land and the adjoining property owner’s land is lawfully fenced, the adjoining owner may have a right to distrain the animals.  State law often allows a landowner that has been damaged by trespassing livestock to retain the trespassing animals until payment has been made for the damages and the reasonable cost of distraint.  The livestock owner must be notified within a certain timeframe of distraint being utilized.  If the owner can’t be found, a common requirement is that the local sheriff is to be notified.  Once notice is given, the animals can only be held for a few days without bringing legal action against the livestock owner to recover the damages incurred.  As an alternative, many states will allow for the sheriff to be summoned to retrieve the livestock, hold them in custody and dispose of them in accordance with state law procedures.  

What About Railroad Fences?

Typically, landowners do not have any responsibility to build or maintain railroad fences. Instead, railroads are responsible for damages caused to animals that are hit by a train regardless of whether they were negligent or not.  Livestock owners do not have to establish that the railroad was negligent.  However, the liability of a railroad can be waived by the adjacent owner by contract.  But, railroads can avoid liability if they enclose their tracks with a lawful fence. Adjacent landowners can require the railroad to enclose its right-of-way with either a lawful fence or a hog-tight fence, but cannot require the railroad to maintain an electric fence.  If the railroad fails to fence-off its right-of-way, state law often provides a procedure for landowners to follow in getting such a fence built.  Issues can also arise, however, when railroads abandon lines.

Public Roads Through Private Pastures

In states from the Great Plains to points further west, it is possible that a public road may exist through a privately-owned pasture by authorization of the public officials.  In other words, a gate and fence could be authorized to be placed over and across certain public roads, but it couldn’t be authorized to be locked to prohibit general public access to the road.  In these situations, the road can be either auto-gated or cattle-guarded. If a gate is used and is left open, criminal penalties can apply. 

Responsibility for Highway Fences

In some states, it is conventional to expect landowners to build highway fences. Other states have resolved the issue by placing a common law duty on the state highway commission or department of transportation the non-delegable responsibility to keep the highways in a reasonably safe condition.


Fences can create numerous legal issues for farmers, ranchers and rural landowners.  Unfortunately, some of those issues can escalate such that a lawyer trained in agricultural fence law issues becomes necessary. 

November 19, 2019 in Civil Liabilities | Permalink | Comments (1)

Thursday, November 14, 2019

Groundwater Discharges of Pollutants and the Supreme Court


In Tuesday’s post,, I discussed the three U.S. Circuit Court of Appeal decisions from 2018 involving groundwater discharges of pollutants and the Clean Water Act (CWA).  The courts reached opposite conclusions on the issue of whether a CWA permit is required when pollutants originate from a point source but are conveyed to navigable waters by a nonpoint source, such as groundwater.  Last week the U.S. Supreme Court heard oral arguments in the one case of the three decisions mentioned above from 2018. 

The Court’s decision will be of monumental importance to agriculture.  In today’s post, I take a look at last week’s oral argument and explain why agriculture should care.

Framing the Issue

In Tuesday’s post, I laid out the basic requirements of the discharge permit requirements of the CWA.  To restate, the CWA requires a National Pollutant Discharge Elimination System (NPDES) permit for the discharge of pollutants into the navigable waters of the United States (WOTUS) “from” a point source.  The CWA (and the underlying regulations) defines a “point source” as a “discernable, confined, and discrete conveyance[s].”  Discharges not fitting within that definition are nonpoint source discharges and are primarily left up to the states to regulate.  The CWA also states that a “navigable” water is contained in a WOTUS, but groundwater is not. 

In the case presently before the Supreme Court, Hawaii Wildlife Fund v. County of Maui, 881 F.3d 754 (9th Cir. 2018), pet. for cert. granted sub. nom., County of Maui v. Hawaii Wildlife Fund, 139 S. Ct. 1164 (2019), treated wastewater from injection wells ultimately commingled with groundwater and dispersed in a manner that caused at least some of it to flow into the Pacific Ocean in a dispersed manner with no identifiable discharge point.  This had been known to occur since at least 1973 and no federal permit had ever been required.  An environmental group sued, and the trial court granted summary judgment to the group, finding that the indirect discharge of a pollutant into the ocean through a “groundwater conduit” constituted a point source of pollution, and that the CWA classifies groundwater as a “navigable water.”  The U.S. Court of Appeals for the Ninth Circuit affirmed.  The U.S. Supreme Court agreed to hear the case to clear up conflicting opinions on the issue by the Circuit Courts. 

What Does “From” Mean?

Boiled down to its essence, the case turns on the meaning of “from.”  As noted above, an NPDES permit is required for point source pollutants – those that originate “from” a point source that are discharged into a navigable water.  But what if the pollutant originates from a point source, travels through groundwater, and then later reaches a WOTUS?  Does the permit requirement turn on a direct discharge into a WOTUS, or simply a discharge that originated at a point source that ultimately ends up in a WOTUS?  Clearly, the wells at issue in the case are point sources – on that point all agree.  But, what about discharges from the wells that aren’t directly into a WOTUS?  Are indirect discharges into a WOTUS via groundwater (which is otherwise exempt from the NPDES) subject to the permit requirement?

At oral argument last week, the federal Environmental Protection Agency (EPA) took the position that discharges into groundwater are excluded from the NPDES permit requirement. The defendant county also pointed out that the CWA distinguishes point source and nonpoint source pollution, and that including indirect discharges into a WOTUS via groundwater would eliminate that distinction and expose countless businesses (and, I would add, farmers) to fines of $50,000 per day based on an “after-the-fact” traceability analysis (i.e., whether the pollutant can be traced from a navigable water back to the point source).  Justice Breyer along with Justice Kagan and Chief Justice Roberts seemed to reject the county’s rationale.  But Justice Alito posited an example of a homeowner with a septic tank whose contents ended up in discharging into a WOTUS.  Justices Breyer, Kavanaugh, Gorsuch and Chief Justice Roberts joined Justice Alito in expressing concern about the potential impact on such a homeowner.  They seemed to reject the environmental group’s traceability test and/or proximate cause tests.  Justice Breyer pointed out that “virtually every little drop of rain that falls finds its way to the sea” and that scientists are “geniuses” who “can trace all kinds of things.”  Justice Kavanaugh expressed concern that if the position of the environmental group were adopted that the CWA’s regulatory balance between the federal government and the various states would be severely (if not entirely) tilted in the federal government’s favor. 

Implications for Agriculture

The case is very important to agriculture because of the ways that a pollutant can be discharged from an initial point and ultimately reach a WOTUS.  For example, the application of manure or commercial fertilizer to a farm field either via surface application or via injection could result in eventual runoff of excess via the surface or groundwater into a WOTUS.  No farmer can guarantee that 100 percent of a manure or fertilizer application is used by the crop to which it is applied and that there are no traces of the unused application remaining in the soil.  Likewise, while organic matter decays and returns to the soil, it contains nutrients that can be conveyed via stormwater into surface water.  The CWA recognizes this and contains an NPDES exemption for agricultural stormwater discharges. But, if the Supreme Court decides in favor of the environmental group, the exemption would be removed, subjecting farmers (and others) to onerous CWA penalties unless a discharge permit were obtained - at a cost estimated to exceed $250,000 (not to mention time delays).

What about farm field tile drainage systems?  Seemingly, such systems would make it easier for “pollutants” to enter a WOTUS.  Such drainage systems are prevalent in the Midwest and other places, including California’s Central Valley.  Should the law discourage agricultural drainage activities?  Thus, a ruling upholding the environmental group’s position would dramatically change agricultural production.  In addition, while large operations would be better positioned to absorb the increased cost of production activities, many mid and small-sized operations would not be able to adjust based simply on the economics involved. 


What the case boils down to is whether the addition of a pollutant to groundwater that eventually reaches a WOTUS requires an NPDES permit.  If so, an NPDES permit would be required whenever any type of seepage to groundwater might occur that could reach a WOTUS.  That result is virtually always present with common agricultural practices, and an NPDES permit requirement for common agricultural husbandry practices would be most disruptive to food production in the United States.  There is a reason that the Congress left the regulation of nonpoint source pollution up to the states rather than create a blanket rule requiring an NPDES permit in practically all situations.  There is also a reason that Congress created an exemption for agricultural stormwater.  Are those reasons legitimate?  Do public policy concerns now override them?

In addition, a ruling in favor of the environmentalist group would certainly raise the issue of how the regulatory bureaucracy would administer such a massive expansion of the NPDES.

To agriculture, the definition of “from” is suddenly very important.   Sometime next year, the “word peddlers” will tell us what it means.

November 14, 2019 in Environmental Law | Permalink | Comments (0)

Tuesday, November 12, 2019

Does a Pollutant Discharge From Groundwater Into a WOTUS Require a Federal Permit?


Under the Clean Water Act (CWA), a National Pollution Discharge Elimination System (NPDES) permit is required to discharge a “pollutant” from a point source into the “navigable waters of the United States” (WOTUS).  Clearly, a discharge directly into a WOTUS is covered.  But, is an NPDES permit necessary if the discharge is directly into groundwater which then finds its way to a WOTUS?  Are indirect discharges from groundwater into a WOTUS covered?   If so, does that mean that farmland drainage tile is subject to the CWA and an NPDES discharge permit is required?  The federal government has never formally taken that position, but if that’s the case it’s a huge issue for agriculture. 

Last week the U.S. Supreme Court heard arguments in a case involving these issues.  The Court’s decision will have very significant implications for agriculture. 

CWA Discharge Permit Basics

The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation.  Under the CWA, point source pollution is the concern of the federal government.  Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field.  Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.

Under 1977 amendments, tile drainage systems were exempted from CWA regulation via irrigation return flows.  See, e.g., Pacific Coast Federation of Fishermen’s Associations, et al. v. Glaser, et al., No. CIV S-2:11-2980-KJM-CKD, 2013 U.S. Dist. LEXIS 132240 (E.D. Cal. Sept. 16, 2013).  They aren’t considered to be point sources.  In addition, several courts have held that the NPDES system only applies to discharges of pollutants into surface water.  These courts have held that discharges of pollutants into groundwater are not subject to the NPDES permit

requirement even if the groundwater is hydrologically connected to surface water.  See, e.g., Umatilla Water Quality Protective Association v. Smith Frozen Foods, 962 F. Supp. 1312 (D. Ore. 1997); United States v. ConAgra, Inc., No. CV 96-0134-S-LMB, 1997 U.S. Dist. LEXIS 21401 (D. Idaho Dec. 31, 1997).  Likewise, in another case, the court determined that neither the CWA nor the EPA covered groundwater solely on the basis of a hydrological connection with surface water.  Village of Oconomowoc Lake v. Dayton Hudson Corporation, 24 F.3d 962 (7th Cir. 1994), cert. denied, 513 U.S. 930 (1994).  See also Rice v. Harken Exploration Co., 250 F.3d 264 (5th Cir. 2001); Cape Fear River Watch v. Duke Energy Progress, Inc., 25 F. Supp. 3d 798 (E.D. N.C. 2014).

But, other courts have taken a different view, finding that the CWA covers pollution discharges irrespective of whether the discharge is directly into a WOTUS or indirectly via groundwater with some sort of hydrological connection to a WOTUS.   See, e.g., Idaho Rural Council v. Bosma, 143 F. Supp. 2d 1169 (D. Idaho 2001); Northern California River Watch v. Mercer Fraser Co., No. 04-4620 SC, 2005 U.S. Dist. LEXIS 42997 (N.D. Cal. Sept. 1, 2005); United States v. Banks, 115 F.3d 916 (11th Cir. 1997), cert. denied, 522 U.S. 1075 (1998); Mutual Life Insurance Co. of New York v. Mobil Corp., No. 96-CV-1781 (RSP/DNH), 1998 U.S. Dist. LEXIS 4513 (N.D. N.Y. Mar. 31, 1998).

2018 Cases

Ninth Circuit case.  Three different U.S. Circuit Courts of Appeal decided cases on the discharge from groundwater issue.  In the first case, Hawai’i Wildlife Fund v. County of Maui, 881 F.3d 754 (9th Cir. 2018), the defendant owned and operated four wells at the Lahaina Wastewater Reclamation Facility (LWRF), which is the principal municipal wastewater treatment plant for a city. Although constructed initially to serve as a backup disposal method for water reclamation, the wells became the defendant’s primary means of effluent disposal into groundwater and, ultimately, the Pacific Ocean. The LWRF received approximately 4 million gallons of sewage per day from a collection system serving approximately 40,000 people. That sewage is treated at LWRF and then either sold to customers for irrigation purposes or injected into the wells for disposal.

The defendant injected approximately 3 to 5 million gallons of treated wastewater per day into the groundwater via its wells.  The defendant conceded, and its expert confirmed that wastewater injected into wells 1 and 2 enters the Pacific Ocean. In addition, in June 2013 the EPA, the Hawaii Department of Health, the U.S. Army Engineer Research and Development Center, and researchers from the University of Hawaii conducted a study on wells 2, 3 and 4. The study involved placing tracer dye into Wells 2, 3, and 4, and monitoring the submarine seeps off Kahekili Beach to see if and when the dye would appear in the Pacific Ocean. This study, known as the “Tracer Dye Study,” found that 64 percent of the treated wastewater from wells 3 and 4 discharged into the ocean. The plaintiff sued, claiming that the defendant was in violation of the Clean Water Act (CWA) by discharging pollutants into navigable waters of the United States without a CWA National Pollution Discharge Elimination System (NPDES) permit. The trial court agreed, holding that an NPDES permit was required for effluent discharges into navigable waters via groundwater.

On appeal, the appellate court held that the wells were point sources that could be regulated through CWA permits despite the defendant’s claim that an NPDES permit was not required because the wells discharged only indirectly into the Pacific Ocean via groundwater. Specifically, the appellate court held that “a point source discharge to groundwater of “more than [a] de minimis” amount of pollutants that is “fairly traceable from the point source . . . such that the discharge is the functional equivalent of a discharge into a navigable water” is regulated under the CWA.” The appellate court reached this conclusion by citing cases from other jurisdictions that determined that an indirect discharge from a point source into a navigable water requires an NPDES discharge permit. The defendant also claimed that its effluent injections are not discharges into navigable waters, but rather were disposals of pollutants into wells, and that the CWA categorically excludes well disposals from the permitting requirements. However, the appellate court held that the CWA does not categorically exempt all well disposals from the NPDES requirements because doing so would undermine the integrity of the CWA’s provisions. Lastly, the defendant claimed that it did not have fair notice because the state agency tasked with administering the NPDES permit program maintained that an NPDES permit was unnecessary for the wells. However, the appellate court held that the agency was actually still in the process of determining if an NPDES permit was applicable. Thus, the appellate court found the lack of solidification of the agency’s position on the issue did not affirmatively demonstrate that it believed the permit was unnecessary as the defendant claimed. Furthermore, the court held that a reasonable person would have understood the CWA as prohibiting the discharges, thus the defendant’s due process rights were not violated. 

EPA seeks input.  After the Ninth Circuit issued its opinion, the EPA, on February 20, 2018, requested comment on whether pollutant discharges from point sources that reach jurisdictional surface waters via groundwater may be subject to Clean Water Act (“CWA”) regulation. Specifically, the EPA sought comment on whether the EPA should consider clarification or revision of previous EPA statements regarding the Agency’s mandate to regulate discharges to surface waters via groundwater under the CWA.  Some courts have taken the view that Congress intended the CWA to regulate the release of pollutants that reach “waters of the United States” regardless of whether those pollutants were first discharged into groundwater. However, other courts, have taken the view that neither the CWA nor the EPA’s definition of waters of the United States asserts authority over groundwater based solely on a hydrological connection with surface waters. EPA has not stated that CWA permits are required for pollutant discharges to groundwater in all cases. Rather, EPA’s position has been that pollutants discharged from point sources that reach jurisdictional surface waters via groundwater or other subsurface flow that has a direct hydrologic connection to the jurisdictional water may be subject to CWA permitting requirements. As part of its request, the EPA sought comment by May 21, 2018, on whether it should review and potentially revise its previous positions. In particular, the EPA sought comment on whether it is consistent with the CWA to require a CWA permit for indirect discharges into jurisdictional surface waters via groundwater. The EPA also sought comment on whether some or all of such discharges are addressed adequately through other federal authorities, existing state statutory or regulatory programs or through other existing federal regulations and permit programs.

Fourth Circuit case.  Approximately two months after the Ninth Circuit issued its opinion, the Fourth Circuit issued its opinion in Upstate Forever, et al. v. Kinder Morgan Energy Partners, LP, et al., 887 F.3d 637 (4th Cir. 2018)The plaintiffs, a consortium of environmental and conservation groups, brought a citizen suit under the CWA claiming that the defendant violated the CWA by discharging “pollutants” into the navigable waters of the United States without a required discharge permit via an underground ruptured gasoline pipeline owned by the defendant’s subsidiary. The plaintiff claimed that a discharge permit was needed because the CWA defines “point source pollutant” (which requires a discharge permit) as “any discernible, confined and discrete conveyance, included but not limited to any…well…from which pollutants are or may be discharged.”  The trial court dismissed the plaintiffs’ claim for lack of standing.

On appeal, the appellate court determined that the trial court did have subject matter jurisdiction under the CWA’s citizen suit provision because the provision covered the discharge of “pollutants that derive from a ‘point source’ and continue to be ‘added’ to navigable waters.” Thus, even though the pipeline was no longer releasing gasoline, it continues to be passing through the earth via groundwater and continued to be discharged into regulable surface waters. This finding was contrary to the trial court’s determination that the court lacked jurisdiction because the pipeline had been repaired and because the pollutants had first passed through groundwater. As such, the appellate court determined that, in accord with the Second and Ninth Circuits, that a pollutant can first move through groundwater before reaching navigable waters and still constitute a “discharge of a pollutant” under the CWA that requires a federal discharge permit. The discharge need not be channeled by a point source until reaching navigable waters that are subject to the CWA.  It is sufficient, the appellate court reasoned, that the discharge of pollutants from a point source through groundwater have a direct hydrological connection to navigable waters of the United States. 

The appellate court did, however, point out that a discharge into groundwater does not always mean that a CWA discharge permit is required. A permit in such situations is only required if there is a direct hydrological connection between groundwater and navigable waters. In the present case, however, the appellate court specifically noted that the pipeline rupture occurred within 1,000 feet of the navigable waters. The appellate court also noted that the defendant had not established any independent or contributing cause of pollution. 

Sixth Circuit Case

In the fall of 2018, the Sixth Circuit decided Tennessee Clean Water Network v. Tennessee Valley Authority, 905 F.3d 436 (6th Cir. 2018).  The case involved a utility that burned coal to produce energy.  As a part of that production process, coal ash is produced.  The coal ash is discharged into man-made ponds. The plaintiffs, environmental activist groups, claimed that the chemicals from the coal ash in the ponds leaked into surrounding groundwater where it was then carried to a nearby lake that was subject to regulation under the Clean Water Act (CWA). They claimed that the contamination of the lake without a discharge permit violated the CWA and the Resource Conservation and Recovery Act (RCRA).

The trial court had dismissed the RCRA claim but the appellate court reversed that determination and remanded the case on that issue. On the CWA claim, the trial court ruled as a matter of law that the CWA applies to discharges of pollutants from a point source through groundwater that is hydrologically connected to navigable waters where the connection is "direct, immediate, and can generally be traced." The trial court held that the defendant’s facility was a point source because it "channel[s] the flow of pollutants . . . by forming a discrete, unlined concentration of coal ash," and that the Complex is also a point source because it is "a series of discernible, confined, and discrete ponds that receive wastewater, treat that wastewater, and ultimately convey it to the Cumberland River." The trial court also determined that the defendant’s facility and the ponds were hydrologically connected to the Cumberland River by groundwater. As for the defendant’s facility, the court held that "[f]aced with an impoundment that has leaked in the past and no evidence of any reason that it would have stopped leaking, the Court has no choice but to conclude that the [defendant’s facility] has continued to and will continue to leak coal ash waste into the Cumberland River, through rainwater vertically penetrating the Site, groundwater laterally penetrating the Site, or both." The trial court determined that the physical properties of the terrain made the area “prone to the continued development of ever newer sinkholes or other karst features." Thus, based on the contaminants flowing from the ponds, the court found defendant to be in violation of the CWA. The trial court also determined that the leakage was in violation of the defendant “removed-substances” and “sanitary-sewer” overflow provisions.

The trial court ordered the defendant to "fully excavate" the coal ash in the ponds (13.8 million cubic yards in total) and relocate it to a lined facility. On further review, the appellate court reversed. The appellate court held that the CWA does not apply to point source pollution that reaches surface water by means of groundwater movement. The appellate court rejected the plaintiffs’ assertion that mere groundwater is equivalent to a discernable point source through which pollutants travel to a CWA-regulated body of water. The appellate court noted that, to constitute a “conveyance” of groundwater governed by the CWA, the conveyance must be discernible, confined and discrete. While groundwater may constitute a conveyance, the appellate court reasoned that it is neither discernible, confined nor discrete. Rather, the court noted that groundwater is a “diffuse medium” that “seeps in all directions, guided only by the general pull of gravity. Thus, it [groundwater] is neither confined nor discrete.” In addition, the appellate court noted that the CWA only regulates pollutants “…that are added to navigable waters from any point source.” In so holding, the court rejected the holdings of the Ninth and Fourth Circuits from earlier in 2018.

EPA interpretive statement.  After receiving over 50,000 comments, on April 15, 2019, the EPA issued an interpretive statement concluding that the releases of pollutants to groundwater are categorically excluded from the NPDES regardless of whether the groundwater is hydrologically connected to surface water.  The EPA reasoned that the Congress explicitly left regulation of groundwater discharges to the states and that the EPA had other statutory authorities through which to regulate groundwater other than the NPDES.  The EPA, in its statement, noted that its interpretation would apply in areas not within the jurisdiction of the U.S. Circuit Courts of Appeal for the Ninth and Fourth Circuits. 


Earlier this year, the U.S. Supreme Court agreed to hear the Ninth Circuit opinion.  Last week, the Court heard oral arguments in the case.  The specific question before the Court is whether the CWA requires a permit when pollutants originate from a point source but are conveyed to navigable waters by a nonpoint source, such as groundwater.  The EPA, in its April 15, 2019, interpretive statement stated that once the U.S. Supreme Court issues its opinion in the matter that the EPA may take further action, if necessary.

How the Supreme Court answers the question has critical implications for agriculture.  In Thursday’s post, I will review the oral argument and the implications for agriculture. 

November 12, 2019 in Environmental Law | Permalink | Comments (0)

Friday, November 8, 2019

Ag Law In The Courts


This month’s installment of legal developments in the courts involving agriculture features odors, estate planning and a farm program regulation. Farmers, ranchers, rural landowners and agribusinesses sometimes find themselves in disputes with other private parties or state or federal government agencies.  Once a month I try to feature a several developments that illustrate the problems that can arise and how they are resolved.

The November installment of ag law in the courts – that’s the focus of today’s post.

The Case of the Obnoxious Odors

Agricultural production operations and ag businesses sometimes produce offensive odors (at least to some).  While neighbors might complain and state and local governments may try to regulate, the question is really one of the relative degree of offensiveness.

In Chemsol, LLC, et al. v. City of Sibley, 386 F. Supp. 3d 1000 (N.D. Iowa 2019), the plaintiffs owned and operated a milk drying facility. Allegations arose that the facility made the local town, the defendant in the case, smell like “rotten eggs, dried blood, rotten animal carcasses (boiling, burning and decomposing), vomit, human waste and dead bodies.” The defendant enacted an odor ordinance in 2013 which prohibited the creation or maintenance of a nuisance," and defined nuisance to include "offensive smells.”  The ordinance barred the following:  “The erecting, continuing or using of any building or other place for the exercise of any trade, employment or manufacture which, by occasioning noxious exhalations, offensive smells or other annoyances, becomes injurious and dangerous to the health, comfort or property of individuals or the public.” In 2015 the town increased the penalties for violating the ordinance from $100 per offense to $750 for a "first offense," and $1,000 for repeated violations. In 2016, the ordinance was amended to clarify that: "[N]uisance" shall mean whatever is injurious to health, indecent, or unreasonably offensive to the senses, or an obstruction to the free use of property, so as essentially to interfere unreasonably with the comfortable enjoyment of life or property. *** Offensive Smells: The erecting, continuing or using of any building or other place for the exercise of any trade, employment or manufacture which, by occasioning unreasonably noxious exhalations, unreasonably offensive smells or other unreasonable annoyances, becomes injurious and dangerous to the health, comfort or property of individuals or the public.” (emphasis added).

From 2012 to 2016 the plaintiffs did not receive any citations under the odor ordinance. In 2016 the plaintiffs began receiving citations but didn’t pay or appeal the associated fines. Abatement of the nuisance was negotiated, but the odors problems persisted. The plaintiffs received 36 citations in 2016 (16 before the abatement hearing and 20 after), four citations in 2017 and one citation in 2018. The plaintiffs chose to reduce odors by drying less product. The plaintiffs sued on the basis that the ordinance violated their due process by causing them to lose business and become unable to sell the business due to bad publicity. The plaintiffs also alleged a constitutional taking had occurred and that the town had tortuously interfered with business operations. The defendant moved for summary judgment and the court agreed.

The court noted that the plaintiffs did not build the plant on any promise or assurance that the defendant would not be enact such an ordinance, and it was within the defendant’s jurisdiction to enact such an ordinance for a facility within the defendant’s limits. The court also determined that the ordinance did not rise to a regulatory taking because economic use of the plaintiffs’ property remained. The court also concluded that the defendant did not act improperly in enforcing the ordinance or in speaking to potential buyers. 

The Case of Crop Insurance Coverage Computation

Under the crop insurance program of the 2014 Farm Bill, crop insurance coverage for low yield losses was to be determined based on actual production history (APH). However, APH is determined by excluding abnormally low-yield years in the computation.  In this case, JL Farms v. Vilsack, No. 2:16-cv-02548-CM-GEB, 2019 U.S. Dist. LEXIS 106789 (D. Kan. Jun. 26, 2019), the Risk Management Agency (RMA) determined that the 2015 winter wheat crop was not excludible from the APH. Thus, the insurer did not exclude the 2015 yield data from the plaintiff’s insurance pay-out computation.

On review by the National Appeals Division ("NAD") of the United States Department of Agriculture. The NAD hearing officer determined that the NAD lacked jurisdiction. On further review the NAD Director again determined that the NAD did not have jurisdiction, but that the RMA had discretion to implement the exclusion. The plaintiff then sought judicial review of the RMA’s decision and the NAD Director’s decision of lack of jurisdiction. The trial court determined that the NAD did have jurisdiction over the matter and remanded the matter to the NAD Director for reconsideration of the exclusion of the 2015 wheat crop from the plaintiff’s APH. The trial court also referenced a recent decision by the U.S. Court of Appeals for the 10th Circuit holding that the Congress intended the exclusion to be available for the 2015 crop year (winter wheat planted in 2014). 

The Ruling on the Reformed Trust

Trusts are very popular tools that are used in estate planning.  One of the key benefits is that they provide a great deal of flexibility to adjust to unknown events that might occur in the future.  One way in which that is done is by including a power of appointment in a trust.  A power of appointment gives the holder of the power the ability to direct the assets of the trust in a certain manner and in a certain amount.  Essentially, the power of appointment gives the person that creates the power in someone else the ability to determine how the property will be distributed at some point in the future.  Basically, the power creates the ability to defer deciding the ultimate distribution of trust assets.  For example, assume that a husband dies and leaves property in trust for his surviving wife and their children.  When the surviving spouse dies, the trust specifies that the remaining trust assets are to pass equally to the children, unless the surviving spouse exercises the power of appointment that was included in the husband’s trust.  At the time of the husband’s death, $2 million worth of assets was included in the trust and the couple had two children, each equally situated in life.  However, when the surviving spouse dies years later, perhaps the children aren’t so equally positioned anymore – one is rather well off and the other is struggling.  The exercise of the power of appointment can give the surviving spouse the ability to “unbalance” the disposition of the trust assets and leave more assets to the child with greater needs. 

A general power of appointment is one that is exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate.  I.R.C. §2041(b)(1). It also means a power that is exercisable in favor of the individual possessing the power, his estate, his creditors, or the creditors of his estate.  I.R.C. §2514(c). Generally, the lapse of a power of appointment during the life of the individual who has the power of appointment is a release of the power.  I.R.C. §2041(b)(2)But, this rule only applies to a lapse of powers during any calendar year to the extent that the property which could have been appointed by exercise of such lapsed powers exceeded the greater of $5,000 or 5% of the aggregate value of the assets out of which the exercise of the lapsed powers could have been satisfied.  I.R.C. §§2041(b)(2); 2514(e).  In addition, generally the exercise or release of a general power of appointment is a transfer of property by the individual possessing such power.  I.R.C. §2514(c).  When that occurs, it can result in a taxable gift to the trust and/or inclusion of the assets in the power holder’s estate.  If large dollar values are involved, that can be a disastrous result.

A recent IRS ruling involved a trust that contained a general power of appointment that had been drafted incorrectly.  The question was whether that error could be corrected without triggering gift tax or causing the property to be included in the power holder’s estate.  In Priv. Ltr. Rul. 201941023 (May 29, 2019), the settlor created an irrevocable trust for the benefit of his six children. The purpose of the trust was to provide for his descendants and reduce transfer taxes by keeping trust assets from being included in a primary beneficiary’s gross estate. Under the trust terms, each child had his or her own separate trust (collectively, Children’s Trusts; individually, Child’s Trust). Each child was the primary beneficiary of his or her Child’s Trust.

Unfortunately, the trust had a drafting error pertaining to the withdrawal provision – it didn’t limit the general power of withdrawal right of a primary beneficiary over assets contributed to the trust to the greater of $5,000 or five percent of the value of the trust assets as I.R.C. §2041(b)(2) required. Thus, any lapse of a primary beneficiary’s withdrawal right would be a taxable transfer by that particular primary beneficiary under I.R.C. §2514 to the extent that the property that could have been withdrawn exceeded the greater of $5,000 or five percent of the aggregate value of the assets. Also, the portion of each child’s trust relating to the lapsed withdrawal right that exceeded the greater of $5,000 or five percent of trust asset value would be included in the primary beneficiary’s estate.

A subsequent estate planning attorney discovered the error in the original drafting upon review of the estate plan. Consequently, the trustee sought judicial reformation to correct the drafting error on a retroactive basis, and the court issued such an order contingent on the IRS favorably ruling. The IRS did favorably rule that the reformation didn’t cause the release of a general power of appointment with respect to any primary beneficiary. The purpose of the reformation, the IRS determined, was to correct a scrivenor’s error and did not alter or modify the trust in any other manner.  That meant that none of the children would be deemed to have released a general power of appointment by reason of the lapse of a withdrawal right that they held with respect to any transfer to their trust.  Thus, no child would be deemed to have made a taxable gift to their trust and no part of any child’s trust would be included in any child’s estate. 

Perhaps there is a “kindler and gentler” IRS after all – at least on this point. 


These are just a small snippet of what’s been going on in the courts and IRS recently that can impact agricultural producers and others involved in agriculture.  Each day brings something new. 

November 8, 2019 in Civil Liabilities, Estate Planning, Insurance | Permalink | Comments (0)

Wednesday, November 6, 2019

S Corporation Considerations


Monday’s post discussed some basic estate and business planning considerations for farm and ranch operations.  When an intergenerational transfer of the business is desired, often entity structuring is a part of the design.  Should there be one entity or more than one?  What types of leases should be involved?  What type of entities should be utilized?  What about an S corporation? 

Considerations about the use of S corporations – it’s the topic of today’s post.

S Corporation Issues

Reasonable compensation.  An S corporation shareholder-employee cannot avoid payroll taxes by not being paid a salary.  This is a “hot button” audit issue with the IRS and, fortunately, recent caselaw does provide helpful guidance on how to structure salary arrangements for S corporation shareholder-employees and the methodology that the IRS (and the courts) uses in determining reasonable compensation. While the incentive in prior years has been to drive compensation low and remove corporate earnings in the form of distributions to avoid employment-related taxes, the advent of the qualified business income deduction may incentivize increasing wages in certain situations, the key is to determine an acceptable range for reasonable compensation and stay within it to avoid IRS scrutiny.

Sales of interests.  Obamacare potentially impacts the sale of interests in entities, including S corporations.  Gain on sale might be subject to an additional tax of 3.8 percent if the gain is deemed to be “passive” – not related to a trade or business.  This means that the stockholder selling an interest in an S corporation must be engaged in the business of the S corporation.  There is a somewhat complex procedure that is used to determine the portion of the gain on sale that is passive and the portion that is deemed to be attributable to a trade or business.  In many small, family-run S corporations much of the gain may not be subject to the health care law’s “passive” tax.  That will be the case if all of the assets of the entity are used in the entity’s business operations and the selling owner materially participates in the business.  There are income thresholds that also apply, so if income is beneath that level, then the “passive” tax doesn’t apply in any event.

Redemptions.  If interests are redeemed, the IRS issued a private letter ruling in 2014 that can be helpful in succession planning contexts.   In Priv. Ltr. Rul. 201405005 (Oct. 22, 2013), The facts of the ruling involved a proposed transfer of ownership of an S corporation from two co-equal owners to key employees.  The IRS determined that the profit on the redemption of the co-owners' shares in return for notes would be treated as capital gain in the co-owners' hands and would be spread-out over the term of the notes.  The IRS also said that there would be no gain to the S corporation, and that the S corporation was entitled to a deduction for interest paid on the notes.  Also, the IRS said that the notes did not constitute a disqualifying second class of S corporate stock. To get these results requires careful drafting. 

S corporation stock held by trusts.  Trusts may also be a useful planning tool along with an S corporation as part of an estate/succession plan.  But, while a decedent’s estate can hold S corporate stock for the period of time that the estate needs for reasonable administration, grantor trusts and testamentary trusts can only hold S corporate stock after an S corporation shareholder dies for the two-year period immediately following deathI.R.C. §1361(c)(2)(A).  If that two-year limitation is violated, the S election is terminated, and the corporation is no longer a “small business corporation.” Thus, grantor and testamentary trusts should not hold S corporate stock beyond the two-year period. Clearly, the issue is to make sure the passage of the stock to a trust doesn’t jeopardize the S corporation’s status.  During the time that the decedent’s estate holds the stock, there should be no problem in maintaining S status unless the administration of the estate is unreasonably extended.  Once a testamentary trust is funded, it must take steps to be able to hold the S corporation stock for no more than two years.  After that, the trust must qualify as a trust that is eligible to hold S corporation stock.  The types of trusts that might cause issues with holding S corporate stock include credit shelter trusts (a.k.a. “bypass trusts”), grantor retained annuity trusts (GRATS), dynasty trusts (often structured as grantor trusts), self-settled trusts (a.k.a. domestic asset protection trusts), intentionally defective trusts and insurance trusts.  If the testamentary trust is an irrevocable trust, the trust language will be the key to determining whether the trust can be appropriately modified to hold S corporation stock. 

However, certain types of trusts can own S corporation stock without jeopardizing the S status of the corporation.  Thus, proper structuring of trusts in conjunction with S corporations is critical.  The basic options are a qualified subchapter S trust (QSST) and an electing small business trust (ESBT).   Each of these types of trusts require precise drafting and careful maintenance to ensure that it can hold S corporation stock without causing the S corporation to lose its S status. 

Issues associated with the death of a shareholder.  Upon an S corporation shareholder’s death, the S corporation’s income is typically prorated between the decedent and the successor shareholder.  The proration occurs on a daily basis both before and after death.  Income that is allocated to the pre-death period is reported on the decedent’s final income tax return, and income that is allocated to the post-death period is reported on the successor’s income tax return.  But an S corporation can make an election to divide the S corporation’s tax year into two separate years.  The first of those years would end at the close of the day of the shareholder’s death. 

Drawbacks of S Corporations

While S corporations can be beneficial in the planning process, they do have their drawbacks.  While the following is not intended to be a comprehensive list of the limitations of utilizing S corporations, each of these points needs to be carefully considered.

Limitations on stock ownership.  As indicated above, only certain types of trusts can hold S corporation stock.  Also, corporations (except for Qualified S Corporation Subsidiary Corporations (Q-Subs)), LLCs and partnerships cannot be S corporation shareholders.  In addition, there is an overall limitation on the number of S corporation shareholders (but it’s high enough that it won’t hardly ever cause problems for family-operated S corporations).  But, the limits on trust and entity ownership of S corporation stock could prove to be a limiting factor for estate, business and succession planning purposes.

Special allocations for tax purposes.  An S corporation must allocate all tax items pro rata.  Special allocations are not permitted.  But special allocations are permitted in an LLC or any other entity that has partnership tax treatment.  So, for example, an entity taxed as a partnership can allocate (with some limitations) capital gain or loss as well as ordinary income or loss to those members that can best utilize the particular tax items. The special allocation rule doesn’t just apply to income and loss, it applies to all tax items.  That would include, for example, depreciation items.  An S corporation can’t do special allocations.  This often can be a distinct disadvantage.    

Death-time basis planning.  A partnership (or LLC taxed as a partnership) is allowed to make an I.R.C. §754 election to increase the basis of its assets when a partner’s interest is sold or when a partner dies.  That means that the entity can increase its adjusted tax basis in the entity’s assets so that it matches the basis that a buyer or heir takes.  That would normally be, for example, the step-up (date of death) basis for inherited property.  An S corporation cannot make an I.R.C. §754 election.  Consequently, this can be another tax disadvantage of an S corporation.

Business loans.  Care must be taken here.  A loan to an S corporation can jeopardize the S election.  Also, state laws must be followed, and the IRS likes to characterize loan repayments as distributions that are taxable.  Also, distributions must also generally be pro rata.  There is more flexibility regarding loans to and from the entity for a partnership/LLC.  A corresponding concern with S corporation loans involves accounting issues involving the matching of interest and other income.  The bottom line is that, in general, it’s more cumbersome to make loans to and from an S corporation compared to an LLC/partnership.

Farm programs.  Whenever there is a limitation of liability, the entity involved is limited to a single payment limit.  That would be the case with a farming S corporation.  So, generally, a general partnership is the entity that best maximizes farm program payment limits – there is a limit for each partner.  Each member can hold their interest as an LLC to achieve the liability limitation that an S corporation would otherwise provide, but there wouldn’t be an entity-level limitation.

Asset distribution.  An S corporation has the potential to recognize gain when corporate assets are distributed.  Generally, LLCs don’t have that issue.

Formalities.  The state law rules surrounding formation are more elaborate with respect to S corporations as compared to LLCs. 

Dissolution.  There generally is less tax cost associated with dissolving an LLC as compared to an S corporation. 


S corporations can be a useful estate/succession planning tool.  With the general plan now being one of inclusion of assets in the decedent’s estate, creating a separate entity for the successor generation can provide valuation benefits for the decedent.  However, care must be taken in utilizing the S corporation.  In addition, other entity types (particularly the LLC) can provide greater tax benefits on numerous issues.  There are drawbacks to using an S corporation.  Also, it’s important to remember that with any type of entity planning as part of an estate/succession plan, there is no such thing as “one size fits all.”  As with any type of planning, consultation with experienced professionals is a must.

November 6, 2019 in Business Planning | Permalink | Comments (0)

Monday, November 4, 2019

Some Thoughts on Ag Estate/Business/Succession Planning


Estate, business and succession planning changed dramatically with the enactment of the American Taxpayer Relief Act (ATRA) enacted in early 2013.  The federal estate tax exemption was indexed for inflation and stood at $5.25 million for deaths in 2013.  It adjusted upward for the next few years until the Tax Cuts and Jobs Act (TCJA) was enacted in late 2017 and increased it to $11.18 million for deaths in 2018.  With an adjustment for inflation it presently stands at $11.4 million for deaths (and taxable gifts made) in 2019.  Consequently, very few estates have any concern about the federal estate tax.  The TCJA also made significant changes to the federal income tax.  One significant new provision is the 20 percent pass-through deduction for individuals and entities other than C corporations. 

For those farming and ranching operations that plan to continue in the family from generation to generation, entity planning is often part of the overall business plan.  What are the major points to consider?  There are numerous tax and non-tax considerations. 

Some thoughts on estate and business planning – it’s the topic of today’s post. 

Fundamental Considerations

Basics.  The goal of most individuals and families is to minimize the impact of the federal estate tax at death.  But, as noted above, with the exemption at $11.4 million for 2019 and “portability” of the amount of any unused exclusion at the death of the first spouse for use by the surviving spouse, the estate tax is not an issue except for very few estates.  That means that, for most families, it is an acceptable strategy to cause assets to be included in the decedent’s estate at death to get a basis “step-up.”  Thus, succession plans that have been in existence for a while should be re-examined to ensure consistency with current law.

Buy-out agreement.  For family businesses involving an S corporation, some sort of shareholder buy-out agreement is a practical necessity.  Over time, however, if that agreement is not revisited and modified, the value stated may no longer reflect reality.  In fact, it may have been established when the estate tax was projected to be more of a potential burden than it is now.  The changes to the federal estate tax in recent years may be one reason, by themselves, to reexamine existing buy-sell agreements.

Consider Not Making Gifts of Business Interests.  Historically, transition planning has, at least in part, involved the parents’ generation gifting business interests to the next generation of the family interested in operating the business.  However, there might be a better option to consider.  It may be a more beneficial strategy to have the next generation of operators start their own businesses and ultimately blend the parents’ business into that of the next generation.  Not only does this approach eliminate potential legal liabilities that might be associated with the parents’ business, it also avoids gift tax complications. 

Instructive Cases 

A couple of recent cases provide guidance on this approach and illustrate how goodwill is treated when a business transitions from one generation to the next.  Goodwill is the value of the business beyond the value of the identifiable business assets.  It’s an intangible asset that is often tied to an individual.  Goodwill can be an important aspect of farm and ranch businesses.

In Bross Trucking, Inc. v. Comr., T.C. Memo. 2014-107, a father owned and operated a trucking company as a C corporation.  He was the sole shareholder.  The company got embroiled in some safety issues and ceased operations.  Consequently, the father’s three sons started their own trucking business.  The sons used some of the equipment that had been leased to their father’s business.  The sons had used the same business model and the business had the same suppliers and customers.  Importantly, the father was not involved in the son’s business.  However, the IRS claimed that the father’s corporation should be taxed on a distribution of intangible assets (i.e., goodwill) under I.R.C. §311. That goodwill, the IRS also maintained, had been gifted to the sons.  The Tax Court disagreed, holding that the goodwill was personal to the father and did not belong to the corporation.  Key to this holding was that the father did not have an employment agreement with the corporation and there was no non-compete agreement.  Thus, there was nothing that tied the father’s conduct to the corporation.  The lack of an employment contract or a non-compete agreement avoided the transfer of goodwill that might have been attributable to customer relationships or other corporate rights.  That had the effect of reducing the corporate value, and also reduced its value on liquidation (an important point for C corporations). 

In Estate of Adell v. Comr., T.C. Memo 2014-155, a similar strategy was involved with a favorable result.  In this case, the Tax Court allowed a reduction in value for estate tax purposes by the amount of the executive’s personal goodwill.  The point is that the value of a business is dependent on the contacts and reputation of a key executive.  Thus, a business owner can sell their goodwill separate from the other business assets.  In the case, the decedent owned all of the stock of a satellite uplink company at the time of his death.  Its only customer was a non-profit company operated by the decedent’s son.  The estate and the IRS battled over valuation with the primary contention being operating expenses that included a charge for the son’s personal goodwill – the success of the decedent’s business depended on his son’s personal relationships with the non-profit’s board and the son did not have a non-compete agreement with the father’s business.  Thus, the argument was, that a potential buyer only if the son was retained.   The Tax Court determined that the son’s goodwill was personally owned independent of the father’s company, and the father’s company’s success was tied to the relationship with the son’s business.  In addition, the Tax Court found it important that the son’s goodwill had not been transferred to his father’s business either via a non-compete agreement or any other type of contract.  The ultimate outcome was that the decedent’s estate was valued at about one-tenth of what the IRS initially argued for.    

These cases indicate that customer (and vendor) relationships can be an asset that belongs to the persons that run the businesses rather than belonging to the businesses.  Thus, those relationships (personal goodwill) can be sold (and valued) separately from corporate assets.   That’s a key point in a present estate landscape.  With the general plan to include assets in the estate to get a basis increase rather than gifting those assets away pre-death to the next generation, an entirely separate entity for the next generation of operators can also provide valuation benefits.  Planning via wills and trusts at the death of the parent can then merge the parent’s business with the next generation’s business.

Another case on the issue, involving an S corporation, resulted in an IRS win.  However, the case is instructive in showing the missteps to avoid.  In Cavallaro v. Comr., T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son.  The parents' S corporation developed and manufactured a machine that the son had invented.  The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine.  The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received.  The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value.  The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987.  The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987.  Instead, the lawyers executed the transfer documents in 1995.  The IRS asserted that no technology transfer had occurred, and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid.  The Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million.  On appeal, the appellate court held that the valuation methodology of the expert witness for the IRS contained an error and remanded the case to the Tax Court.  Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016).  On remand, after correcting for the methodological flaw, the Tax Court decreased the gift value by $6.9 million.  Cavallaro v. Comr., T.C. Memo. 2019-144.

The Cavallaro case represents a succession plan gone wrong.  The taxpayers in the case were attempting to transfer the value in their company (which had been very successful) to their children via another family business in a way that minimized tax liability.  As noted above, what was structured was a merger that was based on a fictitious earlier value transfer between the entities.   The IRS claimed that the taxpayers had accepted an unduly low interest in the merged company and their sons had received an unduly high interest.  The Tax Court agreed.


Estate and business planning is a complex process.  There are many considerations that are part of a successful plan.  Today’s post addressed only a few.

November 4, 2019 in Business Planning | Permalink | Comments (0)

Thursday, October 31, 2019

Are Director Fees Subject to Self-Employment Tax?


An interesting question was posed to me at a recent tax seminar.  The question was whether director fees are subject to self-employment tax.  That question comes up because sometimes farmers, ranchers and others receive income for serving as a director of a farming or ranching business, an agricultural cooperative, an ag lender or other organization. 

Whether a director fee is subject to self-employment tax turns on whether the fee constitutes employee wages.  Making that determination turns on the facts and circumstances of the particular situation.

Director fees and self-employment tax – it’s the topic of today’s post.

Self-Employment Tax Basics

A self-employed individual is one who has net earnings from self-employment as defined by I.R.C. §1402(a).  “Net earnings from self-employment” means gross income derived from a trade or business that the taxpayer conducts (less associated deductions).  Id.  But, a “trade or business” for self-employment tax purposes does not include “the performance of services by an individual as an employee.”  I.R.C. §1402(c)(2). 

A corporate director, under the right set of facts, is not a corporate employee.  Treas. Reg. §31.3121(d)-1(b) specifies that, “Generally, an officer of a corporation is an employee of the corporation. However, an officer of a corporation who as such does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is considered not to be an employee of the corporation. A director of a corporation in his capacity as such is not an employee of the corporation.”

On the self-employment tax issue, the IRS ruled in 1972, that director fees are self-employment income subject to self-employment tax.  Rev. Rul. 72-86, 1972-1 CB 273.  That is certainly the case if a “director” performs no services for the corporation.  But, what if some services are provided?  When does a “director” cross the line and grade over into “employee” status with payments received constituting wages?  If the fees constitute “wages” they aren’t subject to self-employment tax and there could be other implications. 

The Blodgett case

In Blodgett v. Comr., T.C. Memo. 2012-298, the petitioner served on a local bank board.  The board operated independently and represented members of the community that owned the bank.  The board supervised bank management but did not participate in daily bank operations. The bank provided liability coverage, life and disability insurance and retirement benefits, but not health insurance to the board members.  The petitioner was also vested in the bank’s retirement plan for board members.  He put in less than five hours a week on board member business and did not hold himself out as a contractor and did not claim any tax deductions for business expenses because the bank paid all expenses.  The bank issued him a Form 1099-MISC, Miscellaneous Income, reporting "nonemployee compensation" of $26,750 for his services.  He reported the amount on line 21 of his return as “other income” not subject to self-employment tax.  The IRS disagreed, asserting that the income was attributable to work the petitioner performed as an independent contractor and that self-employment tax was owed. 

The Tax Court agreed with the IRS and analyzed the facts based on a seven-factor test.  Those factors, set forth in Weber v. Comr., 103 T.C. 378 (1994), are: (1) extent of control maintained by the bank; (2) responsibility for providing work facilities; (3) the opportunity for the trustee to receive a profit or loss; (4) the ability of the bank to fire the trustee; (5) the trustee duties as part of the bank’s regular business activities; (6) the permanency of the bank-trustee relationship; and (7) the intent of the bank-trustee relationship.

Here's how the factors shook out in Blodgett:

Factors favoring employee status:

  • The bank provided the trustees with meeting rooms, office supplies, and other items necessary to fulfill their duties.
  • The trustees were paid for attending board meetings and did not have additional opportunities for profit or loss.
  • The petitioner had been reelected to his position for more than 10 consecutive three-year terms, but bank management was appointed for one-year terms.

Factors favoring nonemployee status:

  • The board of trustees operated independently from the bank’s management and were not subject to any meaningful control by the bank.
  • Only corporate members could terminate the trustees, and then only on a limited basis including by a vote of the members.
  • The trustees’ duties were primarily related to oversight with no involvement in daily bank operations.
  • Evidence showed that the bank had no intent to create and employer-employee relationship with the trustees and issued Forms 1099-Misc. instead of Forms W-2 to all of the trustees.

The court didn’t simply stack up the factors and see whether a majority of them favored employee or nonemployee status.  Instead, the court placed the most weight on how much control the bank exercised over the trustees and determined that the trustees were not employees and that self-employment tax was owed. 

The Burbach Case

In Burbach v. Comr., T.C. Memo. 2019-17, the petitioner was an engineer whose LLC business involved working with towns to determine the need for a public pool.  If it was determined that a pool had merit, the petitioner would plan and market the pool and organize fundraising for the construction of the pool.  Ultimately, he changed his business form from an LLC to two corporations – one to hold the operating assets of the business and another corporation to hold real estate.  With help from his tax advisor, the petitioner established a self-employed pension plan.  He funded the plan by taking “director fees” out of the operating entity which he then deposited into his personal checking account with subsequent transfers to his pension account.  He reported the director fees on Schedule C and claimed an offsetting deduction for the contributions to his self-employed retirement plan. 

The facts got tangled with respect to late-filed corporate returns and ultimately it was determined that the pension plan needed to be an employer-sponsored plan run through the operating entity because it had employees and also because all the compensation on which plan contributions were based was W-2 compensation that the corporation paid to the petitioner as an employee.  The plan was corrected retroactively with the operating entity as the plan sponsor including all eligible employees in the plan and including the amounts the petitioner received as director fees for plan purposes. 

The parties settled on the plan qualification issues, but the IRS claimed that the director fees the petitioner received were wages as remuneration for employee services.  As wages, the IRS argued, the petitioner couldn’t claim I.R.C. §404 pension plan deductions because he had no self-employment income. 

The Tax Court agreed with the IRS for the following reasons:

  • The petitioner was the operating entity’s sole shareholder and was involved hands-on in the company’s daily affairs.
  • While the petitioner was the operating entity’s only director, there was no evidence that he provided any director services. Instead, the services provided involved daily decisions concerning engineering, project management and marketing.
  • The petitioner had represented to the IRS when he and the operating entity applied for a compliance statement for the pension plan that he was providing services that were essentially employee services.

Consequently, the petitioner had no earnings from self-employment and I.R.C. §404(a)(8) barred him from claiming any deductions for contributions he had made to his Keogh-type pension plan for the tax years at issue.  Instead, he was an “employee” within the meaning of I.R.C. §401(c)(1) and the operating entity was his “employer” under I.R.C. §401(c)(4) by virtue of I.R.C. §404(a)(8). 

Note that the outcome in Burbach was different that the typical outcome with respect to directors’ fees.  While it’s a facts and circumstances determination, most often those facts indicate that directors’ fees are self-employment income.  Had that been the case in Burbach, the petitioner, as a corporate director, could have established a Keogh plan based on those fees.  See, e.g., I.R.C. §3121(d)(1); Treas. Reg. §31.3121(d)-1(b).  However, the petitioner provided more than minor services and was classified as an employee whose director fees were classified as wages. 


It’s not uncommon in rural areas for farmers, ranchers and others to serve on various corporate boards for which compensation is received.  It’s important to properly report the director fee income on the return.  That will turn on the classification of the relationship of the taxpayer to the entity involved.  Facts and circumstances of each situation are critical.  If the taxpayer is deemed to be an independent contractor with self-employment income, perhaps there are associated costs that can be deducted to help offset the income and self-employment tax.  Likewise, it may be possible to establish a pension plan.  But the facts must support the classification desired.

October 31, 2019 in Income Tax | Permalink | Comments (0)

Tuesday, October 29, 2019

Does the Sale of Farmland Trigger Net Investment Income Tax?


One of the new taxes created under Obamacare is a 3.8 percent tax on passive sources of income of certain individuals.  It’s called the “net investment income tax” and it took effect in January of 2013.  Its purpose was to raise about half of the revenue needed for Obamacare.  It’s a complex tax that can surprise an unsuspecting taxpayer – particularly one that has a one-time increase in investment income (such as stock).  But it can also apply to other sources of “passive” income, such as income that is triggered upon the sale of farmland.

But are farmland sales always subject to the additional 3.8 percent NIIT?  Are there situations were the sale won’t be subject to the NIIT?  These questions are the topic of today’s post.


The NIIT is 3.8% of the lesser of (1) net investment income (NII); or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). I.R.C. §1411.  The threshold amount is not indexed for inflation.  For this purpose, MAGI is defined in Treas. Reg. §1.1411-2(c)(2).  For an estate or trust, the NIIT is 3.8% of the lesser of (1) undistributed NII; or (2) the excess of AGI (as defined in I.R.C. §67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($12,750 for 2019).  I.R.C. §1411(a)(2).   

What is NII? For purposes of the NIIT, net investment income (NII) is gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NII tax doesn't apply. I.R.C. §1411(c)(1)(A)(i).  If the taxpayer either owns or is engaged in a trade or business directly or indirectly through a disregarded entity, the determination of character of income for NIIT purposes is made at the individual level.  Treas. Reg. §1.1411-4(b)(1).  If the income, gain or loss traces to an investment of working capital, it is subject to the NIIT.  I.R.C. §1411(c)(3).  Also, the NIIT applies to business income if the trade or business at issue is a passive activity.  I.R.C. §1411(c)(2)(A). But, if income is subject to self-employment tax, it’s not NII subject to the NIIT.  I.R.C. §1411(c)(6)

Sale of Farmland and the NIIT

Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of I.R.C. §469

If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales – the I.R.C. §469(f)(3) approach and the I.R.C. §469 approach

I.R.C. §469(h)(3) approach.  I.R.C. §469(h)(3) provides that “a taxpayer shall be treated as materially participating in any farming activity for a taxable year if paragraph (4) or (5) of I.R.C. §2032A(b) would cause the requirements of I.R.C. §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died during the taxable year.” The requirements of I.R.C. §2032A(b)(1)(C)(ii) are met if the decedent or a member of the decedent’s family materially participated in the farming activity five or more years during the eight years preceding the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the decedent was retired or disabled.  I.R.C. §2032A(b)(4). If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively manages the farming activity when the spouse is not retired or disabled.   I.R.C. §2032A(b)(5).

To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer is continually receiving social security benefits or is disabled; and materially participated in the farming activity for at least five of the last eight years immediately preceding the earlier of death, disability, or retirement (defined as receipt of social security benefits).

The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive social security benefits, the surviving spouse must only actively participate in the farming operation to meet the material participation test. 

“Normal” I.R.C. §469 approach. A counter argument is that I.R.C. §469(h)(3) concerns the recharacterization of a “farming activity,” but not the recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity, §469(h)(3) does not apply and the normal material participation tests under §469 apply. 

What are the material participation tests of I.R.C. §469?  As set forth in Treas. Reg. §1.469-5T, they are as follows:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity  of any other individual (including individuals  who are not owners of interests in the activity) for such year;

(4) The  activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The above tests don’t apply to a limited partner in a limited partnership, and only one of the tests is likely to have any potential application in the context of a retired farmer to determine whether the taxpayer materially participated in the farming activity – the test of material participation for any five years during the ten years preceding the sale of the farmland. 

Clearly, the “normal” approach would cause more  transactions to be subject to NIIT.  It’s also the approach that the IRS uses, and it is likely the correct approach.

Sale of land held in trust.  When farmland that has been held in trust is sold, the IRS position is that only the trustee of the trust can satisfy the material participation tests of §469.   This is an important point because of the significant amount of farmland that is held in trust, particularly after the death of the first spouse, and for other estate and business planning reasons.  However, the IRS position has been rejected by the one federal district court that has ruled on the issue.  Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003).  The IRS did not appeal the court’s opinion, but continued to assert in in litigation in other areas of the country.  In a case from Michigan in 2014, the U.S. Tax Court in a full tax court opinion, rejected the IRS’s position.  Frank Aragona Trust v. Comm’r, 142 T.C. 165 (2014).    The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of non-trustee employees would count toward the material participation test.  The court’s opinion makes it less likely that the NIIT will apply upon trust sales of farmland where an actual farming business is being conducted.


Obamacare brought with it numerous additional taxes.  One of those, the NIIT, applies to passive income of taxpayer’s with income above a certain threshold.  The NIIT can easily be triggered upon sale of particular assets that have been held for investment or other purposes, including farmland.  Some planning may be required to avoid its impact. 


October 29, 2019 in Business Planning, Income Tax | Permalink | Comments (0)

Friday, October 25, 2019

Regulating Existing Water Rights – How Far Can State Government Go?


Water is an important natural resource to agriculture.  In some parts of the country it is more plentiful than it is in other areas.  That relative scarcity has led the legal system to develop, over time, different approaches for the allocation of water rights.  Particularly in the western two-thirds of the U.S. where water is most scarce, water rights are regulated by at the state level.

The state regulation of water rights can have a significant impact on agricultural activities and land values.  But, just how far can a state go in regulating such rights?  How solid is the water right of a farmer or rancher?  It’s a big issue that is looming large in Kansas at the present time.

The state regulation of water rights – it’s the topic of today’s post.

The Prior Appropriation System

Most of the United States west of the 100th Meridian (a longitude line connecting the North and South Poles that runs through Cozad, Nebraska, Dodge City, Kansas that also forms the eastern border of the Texas panhandle with Oklahoma) utilizes the prior appropriation system for purposes of allocating water.  See, e.g., In re Water Rights of Deschutes River and Tributaries, 134 Ore. 623, 286 P. 1049 (1930).  

The prior appropriation system is based on a recognition that water is relatively scarce, and establishes rights to water based on when water is first put to a beneficial use.  The doctrine grants to the individual first placing available water to a beneficial use, the right to continue to use the water against subsequent claimants.  Thus, the doctrine is referred to as a “first in time, first in right” system of water allocation. The oldest water right on a stream is supplied with the available water to the point at which its state-granted right is met, and then the next oldest right is supplied with the available water and so on until the available supply is exhausted.  In order for a particular landowner to determine whether such person has a prior right as against another person, it is necessary to trace back to the date at which a landowner's predecessor in interest first put water to a beneficial use.  The senior appropriator, in the event of dry conditions, has the right to use as much water as desired up to the established right of the claimant to the exclusion of all junior appropriators. 

The right to divert and make consumptive use of water from a watercourse under the prior appropriation system is typically acquired by making a claim, under applicable procedure, and by diverting the water to beneficial use.  The “beneficial use” concept is basic; a non-useful appropriation is of no effect.  What constitutes a beneficial use depends upon the facts of each particular case.  A prior appropriation water right is typically administered by a state agency that certifies via the issuance of a permit that a water right has been acquired dating from a particular time and tying it to a particular diversion point. 

As applied to groundwater, the prior appropriation doctrine holds that the person who first puts groundwater to a beneficial use has a priority right over other persons subsequently desiring the same water.  This doctrine is applied in many western states that also follow the prior appropriation doctrine with respect to surface water. 

A prior appropriation water right is typically administered by a state agency that certifies via the issuance of a permit that a water right has been acquired dating from a particular time and tying it to a particular diversion point.  Accordingly, such a state administrative process basically confirms the application of the prior appropriation system.  But, can a state do more than simply validate a prior appropriation right and establish a regulatory framework for protecting those rights?  Can a state modify the regulatory system in a manner that diminishes existing water rights without triggering liability to the existing right holders or owing them compensation?  This last point is being tested in Kansas, a state that utilizes the prior appropriation doctrine, at the present time.

Kansas Case

A case in western Kansas is presently testing the limits of how far a state regulatory agency can go in regulating existing water rights.  Just recently the local county trial court issued its opinion in Friesen v. Barfield, No. 2018 CV 10 (Gove County, KS Dist. Ct. Oct. 15, 2019).  The case involved the application of a Kansas law that took effect in 2012, that modified existing water rights.

Under the facts of the case, Kansas Ground Water Management District (GMD) 4 was the first GMD to implement a Local Enhanced Management Area (LEMA) that Kansas law authorized beginning in 2012. A LEMA allows GMD’s to voluntarily implement water conservation practices. After great success with the first LEMA, GMD 4 proposed a district-wide LEMA. The GMD held many public meetings over 2015 and 2016. The GMD Board approved the final LEMA plan and submitted it to the Chief Engineer, Division of Water Resources (CE). The CE approved the LEMA Plan on June 27, 2017, and an official public notice and comment period was opened. After the required two public hearings, the CE found that the LEMA plan was satisfactorily addressed the water conservation issues within GMD 4, and approved the plan. On April 13, 2018, the CE issued the Order of Designation creating the GMD District-Wide LEMA.

The plaintiffs, irrigators and voting members of the GMD, sued to stop the implementation of the LEMA on the basis that it violated vested water rights, was arbitrary and capricious, and unconstitutional. The local trial court disagreed and upheld the district-wide LEMA. The plaintiffs claimed that the water conservation restrictions contained in the proposal were a “collateral attack” on perfected water rights that the CE could not alter. The trial court disagreed, concluding that the groundwater permits did not guarantee any set amount of water. In addition, the trial court noted that the district-wide LEMA was not a permanent reduction in water appropriation but contemplated revisiting the matter in the future. Thus, the trial court concluded that so long as the LEMA is in place and the reduction in pumping is within state law limits, the CE had the discretion to approve the district-wide LEMA.

The plaintiffs also claimed that state law did not provide a definitive guide to the CE and did not protect against arbitrary action, unfairness, or favoritism. The trial court disagreed, noting that state law establishes six prerequisites for a LEMA, five of which must occur within the LEMA area - including decline of the water source. In addition, the trial court noted that the LEMA was additionally reviewable by the state Ag Secretary and subject to judicial review. The trial court also noted that the GMD is elected in a democratic process.

On the plaintiffs’ constitutional equal protection claim, the trial court determined that the LEMA, while sorting irrigators into different classes, did not violate equal protection because such sorting was rationally related to the LEMA's purposes of conserving water resources. On the plaintiffs' claim that the state law governing a LEMA cannot adversely affect vested water rights, the trial court found it relevant that the LEMA was not permanent and concluded that further reductions in water permits are not a taking because all economic benefits of the water have been eliminated. The plaintiffs claimed that the appeal process for the LEMA was inadequate because it did not provide for review by an independent unbiased tribunal. The trial court disagreed, noting that state law provides for judicial review. Also, the trial court determined that the recordkeeping requirements of irrigators was not unconstitutionally vague. The LEMA allows irrigators two ways to record water usage, inspect and record meter readings on a bi-weekly basis or "install or maintain an alternative method of recording," other than the meter that is sufficient to be used to determine operating time in the event of a meter failure."

On the claim that the CE did not follow proper procedure when implementing the LEMA plan, the trial court determined that state law did not require the CE to include findings of fact or law in notice letters. In addition, the final orders did not need to consider constitutional concerns as those are properly reserved for a court. Likewise, the trial court held that the CE did not unlawfully delegate oversight of the LEMA hearing, and that the creation of the district-wide LEMA was not done in a manner that was arbitrary and capricious. 


The Kansas case is the opening round in what will likely be lengthy litigation on the issue of how far a state can go in regulating existing, vested water rights.  As the litigation proceeds, the state might do well to remember that for an alleged regulatory taking of private property rights by the state, disaffected parties no longer need to endure state court litigation on the taking issue before seeking compensation in the federal court system.  Knick v. Township of Scott, 139 S. Ct. 2162 (2019).

October 25, 2019 in Water Law | Permalink | Comments (0)

Wednesday, October 23, 2019

Recapture – A Dirty Word In Tax Code Lingo


In 1972, comedian George Carlin listed in a monologue the “Seven Words You Can Never Say on Television.”  He then proceeded to use all seven words multiple times.  The use of those words constitutes a violation of Federal Communications Commission standards and triggers a penalty.  In the tax world, there are also “dirty” words, and they are used to describe something that happens in tax that triggers a bad tax result for the taxpayer.  “Recapture” is one of those words.  It means that a tax benefit previously received must be given up – paid back. That “pay back” is often at ordinary income tax rates rather than the (often) more favorable capital gain rates.

Recapture in the context of depletion deductions previously claimed that is associated with oil and gas interests – it’s the topic of today’s post.

Recapture – What Is It?

At its core, recapture is the Code’s procedure for triggering income on a gain a taxpayer realizes upon the disposition of an asset that had previously provided a tax benefit, such as through depreciation.  Because depreciation can be deducted from ordinary income to reflect the wear-and-tear on an asset (an exhaustion factor) used in the taxpayer’s trade or business or for the production of income where the asset has a determinable useful life of more than one year, gain on the disposal of the asset (up to the taxpayer’s recomputed basis in the asset (see, e.g. I.R.C. §1016 and/or I.R.C. §1245(a)(2)(A)) must be reported as ordinary income.  It is not reported as capital gain in accordance with I.R.C. §1231.  Depreciation recapture attributable to tangible personal property is governed by I.R.C. §1245.  The provision governing recapture associated with real property is I.R.C. §1250.  For I.R.C. §1250 recapture purposes, the IRS refers to it as “additional depreciation” in IRS Pub. 544.  In I.R.S. Pub. 544, the IRS describes it as the portion of accumulated depreciation that exceeds straight line depreciation.  It is taxed at ordinary income rates to the extent of gain realized at a maximum of 37 percent (presently).  The portion corresponding to straight-line depreciation is “unrecaptured §1250 gain” and is taxed at a maximum rate of 25 percent.  Any remaining gain is long-term capital gain if the taxpayer had held the property for over a year, and is taxed at a maximum capital gain rate of 20 percent. 

Depletion Deduction Recapture

There’s another recapture section of the Code – I.R.C. §1254.  It’s titled, “Gain from disposition of interest in oil, gas, geothermal, and other mineral properties.”  While gain on the sale or exchange of natural resources is generally capital gain in nature via I.R.C. §1221 or I.R.C. §1222 or via the netting process of I.R.C. §1231, I.R.C. §1254 taxes as ordinary income the recapture of depletion deductions previously claimed when an oil or gas interest is disposed of in a taxable transaction.  Under I.R.C. §1254, the amount recaptured as ordinary income is the lesser of (1) the sum of the deductions for depletion under I.R.C. §611 that reduced the property’s adjusted basis, and the intangible drilling and development costs currently deducted under I.R.C. §263; or (2) the gain obtained by deducting the adjusted basis of the property from the amount realized.  I.R.C. §§1254(a)(1)(A),(B). 

Because I.R.C. §1254 applies to depletion that reduces adjusted basis, it applies to both percentage and cost depletion – to the extent either depletion approach reduced the adjusted basis of the subject property.  Thus, gain in excess of depletion previously allowed is taxed as ordinary income.  It also applies separately to each property of the taxpayer, if the taxpayer has more than a single property.  I.R.C. §614 defines “property” for this purpose.  Also, if the taxpayer only disposes of a portion of a property that is subject to I.R.C. §1254 depreciation recapture, rules governing partial dispositions can apply.  See I.R.C. §1254(a)(2); Treas. Reg. §1.1254-1(c). 

Consider the following example:

Suzy, in 2011, acquired a working interest in an oil and gas deposit.  Her original basis in the interest was $100,000.  During Suzy’s period of ownership, she was allowed (and claimed) $75,000 of depletion deductions.  Thus, her adjusted basis in the working interest is $25,000 in accordance with I.R.C. §1016(a)(2).  Suzy did not expense any intangible drilling and development costs.  Suzy later sells her working interest in the deposit in 2019 for $125,000 - its fair market value at the time of sale.  Suzy has realized gain of $125,000 less her adjusted basis of $25,000, or $100,000.  Applying I.R.C. §1254(a)(1), Suzy has recapture of the previously claimed depletion deductions of the lesser of $75,000 or $100,000.  Thus, $75,000 of the $100,000 gain is treated as ordinary income.  The remaining $25,000 gain is taxed as long-term capital gain in accordance with I.R.C. §1231

Other Rules on Recapture

As noted above, recapture is potentially triggered when the taxpayer’s interest is disposed of in a taxable transaction.  In other words, there must be a “disposition” of the asset before recapture is possible.  Some transactions do not constitute a “disposition” for purposes of recapture under I.R.C. §1254.  These include mortgaging the property (Treas. Reg. §1.1254-1(b)(3)(ii)(A)); any abandonment (unless the taxpayer recognizes income on the foreclosure of a nonrecourse debt) (Treas. Reg. §1.1254-1(b)(3)(ii)(B)); leasing or subleasing the property (Treas. Reg. §1.1254-1(b)(3)(ii)(C)); the termination or election of S corporation status (Treas. Reg. §1.1254-1(b)(3)(ii)(D)); including the property in a pooling or unitization arrangement (Treas. Reg. §1.1254-1(b)(3)(ii)(E)); the expiration or reversion of an operating mineral interest in whole or in part by the terms of the agreement (Treas. Reg. §1254-1(b)(3)(ii)(F)); or any conversion of an overriding royalty interest that at the grantor’s option (or at the option of a successor in interest) converts to an operating mineral interest after a certain amount of production.  Treas. Reg. §1.1254-1(b)(3)(ii)(G).  Also, when taxpayers exchange their interests in oil and gas partnerships for stock of a newly organized corporation, they don’t have any gain or loss except to the extent that their share of partnership liabilities exceed their basis.  In this situation, there is no recapture of intangible drilling costs.  Priv. Ltr. Rul. 8107099 (Nov. 21, 1980). 

If the disposition of the oil or gas (or geothermal) property is by gift, recapture is not triggered.  Treas. Reg. §1.1254-2(a)(1).  But if the transaction is a part gift/part sale transaction (typically utilized in estate planning situations and other transactions involving family members) recapture can apply to any gain that the transaction triggers.  Treas. Reg. §1.1254-2(a)(2).  The charitable deduction associated with a gift to a charitable organization of a working or operating interest in an oil or gas property must be reduced by the amount of any intangible drilling and development costs attributable to the donated interest that the donor previously deducted under I.R.C. §1254I.R.C. §170(e)(1)(A).   

As usual, a transfer on account of death does not trigger recapture.  Treas. Reg. §1.1254-2(b).  Also, if the disposition occurs as part of a like-kind exchange under I.R.C. §1031, the depreciation recapture taxed as ordinary income is limited to the “boot” (gain attributable to “unlike” property) involved in the exchange.  Treas. Reg. §1.1254-2(c).  On this last point, it appears to be implicit in the regulation that an interest in an oil and gas property constitutes real estate for purposes of I.R.C. §1031.  That’s an important point now that personal property is not eligible for tax-deferred treatment under I.R.C. §1031.

When a partnership disposes of an interest in oil and gas (or other natural resources), the amount treated as ordinary income is determined at the partner level.  Each partner recognizes as ordinary income the lesser of the partner’s I.R.C. §1254 costs with respect to the property disposed of, or the partner’s share of the amount (if any) by which the amount realized upon the sale, exchange, or involuntary conversion, or the fair market value of the property upon any other disposition, exceeds the adjusted basis of the property.  Treas. Reg. §1.1254-5(b)(1). 


Oil and gas taxation is a bit unique in many respects.  Depletion, while conceptually the same as depreciation, is nuanced.  The rules on recapture of the depletion deduction generally follow the rules for depreciation recapture.  That means if the rules are triggered, the result is not going to be a good one for the taxpayer.  Remember, “recapture” is one of the “dirty” words in tax.  Avoid it if you can.

October 23, 2019 in Income Tax | Permalink | Comments (0)

Monday, October 21, 2019

More on Cost Depletion – Bonus Payments


Last week’s post on cost depletion generated an interesting question from a reader concerning whether a bonus payment that a landowner receives upon signing an oil and gas lease agreement entitles the landowner to a cost depletion deduction on the payment.   That’s an important question.  The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies, including bonus payments.

The taxation of bonus payments associated with oil and gas leases – that’s the topic of today’s post.

Bonus payment

Character of the gain.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor (landowner) when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is generally categorized as ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014)

A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.  A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Cost depletion?  Can a lessor claim cost depletion on a bonus payment?  This question came up in a Tax Court case in 2013.  In Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 558 Fed. Appx. 199 (3d Cir. 2014), the taxpayer owned a tract of land in Pennsylvania and entered into an oil and gas agreement with an oil and gas company.  The lease called for the taxpayer to receive a lease bonus payment upfront for entering into the lease agreement.  The taxpayer was also entitled to a royalty payment of 16 percent of the net profits of oil and gas extracted from the leased premises.  The bonus payment was not tied to extraction or production in any fashion.  It was purely an upfront payment made to induce the taxpayer to execute the lease agreement.  The taxpayer reported the bonus payment as long-term capital gain rather than ordinary income on the assertion that the transaction amounted to a sale of oil and gas.   On audit, the IRS disagreed, recharacterized the bonus payment as ordinary income and slapped a 20 percent accuracy-related penalty on top. 

The Tax Court agreed with the IRS, citing the classic U.S. Supreme Court case of Burnet v. Hamel, 287 U.S. 103 (1932).   On the sale/lease issue, the Tax Court taxpayer retained an economic interest in the oil and gas deposits that were the subject matter of the lease.  That was true, the Tax Court reasoned because under the lease the taxpayer was entitled to royalty payments computed as a percentage of net profits of oil and gas that were extracted from the property.  That meant that the taxpayer possessed an economic interest in the in-place minerals.  See, e.g., Kittle v. Comr., 21 T.C. 79 (1953).  Had the transaction been a sale, the Tax Court reasoned, there would have been an exchange of a set quantity of oil and gas for a particular price.   

The taxpayer also claimed that the bonus income was subject to percentage depletion.  Percentage depletion is a cost recovery method that provides a tax deduction for most natural resources.  Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting fossil fuels, minerals, or other nonrenewable resources.   For oil and gas, the allowable statutory percentage depletion deduction is the lesser of net income or 15% of gross income. If net income is less than 15% of gross income, the deduction is limited to 100% of net income.  I.R.C. §613(b)(2).  The Tax Court disagreed with the taxpayer’s claim that percentage depletion applied.  I.R.C. §613A(d) bars percentage depletion from applying to lease bonus payments.  The payment must be tied to production for percentage depletion to apply.  See Treas. Reg. §1.613A-3(j). 

But the Tax Court did indicate that the taxpayer’s bonus payment could be eligible for cost depletion.  The Tax Court noted that cost depletion, in accordance with Treas. Reg. §1.612-3(a)(1), is tied to the taxpayer’s basis for depletion.  The amount of the deduction is dependent upon depletion basis, future expected royalties and the amount of the upfront bonus payment.  The taxpayer needed to establish all of these amounts to claim a deduction for cost depletion.  The taxpayer failed to do so.  The Tax Court also upheld the accuracy-related penalty.

Establishing Basis

The Dudek case makes it clear that the taxpayer must establish a basis in the minerals subject to an oil and gas lease agreement to be able to claim cost depletion.  That can be tricky when land is acquired that has an oil and gas deposit and purchase transaction combines both the land and the deposit together.  It is the position of the IRS that minerals do not have a separate cost basis unless the seller’s cost stipulated such an amount; or was the result of an estate tax valuation that contained the separate valuations; or the seller’s cost basis can be properly allocated in accordance with existing evidence at the time of the acquisition.  I.R.M. (Dec. 3, 2013).  While the IRS has indicated that a taxpayer might be able to establish a separate value for the minerals based on the evidence, it clearly is the taxpayer’s burden to prove the basis allocated to the oil and gas (or other mineral) deposit.  See, e.g., Rev. Rul. 69-539, 1969-2 CB 141; Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979)That allocation might even be 100 percent of the taxpayer’s basis in the lease if a zero estimate of future royalties is reasonable (such as in a wildcat area).  See, e.g., Collums v. United States, 480 F. Supp. 864 (D. Wyo. 1979); but see Tech. Adv. Memo. 8532011 (May 7, 1985). 


Cost depletion can be confusing.  The Dudek opinion reiterates the long-standing ordinary income treatment of bonus payments associated with oil and gas leases.  It also points out that cost depletion can apply to the payments.  But work must be done to be able to claim cost depletion, and that burden is on the taxpayer. 

October 21, 2019 in Income Tax | Permalink | Comments (0)

Thursday, October 17, 2019

Bad Debt Deduction


When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Ag retail businesses are experiencing tougher credit relations with farm clients due to difficult times in some sectors of production agriculture.  Thus, a debt can turn into a “bad debt.”  That has tax consequences. An income tax deduction is allowed for debts which become worthless within the taxable year.   

What does it take to be able to deduct a bad debt?  Is there a tax difference between a business bad debt and a non-business bad debt? 

Distinguishing between business and non-business bad debts.  That’s the topic of today’s blog post.

Elements Necessary For Deductibility

Debtor-creditor relationship.  For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal, valid, and enforceable obligation to pay a fixed or determinable sum of money.  See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94; Treas. Reg. §1.166-1(c).  In addition, the taxpayer must be able to show that it was the intent of the parties at the time the transaction was entered into to create that debtor-creditor relationship.  The requisite intent is established by showing that when the relationship was formed, the taxpayer had an actual expectation of repayment and intended to enforce the debt if necessary.  Thus, a deductible bad debt can derive from a loan made in the context of protecting the taxpayer’s investment if the purpose of making the loan was for business and their was intent to collect on the loan if necessary. 

While a formal loan agreement helps establish this intent, the lack of one will not absolutely bar the finding of a bona fide debt.  Conversely, the existence of paperwork documenting the transaction (such as a note) does not always mean that the transaction constitutes a bona fide debt stemming from a debtor-creditor relationship. 

Related party?  The fact that the debtor and creditor are related parties does not preclude a bad debt deduction.  The key is whether the loan that is now worthless was made for legitimate business purposes and arises from a debtor-creditor relationship and meets the other requirements as noted above.  However, the IRS tends to look more closely to debts involving related parties than those involving non-related parties. 

Classification of Bad Debts

For individuals and entities taxed as individuals, bad debts may be business bad debts or nonbusiness bad debts.  Corporations have only business bad debts.  Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.

So what is the distinction between a business bad debt and a nonbusiness bad debt?  A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors.  The loan transaction must have a relationship to the taxpayer’s trade or business.  Treas. Reg. §1.166-5(b).  According to the U.S. Supreme Court, the relationship of the loan transaction to the taxpayer’s trade or business is dependent upon whether the taxpayer’s “dominant motivation” for the loan was related to the taxpayer’s business.  United States v. Generes, 405 U.S. 93 (1972). In Generes, the Court concluded that the taxpayer's status as an employee was a business interest, but the taxpayer’s status as a shareholder was a nonbusiness interest.  But, this does not appear to be a blanket rule for every situation.  While the Court indicated that a business bad debt can arise from a loan transaction entered into to protect an employment status, source of income, a business relationship or to protect a business reputation, the Court also seemed to indicate that a shareholder can still experience a business bad debt if the loan transaction has a business purpose and otherwise meets the requirements of a business bad debt.  The facts are critical.

A taxpayer that is in the trade or business of lending money generally treats uncollectable loans as business bad debts. See, e.g., Henderson, 375 F.2d 36 (5th Cir. 1967); Serot v. Comr., T.C. Memo. 1994-532; aff’d. without pub. op., 74 F.3d 1227 (3d Cir. 1995); Owens v. Comr., T.C. Memo. 2017-157.  The cases cited also provide good guidance on how much loan activity is necessary for a taxpayer to be treated as being in the trade or business of lending money. 

Claiming the Deduction

A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income. A business bad debt may be totally worthless (no collection potential) or partially worthless.  I.R.C. §166(a)(1)-(2).  In any event, the allowed deduction for a bad debt does not include any amount that was deducted in a prior year at a time that the debt was only partially worthless.  Treas. Reg. §1.166-3(b).   

A bad debt is deductible when worthlessness can be established.  A nonbusiness bad debt must be wholly worthless in the year for which the deduction is claimed.  Cooper v. Comr., T.C. Memo 2015-191; Treas. Reg. §1.165-5(a)(2).  But, the actual tax year of worthlessness can sometimes be difficult to determine.  If the IRS, on audit, views worthlessness to have occurred in a year before the bad debt deduction was actually claimed, the applicable statute of limitation for seeking a refund or credit for a bad debt is seven years (rather than the normal three years).  I.R.C. §6511(d). 

But, a bad debt can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan entered into for profit.  That can be a key point with many farming operations and loans between family members.  See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276.  It’s critical to properly document the arrangement.


Careful tax planning can help maximize the tax benefit of a bad debt deduction and minimize the economic pain.  Today’s post covered the basics of bad debts, perhaps a future post can dig a little further.

October 17, 2019 in Income Tax | Permalink | Comments (0)

Tuesday, October 15, 2019

Cost Depletion of Minerals


A taxpayer that is engaged in a trade or business can recover the cost of a business asset through depreciation.  In other words, an asset is not depreciable unless it is used in the taxpayer’s trade or business or used for the production of income.  In essence, the depreciation deduction is to account for the wear-and-tear of the asset as it is used in the business or to produce income for the taxpayer.   But, the asset must have a determinable useful life of more than one year.  Land, for example, is not depreciable because it does not have a determinable useful life.

But, there are other business and/or income-producing assets that are not eligible for depreciation.  For example, natural resources such as sand and gravel deposits, as well as deposits for oil and gas are not depreciated.  But don’t these assets wear out?  They do and can be eligible for a depletion allowance.  The deductible allowance for depletion is computed differently than is the deduction for depreciation.  One method of computing it is called “cost depletion.”   

The cost depletion method of computing deductions associated with oil, gas and other minerals – it’s the topic of today’s post.

Cost Depletion

Depletion is the descriptive term for the using of a natural resource by mining, drilling, quarrying or the like.  A depletion allowance allows the owner of the resource to recover the cost of the reduction of reserves of the resource as production and sales occur. To be a resource “owner” entitled to a claim depletion, the taxpayer must have an “economic interest” in the natural resource as an owner, and the legal right to the income from the extraction of the minerals.  In addition, a depletion deduction is only allowed when there is production and sale activity from the minerals which provides income to the taxpayer for the tax year. 

As noted, a taxpayer is entitled to recover the taxpayer’s cost basis in natural resources over the life of the resources.  The cost depletion method of computing that cost recovery is tied to the quantity of the resource sold each year.  There are unique rules that can apply when determining cost depletion on production payments, advance royalties, bonuses.  In addition, sometimes the computational rules are different depending upon the particular natural resource involved.  These unique aspects are beyond the scope of today’s post.

Via cost depletion, the taxpayer recovers the taxpayer’s capital investment (i.e., tax basis) in the minerals while the minerals produce income.  Thus, with respect to oil and gas, for example, the cost basis of the property must be allocated between the land and the associated capital assets that were acquired with the land purchase – fences; tile lines; buildings; equipment; and the mineral deposit.  The use of the cost depletion method is dependent upon having made these allocations.

Under the cost depletion approach, the taxpayer annually deducts a portion of the taxpayer’s capital investment, less prior deductions, that equal the fraction of the estimated remaining recoverable reserves that have been produced and sold during that particular year.  Over the life of the deposit, the total cumulative amount recovered under the cost depletion method cannot exceed the taxpayer’s capital investment.    

The IRS does not provide a form for computing the cost depletion deduction.  However, a formula is utilized to make the computation.  Under the formula, the deposit’s adjusted basis is divided by the units of the mineral deposit that remain as of the end of the tax year (i.e., total recoverable units).  The result of that is known as the “depletion unit” or a rate per unit.  That amount is then multiplied by the units of mineral that were sold within the tax year based on the taxpayer’s accounting method.  The taxpayer bears the burden of establishing basis, remaining units and the units sold during the year.  Treas. Reg.§1.612-1(b)(1)(i).  

With respect to oil and gas, cost depletion is computed with respect to each oil and gas property by reference to the total number of recoverable units that the property is estimated to contain, and the number of units sold from the property during the tax year.  Treas. Reg. §1.611-2(a).  An account is to be maintained for each property and annually adjusted for units sold and for depletion claimed.  Treas. Reg. §1.611-2(a).  The total recoverable units is the sum of the number of units that remain at year end plus the number of units of minerals sold during the tax year.  The landowner must determine the recoverable units of minerals via industry custom, and can utilize (by election) an IRS safe harbor.  See Rev. Proc. 2004-19, 2004-10 IRB 563.     

Consider the following example:

Jed buys a tract of land that contains a mineral deposit of sand and gravel.  Jed paid $500,000 for the tract, and his accountant allocated $125,000 to the land and $375,000 to the minerals.  Jed hired other experts to measure the amount of the marketable minerals via a geological survey and they determined that the deposit contained $100,000 tons of marketable minerals.  During the year, 5,000 tons of minerals were mined and sold.  Jed’s cost depletion deduction would be computed as follows:  $375,000/$100,000 x 5,000 = $18,750.                

In the second year (Year 2), another 5,000 tons of the sand and gravel are mined and sold. In Year 2, the property's basis has been reduced to $356,250 by the depletion allowed in the first year. Also, the units remaining as of the tax year have been reduced to 95,000 by the units sold in the first year.  The cost depletion deduction in Year 2 would be $18,747.37 ($356,200/95,000 x 5,000).   

The Importance of Basis

Clearly, properly computing income tax basis is critical to determining the proper depletion deduction.  The basis number only applies to the mineral property.  Thus, it doesn’t include non-mineral real estate or non-mineral assets that aren’t used for producing minerals.  It also doesn’t include the residual value of land and improvements when operations end.  Treas. Reg.§1.612-1(b)(1)(ii).   But, it does include capitalized drilling and development costs recoverable through depletion.  Treas. Reg.§1.612-1(b)(1).

Adjustments to basis will occur over time and include (as applied to oil and gas) oil and gas drilling and development costs that were capitalized. But, not included in any basis adjustment are any mineral exploration and development expenses that are treated as deferred expenses and any basis of depreciable property that is leased together with depletable mineral property.  Treas. Reg. §1.612-1(b)(1).

Deductions for cost depletion stop once the sum of the depletion deductions equals the cost or other basis of the property plus allowable capital additions.  Treas. Reg. §1.611-2(b)(2).  

Recordkeeping is essential.  The basis of the depletable property is to be recorded in a separate account, along with any capital additions and adjustments.  Treas. Reg. §1.611-2(b)(1).  If that’s not done, the cost depletion deduction may be lost for the tax year and/or upon later disposition of the property.  See, e.g., Winifrede Land Company, 12 T.C.M. (CCH) 289 (1953). 


Last year, I devoted a post to the issue of depletion of minerals.  Today’s post took a bit of a closer look at one aspect of depletion – cost depletion.  The depletion deduction can be complicated, but when big dollars are involved, getting it right matters.

October 15, 2019 in Real Property | Permalink | Comments (0)

Friday, October 11, 2019

Regulatory Takings – Pursuing a Remedy


The power to “take” private property for public use (or for a public purpose) without the owner's consent is an inherent power of the federal and state governments.  However, the United States Constitution limits the government's eminent domain power by requiring federal and state governments to pay for what is “taken.”  The Fifth Amendment states in part “...nor shall private property be taken for public use without just compensation.” 

Whether a taking has occurred is not an issue when the government physically takes the property, with the only issue being whether the taking is compensable and the amount of compensation due to the landowner.  However, for non-physical (regulatory) takings, the issue is murkier.  At what point does government regulation of private property amount to a compensable taking?  In a previous post I addressed U.S. Supreme Court guidance on how to determine the property that the landowner claims has been taken. 

If the taking is by a state or local government, must the landowner “exhaust” state court remedies before seeking compensation for a regulatory taking?  If so, it could result in a landowner having no real access to the federal court system on a constitutional taking claim.  It’s an issue that the U.S. Supreme Court addressed late in its last term this past June.  It’s also the topic of today’s post – pursuing a “takings” remedy in federal court for a state/local-level regulatory taking

Regulatory (Non-Physical) Takings

A non-physical taking may involve the governmental condemnation of air space rights, water rights, subjacent or lateral support rights, or the regulation of property use through environmental restrictions.  How is the existence of a regulatory taking determined?  There are several approaches that the Supreme Court has utilized.

Multi-factor balancing test.  In a key case decided in 1978, the U.S. Supreme Court set forth a multi-factored balancing test for determining when governmental regulation of private property effects a taking requiring compensation.  In Penn Central Transportation Co. et al. v. New York City, 438 U.S. 104 (1978), the Court held that a landowner cannot establish a “taking” simply by being denied the ability to exploit a property interest believed to be available for development.  Instead, the Court ruled that in deciding whether particular governmental action effects a taking, the character, nature and extent of the interference with property rights as a whole are the proper focus rather than discrete segments of the owner’s property rights.  In 2005, the Court confirmed the multi-factor test and noted that the touchstone for deciding when a regulation is a taking is whether the restriction on property usage is functionally equivalent to a physical taking of the property.  Lingle, et al. v. Chevron U.S.A., Inc., 544 U.S. 528 (2005).  

Total regulatory taking.  In Lucas v. South Carolina Coastal Council, 505 U.S. 1003 (1992), the landowner purchased two residential lots with an intent to build single-family homes.  Two years later, the state legislature passed a law prohibiting the erection of any permanent habitable structures on the Lucas property.  The law's purpose was to prevent beachfront erosion and to protect the property as a storm barrier, a plant and wildlife habitat, a tourist attraction, and a “natural health environment” which aided the physical and mental well-being of South Carolina's citizens.  The law effectively rendered the Lucas property valueless.  Lucas sued the Coastal Council claiming that, although the act may be a valid exercise of the state's police power, it deprived him of the use of his property and thus, resulted in a taking without just compensation.  The Coastal Council argued that the state had the authority to prevent harmful uses of land without having to compensate the owner for the restriction.

The Supreme Court ruled for Lucas and opined that the state's interest in the regulation was irrelevant since the trial court determined that Lucas was deprived of any economically viable alternative use of his land.  The Lucas case has two important implications for environmental regulation of agricultural activities.  First, the Lucas court focused solely on the economic viability of the land and made no recognition of potential noneconomic objectives of land ownership.  However, in the agricultural sector land ownership is typically associated with many noneconomic objectives and serves important sociological and psychological functions.  Under the Lucas approach, these noneconomic objectives are not recognized.  Second, under the Lucas rationale, environmental regulations do not invoke automatic compensation unless the regulations deprive the property owner of all beneficial use.

Under the Lucas approach, an important legal issue is whether compensation is required when the landowner has economic use remaining on other portions of the property that are not subject to regulation.

Unconstitutional conditions.  In Nollan v. California Coastal Commission,483 U.S. 825 (1987), the plaintiff owned a small, dilapidated beach house and wanted to tear it down and replace it with a larger home.  However, the defendant was concerned about preserving the public's viewing access over the plaintiff's land from the public highway to the waterfront.  Rather than preventing the construction outright, the defendant conditioned the plaintiff's right to build on the land upon the plaintiff giving the defendant a permanent, lateral beachfront easement over the plaintiff's land for the benefit of the public.  Thus, the issue was whether the state could force the plaintiffs to choose between their construction permit and their lateral easement.  The Court held that this particular bargain was impermissible because the condition imposed (surrender of the easement) lacked a “nexus” with, or was unrelated to the legitimate interest used by the state to justify its actions - preserving the view.  The Court later ruled similarly in Dolan v. Tigard, 512 U.S. 374 (1994).  These cases hold that the government may not require a person to give up the constitutional right to receive just compensation when property is taken for a public use in exchange for a discretionary benefit that has little or no relationship to the property. The rule of the cases does not apply to situations involving impact fees and other permit conditions that do not involve physical invasions, but it would apply to monetary exactions where none of the plaintiff’s property is actually taken.  See, e.g., Koontz v. St. Johns River Water Management District, 133 S. Ct. 2586 (2013).

State/Local Takings – Seeking a Remedy

For a landowner that has sustained a state/local regulatory (or physical) taking, can compensation be sought initially in federal court or must legal procedures be first pursued in state court with federal courts only available if compensation is denied at the state level?  The U.S. Supreme Court answered this question in 1985.  In Williamson Regional Planning Commission v. Hamilton Bank of Johnson City, 473 U.S. 172 (1985), the Court held that if a state provides an adequate procedure for seeking just compensation, there is no Fifth Amendment violation until the landowner has used the state procedure and has been denied just compensation.  However, 28 U.S.C. §1738, would then be applied with the resulting effect that the failure to receive compensation at the state level generally meant that there was no recourse in the federal courts because of the preclusive effect of the landowner having already litigated the same issue(s) in the state courts.  See, e.g., San Remo Hotel L.P., v. City and County of San Francisco, 545 U.S. 323 (2005).  This “catch-22” was what the Court examined earlier this year.

The 2019 Case

In Knick v. Township of Scott, 139 S. Ct. 2162 (2019), the plaintiff owned a 90-acre farm in Pennsylvania on which she grazed horse and other animals.  The farm includes a small graveyard where ancestors of the plaintiff’s neighbors were buried.  Such “backyard burials” are permissible in Pennsylvania.  In late 2012, the defendant passed an ordinance requiring that “[a]ll cemeteries…be kept open and accessible to the general public during daylight hours.”  The ordinance defined a “cemetery” as “[a] place or area of ground, whether contained on private or public property which has been set apart for or otherwise utilized as a burial place for deceased human beings.”  In 2013, the defendant notified the plaintiff of her violation of the ordinance.  The plaintiff sued in state court for declaratory and injunctive relief on the basis that the ordinance amounted to a taking of her property, but she did not seek compensation via an inverse condemnation action.

While the case was pending, the defendant agreed to not enforce the ordinance.  As a result, the trial court refused to rule on the plaintiff’s action.  Without any ongoing enforcement of the ordinance, the plaintiff couldn’t show irreparable harm.  Without irreparable harm, the court noted, the plaintiff couldn’t establish what was necessary for the equitable relief she was seeking.  Frustrated at the result in state court, the plaintiff filed a takings claim in federal court.  However, the federal trial court dismissed the case because she hadn’t sought compensation at the state level.  Knick v. Scott Township, No. 3:14-CV-2223st (M.D. Pa. Oct. 29, 2015).  The appellate court affirmed, citing the Williamson case.  Knick v. Township of Scott, 862 F.3d 310 (3d Cir. 2017). 

In a 5-4 decision, Chief Justice Roberts (joined by Justices Alito, Gorsuch, Kavanaugh and Thomas), writing for the majority, reversed.  He pointed out that there is a distinction between the substance of a right and the remedy for the violation of that right.  It’s the takings clause of the Fifth Amendment that establishes that the government can only take (either physically or via regulation) private property by paying for it. The government’s infringement on private property is what triggers possible compensation.  The Constitutional violation has occurred and a state court decision that makes the landowner financially whole simply remedies that violation.  It doesn’t redefine the property right.  Thus, the majority opinion reasoned, laws confer legal rights and when those rights are violated there must be legal recourse.  See, e.g., Marbury v. Madison, 5 U.S. 137 (1803).  As the majority noted, “a government violates the Takings Clause when it takes property without compensation, and…a property owner may bring a Fifth Amendment claim [in federal court]… at that time.”


The Court’s decision is a significant win for farmer’s, ranchers, and other rural landowners that are impacted by state and local regulations impacting land use.  A Fifth Amendment right to compensation accrues at the time the taking occurs.  It’s also useful to note that the decision would not have come out as favorably without the presence of Justices Gorsuch and Kavanaugh on the Court.  That’s a point that agricultural interests also note.   


October 11, 2019 in Environmental Law, Regulatory Law | Permalink | Comments (0)

Wednesday, October 9, 2019

Ag Law in the Courts


Agricultural law issues in the courts are many.  On a daily basis, cases involving farmers, ranchers, rural landowners and agribusinesses are decided.  Periodically, on this blog I examine a few of the recent court decisions that are of particular importance and interest.  Today’s post is one such post.

Proving water drainage damage; migrating gas and the rule of capture; and suing for Clean Water Act (CWA)  – these are the topics of today’s post.

The Case of the Wayward Water

In Kellen v. Pottebaum, 928 N.W.2d 874 (Iowa Ct. App. 2019), the defendant installed a drain pipe that discharged water from the defendant’s land to the plaintiffs’ land. The plaintiff sued alleging that the pipe caused an unnatural flow of water which damaged the plaintiff’s farmland and sought damages and removal of the pipe. The defendant counterclaimed arguing that the plaintiff’s prior acts and/or inaction regarding the flow of the water caused damage to the defendant’s property. The trial court determined that neither party had established their claims and dismissed each claim with prejudice.

The appellate court affirmed.  As for the sufficiency of the evidence, the appellate court noted that the defendant owned the dominant estate and the plaintiff owned the servient estate. As such, if the plaintiff could prove that the installation of the pipe considerably increased the volume of water flowing onto the plaintiff’s land or substantially changed the drainage and actual damage resulted, the plaintiff would be entitled to relief. However, most of the evidence presented to the court was the observations of lay witnesses rather than measured water flow. Accordingly, the appellate court agreed with the trial court that the plaintiff did not prove by a preponderance of the evidence that installation of the pipe caused the increased water flow. The appellate court noted that a “reasonable fact finder” could attribute the additional water on the plaintiffs’ property to the increased rain fall during the years at issue. The appellate court also determined that the plaintiffs did not prove by preponderance of the evidence that installation of the pipe substantially changed the drainage. The water did not flow in a different direction on the plaintiff’s property. Rather, the defendant altered the flow of water across his property in a natural direction towards the plaintiff’s drainage, which is permissible under state (IA) law. Thus, the plaintiff did not prove harm by a preponderance of the evidence. The appellate court also concluded that the trial court did not abuse its discretion excluding some of the plaintiff’s evidence. 

Ownership of Migrated Gas

In Northern Natural Gas Co. v. ONEOK Field Servs. Co., LLC, No. 118,239, 2019 Kan. LEXIS 324 (Kan. Sup. Ct. Sept. 6, 2019), the plaintiff operated an underground gas storage facility, which was certified by the proper state and federal commissions. The defendants were producers with wells located two to six miles from the edge of the plaintiff’s certified storage area. Stored gas migrated to the defendants’ wells and the defendants captured and sold the gas as their own. The plaintiff sued for lost gas sales and the defendants moved for summary judgment on the grounds that the Kansas common law rule of capture allowed the gas extraction. The trial court granted the defendants’ motion. Two years later, the plaintiff received certification to expand the storage area into the areas with the defendants’ wells. Another dispute arose as to whether the defendants could capture the gas after the plaintiff’s storage area was expanded. The trial court held that the defendants could under the common law rule of capture.

On review, the Kansas Supreme Court reversed and remanded on the basis that the rule of capture did not apply. That rule, the Court noted, allows someone that is acting within their legal rights to capture oil and gas that has migrated from the owner’s property to use the migrated oil and gas for their own purposes. The rule reflects the application of new technology such as injection wells and applies to non-native gas injected into common pools for storage. However, the Court reasoned, the rule does not apply when a party (such as the plaintiff) is authorized to store gas and the storage is identifiable. The Court determined that state statutory law did not override this recognized exception to the application of the rule of capture. The Court remanded the case for a computation of damages for the lost gas. 

Jurisdiction Over CWA §404 Permit Violations – Who Can Sue?

A recent case involving a California farmer has raised some eyebrows.  In the case, the trial court allowed the U.S. Department of Justice (DOJ) to sue the farmer for an alleged CWA dredge and bill permit violation without a specific recommendation from the Environmental Protection Agency (EPA).  The farmer was alleged to have discharged “pollutants” into a “waters of the United States” (WOTUS) as a result of tractor tillage activities on his farmland containing or near to wetlands contiguous to a creek that flowed into a WOTUS.  Staff of the U.S. Army Corps of Engineers (COE) saw the tilled ground and investigated.  The COE staff then conferred with the EPA and then referred the matter to the U.S. Department of Justice (DOJ).  The DOJ sued (during the Obama Administration) for enforcement of a CWA §404 permit “by the authority of the Attorney General, and at the request of the Secretary of the Army acting through the United States Corps of Engineers.”  The DOJ alleged that the equipment "constituted a 'point source'" pollutant under the CWA and "resulted in the placement of dredged spoil, biological materials, rock, sand, cellar dirt or other earthen material constituting “pollutants” (within the meaning of 33 U.S.C. § 1362(6) into waters of the United States. The DOJ alleged that the defendant impacted water plants, changed the river bottom and/or replaced Waters of the United States with dry land, and "resulted in the 'discharge of any pollutant' within the meaning of 33 U.S.C. § 1311(a)." 

The defendant moved for summary judgment on the basis that the CWA authorizes only the EPA Administrator to file a CWA §404 enforcement action and that the court, therefore, lacked jurisdiction.  The court disagreed with the defendant on the basis that 28 U.S.C. §1345 conferred jurisdiction.  That statute states, “Except as otherwise provided by Act of Congress, the district courts shall have original jurisdiction of all civil actions, suits or proceedings commenced by the United States or by any agency or officer thereof expressly authorized to sue by Act of Congress.  The court rejected the defendant’s claim that 33 U.S.C. §1319(b) and 33 U.S.C. §1344(s)(3) authorized only the EPA to sue for violations of the CWA, thereby limiting the jurisdiction conferred by 28 U.S.C. §1345.  Those provisions provide that the EPA Secretary is the party vested with the authority to sue for alleged CWA violations.  The court determined that there is a “strong presumption” against implied repeal of federal statutes, especially those granting jurisdiction to federal courts.  In addition, the court determined that the defendant failed to show that the general grant of jurisdiction was irreconcilable with either of the statutes the defendant cited.  Accordingly, the court determined that the defendant could be sued by the U.S. Department of Justice upon the mere recommendation of the COE and without a specific recommendation from the EPA alleging a CWA violation, and in a situation where the CWA did not determine any CWA jurisdiction and only the COE did.  This finding was despite a 1979 Attorney General opinion No. 197 determining that the EPA and not the COE has the ultimate authority to construe what is a navigable WOTUS.

Ultimately, the parties negotiated a settlement. The settlement included $1,750,000 civil penalty. The land which the farmer’s acts occurred will be converted to a conservation reserve and a permanent easement will run with the land to bar any future disturbance.  The settlement also specified that the farmer would spend $3,550,000 "to purchase vernal pool establishment, re-establishment, or rehabilitation credits from one or more COE-approved mitigation banks that serve the [applicable] area . . . .".  The settlement also included other enforcement stipulations, including fines and the civil penalty for noncompliance.  No comments on the settlement were received during the public comment period, after which the settlement was submitted to the court for approval.  The court approved the settlement ad consent decree on the basis that it was fair, reasonable, properly negotiated and consistent with governing law.  The court also determined that the settlement satisfied the goals of the CWA in that it permanently protected the Conservation Reserve (which contained between 75 and 139 acres of WOTUS); fixed damage caused by unauthorized discharges; applied a long-term pre-clearance injunction; required off-site compensatory mitigation and recouped a significant civil penalty.  The case is United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 75309 (E.D. Cal. May 3, 2019)United States v. Lapant, No. 2:16-CV-01498-KJM-DB, 2019 U.S. Dist. LEXIS 93590 (E.D. Cal. Jun. 3, 2019).


The three cases summarized today further illustrate the various legal battles that involve farmers, ranchers and rural landowners.  They also illustrate the need to legal counsel that is well-versed in agricultural issues.  That’s what we are all about in the Rural Law Program at Washburn Law School – providing high-level training in agricultural legal and tax issues and then getting new graduates placed in rural areas to represent farmers and ranchers. 

October 9, 2019 in Environmental Law, Real Property, Water Law | Permalink | Comments (0)

Monday, October 7, 2019

The Importance of Income Tax Basis “Step-Up” At Death


2013 marked the beginning of major law changes impacting estate planning.  Those changes were continued and, in some instances, enhanced by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.  In particular, the “applicable exclusion amount” was enhanced such that (for deaths in 2019) the associated credit offsets the first $11.4 million in taxable estate value (or taxable gifts).  Consequently, the vast majority of estates are not impacted by the federal estate tax.  The “stepped-up” basis rule was also retainedI.R.C. §1014.  Under that rule, property included in the estate at death gets an income tax basis in the hands of the heirs equal to the property’s fair market value (known as “stepped-up” basis).  Much estate planning now emphasis techniques to cause property inclusion in a decedent’s estate at death to get the basis increase. 

What are the planning steps to achieve a basis increase?  What about community property?  These are the issues addressed in today’s post.

Basis “Step-Up” Considerations – First Things First

As noted above, under present law, the vast majority of estates do not face federal estate tax at death.  Thus, obtaining a basis increase for assets included in the gross estate is typically viewed as more important.  Consequently, an initial estate planning step often involves a comparison of the potential transfer tax costs with the income tax savings that would arise from a “step-up” in basis.  Unfortunately, this is not a precise science because the applicable exclusion adjusts be for inflation or deflation and could change dramatically depending on the whim of politicians. 

It’s also important to note that a basis increase is of no tax help to the owner of the property that dies.  The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. The degree of the benefit is tied to the asset.  Farm and ranch land may never be sold or may only be sold in the very distant future.  A basis adjustment at death is also beneficial if the asset involved is depreciable or subject to depletion.  An additional consideration is whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.

Exceptions To “Stepped-Up” Basis

There are exceptions to the general rule of date- of-death basis.  For example, if the estate executor elects alternate valuation under I.R.C. §2032, basis is established as of the alternate valuation date (typically six months after death).  Also, if the estate executor elects special use valuation under I.R.C. §2032A, the lower agricultural use value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs.  For deaths in 2019, the maximum statutory value reduction for elected land is $1,160,000. 

In addition, for land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C. §2031(c), a “carryover” basis applies to the property.  Also not receiving a basis increase at death is property that constitutes income in respect of a decedent (such as unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other things).  There’s also a special basis rule that involves appreciated property that was gifted to the decedent within one year of death, where the decedent transferred the property back to the original donor of such property (or the spouse of the donor).  The donor receiving the property back will take as a basis the basis that the decedent had in the property immediately before the date of death. I.R.C. §1014(e).  The property basis won’t step-up to fair market value at the date of the decedent’s death.

Community Property Considerations 

The advantage of community property.  On the basis step-up issue, estates of persons living in community property states have an advantage over estates of persons domiciled in separate (common law) property states.  Under community property law, all assets acquired during marriage by either spouse, except gifts, inheritances, and assets acquired with separate property, are considered to be owned equally by the spouses in undivided interests.  The title of an asset is not definitive in terms of ownership in community property states like it is in common law states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. 

The ownership portion of the couple’s community property that is attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax purposes.  This became the rule for deaths after 1947.  Restated differently, there is a basis adjustment of both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of the community property was included in the decedent’s gross estate under the federal estate tax rules – which would normally be the result.  The federal tax law considers the surviving spouse’s share to have come from the decedent.  The result is a 100 percent step-up in the basis of the property.  Conversely, in a common law property state, property that one spouse owns outright at death along with only 50 percent of jointly owned property is included in the estate of the first spouse to die (and receives a basis adjustment) unless the rule of Gallenstein v. Comr., 975 F.2d 286 (6th Cir. 1992) applies to provide a 100 percent basis step-up for property acquired before 1977.   

Community property spousal trusts.  Three common law property states, Alaska, South Dakota and Tennessee, authorize the creation of “community property trusts” for married couples that establish via the trust an elective community property system.  See, Alaska Stat. Ann. §34.77.100; Tenn. Code Ann. Ch. 35-17-101 – 35-17-108; S.D. Cod. Laws. Ch. 55-17-1 – 55-17-14.   In these states, married couples can classify property as community property by transferring the property to a qualifying trust.  

Under the Alaska provision (enacted in 1998), at least one trustee must be an individual who resides in Alaska or a trust company or bank with its principal place of business in Alaska.  The trust is irrevocable unless it provides for amendment or revocation.  Certain disclosures must be made for the trust to be valid, and the trust must contain specific language declaring that the property contained in the trust is to be community property.  Resident married couples can also execute an agreement to create community property for property that is not held in trust.

The Tennessee provision was enacted in 2010 and allows married couples to convert their property to community property by means of a “Community Property Trust.”  Again, the idea of the trust is to achieve a 100 percent basis step-up for all of the trust property at the death of the first spouse.  Comparable to the Alaska provision, at least one trustee must be an individual that resides in Tennessee or a company that is authorized to act as a fiduciary in Tennessee.   

Under the South Dakota law (enacted in 2016), property contained in “South Dakota Spousal Trust” is considered to be community property even if one spouse contributed more than 50 percent of the property to the trust.  At least one trustee must be a South Dakota resident, which could be one of the spouses.  S.D. Cod. Laws §§55-17-1; 55-3-41.  The trust must state that the trust property is intended to be community property and must specify that South Dakota law applies.  S.D. Cod. Laws §55-17-3.  Both spouses must sign the trust.  S.D. Cod. Laws §55-17-1.  Nonresidents can also utilize such a trust if a trustee is a qualified person that resides in South Dakota.  In addition, significant disclosures are required between the spouses and both must consent and execute the trust.  S.D. Cod. Laws §§55-17-11; 55-17-12.  The trust can be either revocable or irrevocable if the trust language allows for amendment or revocation.  S.D. Cod. Laws. §55-17-4. 

Transfer of farmland.  Can farmland that is owned in joint-tenancy, tenancy-by-the-entirety, or co-tenancy in a common law property state be transferred to a Community Property Trust created under the laws of these states and be treated as community property in order to achieve a full stepped-up basis at the death of the first spouse?  Normally the law of “situs” (e.g. the location of where land is located) governs the legal status of the land transferred to a trust that is administered in another state.  Neither the Alaska, South Dakota, nor Tennessee laws clearly address the legal nature of farmland that is transferred to such a trust from a common law property state, and there appears to be no caselaw or IRS rulings that address the question.  Thus, a preferable planning approach might be to transfer the out-of-state farmland to an entity such as a limited liability company or family limited partnership followed by a transfer of the interests in the entity to the trust.  Perhaps doing so would avoid questions concerning the property law and income tax basis issues associated with the out-of-state farmland.

The UDCPRDA.  Presently, sixteen states (Alaska; Arkansas; Colorado; Connecticut; Florida; Hawaii; Kentucky; Michigan; Minnesota; Montana; New York; North Carolina; Oregon; Utah; Virginia and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”).  The UDCPRDA specifies how property that was acquired while the spouses resided in a community property state passes at death if the spouses then reside in a common law property state.  The UDCPRDA preserves the community property nature of the property, unless the couple has taken some action to sever community property rights.  It does so by specifying that upon the death of the first spouse, one-half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse.  This should achieve a full basis step-up due to the unlimited marital deduction of I.R.C. §2056, however there aren’t any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).

Other Techniques

The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s common law property at the death of the first spouse.

One way to achieve the basis increase is to give each spouse a power of appointment over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust.  The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.

Another technique involves the use of a joint exempt step-up trust (JEST).  In essence, both spouses contribute their property to the JEST that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, with the result that the trustee distributes half of the assets back to each spouse. If there is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate.  Upon the first spouse’s death, assets equal in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included in the surviving spouse’s estate.  Any asset in excess of the funding of the bypass trust will go into an electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7).  If the first spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to fund a bypass credit shelter trust.  These assets will avoid estate taxation at the surviving spouse’s death.

The JEST technique comes with caution.  Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse arguably has dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death.  That could mean that I.R.C. §1014(e) applies to disallow a basis increase in the surviving spouse’s one-half interest in the trust due to retained control over the trust assets within a year of death.  See, Priv. Ltr. Ruls. 9308002 (Nov. 16, 1992) and 200101021 (Oct. 2, 2000). 


For the vast majority of people, avoiding federal estate tax at death is not a concern.  Some states, however, do tax transfers at death and the exemption in those states is often much lower than the federal exemption.  But, achieving an income tax basis at death is of primary importance to many people.  Community property has an advantage on this point, and other planning steps might be available to receive a full basis step-up at death.  In any event, estate and income tax basis planning is a complex process for many people, especially those with farms and ranches and other small businesses that are trying to make a successful transition to the next generation.  Competent legal and tax counsel is a must.

October 7, 2019 in Estate Planning, Income Tax | Permalink | Comments (0)

Wednesday, October 2, 2019

Hobby Losses Post-2017 and Pre-2026 – The Importance of Establishing a Profit Motive


Court cases are many in which the IRS has asserted that the taxpayer is engaged in an activity without an intent to make a profit.  If the IRS prevails in its claim that the taxpayer’s activity is a hobby, deductions for losses from the activity are severely limited.  The tax result is even harsher as a result of the Tax Cuts and Jobs Act (TCJA). 

What does it take to be conducting an activity with a profit intent?  How did the TCJA change the impact of the “hobby loss” rules?  These are the topics of today’s blog post.

Tax Code Rules

What is a “hobby”?  A “hobby” under the Code is defined in terms of what it is not.  I.R.C. §183.  A hobby activity is essentially defined as any activity that a taxpayer conducts other than those for which deductions are allowed for expenses incurred in carrying on a trade or business or producing income.  I.R.C. §§162; 212.  The determination of whether any particular activity is a hobby activity or not is based on the facts and circumstances of each situation.  It’s a highly subjective determination.  But the Code provides a safe harbor.  I.R.C. §183(d).  Under the safe harbor, an activity that doesn’t involve horse racing, breeding or showing must show a profit for three of the last five years, ending with the tax year in question.  It’s two out of the last seven years for horse-related activities.  If the safe harbor is satisfied (either for horse activities or other activities, a presumption arises that the activity is not a hobby.  The safe harbor applies only for the third (or second) profitable year and all subsequent years within a five-year (or seven-year) safe-harbor period that begins with the first profitable year.  Treas. Reg. §1.183-1(c). 

The burden of proof.  Satisfaction of the safe harbor shifts the burden to prove that the activity is a hobby (i.e., lacks a profit motive) to the IRS.  But the IRS can rebut the for-profit presumption even if the safe harbor is satisfied – although it doesn’t tend to do so without extenuating circumstances.   

What about losses in early years?  As noted above, the safe harbor applies only after a taxpayer incurs a third profitable year within the five-year testing period.  That means that only loss years arising after that time (and within the five-year period) are protected.   Losses incurred in the first several years are not protected under the safe harbor.  It makes no difference whether the activity turns a profit in later years.

Postponing the safe harbor.  It is possible to postpone the application of the safe harbor until the close of the fourth tax year (or sixth (for horse activities) after the tax year the activity begins.  I.R.C. §183(e).   This is accomplished by making an election via Form 5213 to allow losses incurred during the five-year period to be reported on Schedule C.  Thus, if the activity shows a profit for three or more of the five years, the activity is presumed to not be a hobby for the full five-year period.  The downside risk of the election occurs if the taxpayer fails to show a profit for at least three of the five years.  If that happens, a major tax deficiency could occur for all of the years involved.  Thus, filing Form 5213 should not be made without thoughtful consideration.  For example, while the election provides more time to establish that an activity is conducted with a profit intent, it will also put the IRS on notice that an activity may be conducted without a profit intent.  It also extends the statute of limitations for a tax deficiency (and refund claims) associated with the activity.  See, e.g., Wadlow v. Comr., 112 T.C. 247 (1999).    

Showing a Profit Intent – Some Recent Cases

While the IRS is presently not aggressively auditing many returns involving farm-related activities, the hobby loss area involving ag activities is one of them.  So, what does it take to establish the necessary profit intent?  Some recent court decisions provide guidance. 

Cattle ranching activity deemed to be a hobby.  In Williams v. Comr., T.C. Memo. 2018-48, the petitioner grew up on the family ranch in the Texas panhandle.  He then went on to have a career as a chiropractor.  He also operated a publishing and research business and a gun shop. He sold his chiropractic practice and bought an 1,100-acre ranch in south-central Texas. He ran a feeder-stocker cattle operation on the ranch, employing two ranch workers to tend to the cattle. The petitioner also hired a bookkeeper to manage his various business activities and a CPA to do the tax work for his businesses. He put approximately six to eight hours a week into the cattle ranching activity, and also spent time in his other business ventures. He modified his cattle operation after encountering problems that were detrimental to the viability of the business. The petitioner’s publishing business showed an average profit of approximately $300,000 each year; the gun shop was approximately a break-even business; and the cattle business averaged Schedule F losses of about $100,000 annually over a 15-year period, never showing a profit in any year (although losses declined on average over time).

The IRS examined years 2011 and 2012 and disallowed the loss from the ranching activity on the basis that the petitioner did not engage in the activity with a profit intent. The Tax Court analyzed each of the nine factors under Treas. Reg. §1.183-2. Of the nine factors contained therein, only one favored the petitioner - he did not derive any personal pleasure from the cattle ranching activity. The Tax Court determined that the petitioner did not operate the ranch in a businesslike manner; had no formal education in animal husbandry; did not view the hours spent in the activity by the employees as attributable to the petitioner; did not have a reasonable expectation of appreciation of the value of the ranch’s assets (but the Tax Court ignored the building improvements and fences that were built); had no history of running comparable businesses profitably; and had substantial income from other sources that the losses from the ranching activity offset.

Horse activity was a hobby.  In Sapoznik v. Comr., T.C. Memo. 2019-77, the petitioners bought a horse in 2011 and participated in horse shows in 2014 and 2015. The horse was top-ten in its class nationally, and the petitioners hoped to be able to sell the horse for more than its purchase price. However, the lost more than $100,000 and sold the horse for what they paid for it. The petitioners deducted the $100,000 loss and the IRS rejected the deduction and assessed a penalty exceeding $6,000. The Tax Court agreed with the IRS that the activity was a hobby.  The Tax Court noted that the petitioners had not conducted the activity in a businesslike manner. They also had no written business plan and didn’t keep accurate books and records. They also made no changes in how they conducted the activity to reduce expenses or generate additional income, and they did not attempt to educate themselves on how to conduct the activity. They also did not rely on the activity as a major source of their income, and never came close to making a profit. 

Profit was “too gone for too long.” In Donoghue, et ux. v. Comr., T.C. Memo. 2019-71, the petitioners, sustained losses in their horse breeding/racing activity for almost 30 years without ever showing a profit. The husband was a computer programmer and his wife a retired paralegal and business executive. The wife had been a life-long horse enthusiast. They operated the activity via a partnership as a “virtual farm.” The IRS denied the loss deductions from the activity and the Tax Court agreed on the basis that the petitioners couldn’t satisfy the requirements of the regulations under I.R.C. §183. The Tax Court noted that the evidence clearly established that the petitioners didn’t operate the activity in a businesslike manner. They didn’t breed, race or sell any of their horses during the years at issue. While they had separate bank accounts and some records, the records were incomplete or inaccurate. While the petitioners had written business plans, the plans projected net losses and remained essentially unchanged from the original plans 30 years earlier. Also, their long string of unbroken losses was used to offset non-farm income, and the petitioners derived substantial personal pleasure from the activity. They left the “grueling aspects” of the activity to others that they paid, and there was no evidence that they sought expert advice concerning how to make a profit at the activity. Instead, they sought only general advice.

Golf course activity conducted for profit.  In one recent non-ag case, WP Realty, LLP v. Comr., T.C. Memo. 2019-120, a profit intent was found to be present.  The petitioner, a limited partnership, owned and operated a golf course. The limited partner and sole shareholder of the general partner was a real estate developer and developer of golf courses who created a nonprofit corporation to which he planned to donate the golf course at issue. The IRS approval of nonprofit status was conditioned on the corporation focusing only on charitable activities and distributing funds to a medical center. As a result, the golf course gave access to the corporation and members.  The corporation paid rent and members paid fees for golf rounds. The golf course was managed by an experienced manager. The manager kept complete books and records and maintained budgets for the course and facilities. Between 2001 and 2015, the golf course sustained losses which flowed through the petitioner to the limited partner. The golf course reported a net profit in 2016.

The IRS denied the loss deductions on the basis that the golf course was not engaged in its activity for profit. The Tax Court disagreed based on the nine factors of Treas. Reg. §1.183-2(b), a predominance of which favored the petitioner. The golf course was operated in a businesslike manner with complete and accurate books and records, and the records were used to determine when capital improvements should be made. Steps were also taken to make the golf course more profitable. In addition, the managers had extensive experience in the golf industry and in managing golf clubs. The Tax Court also noted that the limited partner had successfully developed two other golf clubs and did not derive substantial tax benefits from the passed-through losses. While a long history of losses was present, that factor was not enough to negate the petitioner’s actual and honest intent to make a profit. 

TCJA Change

The TCJA suspends miscellaneous itemized deductions for years 2018-2025.  Thus, deductions for expenses from an activity that is determined to be a hobby are not allowed in any amount for that timeframe.  I.R.C. §67(g).  But all of the income from the activity must be recognized in adjusted gross income.  That’s painful, and it points out the importance of establishing the requisite profit intent. 


Hobby activities involving agricultural activities (especially those involving horses) have been on the IRS radar for quite some time.  That’s not expected to change.  It’s also an issue that some states are rather aggressive in policing.  See, e.g., Howard v. Department of Revenue, No. TC-MD 160377R, 2018 Ore. Tax LEXIS 35 (Ore. Tax Ct. Mar. 16, 2018); Feola v. Oregon Department of Revenue, No. TC-MD 160081N, 2018 Ore. Tax. LEXIS 48 (Ore. Tax. Ct. Mar. 27, 2018).  It’s also not an issue that the U.S. Supreme Court is likely to review if the taxpayer receives an unfavorable opinion at the U.S. Circuit Court of Appeals level.  See, e.g., Hylton v. Comr., T.C. Memo. 2016-234, aff’d., No. 17-1776, 2018 U.S. App. LEXIS 35001 (4th Cir. 2018), cert. den., No. 18-789, 2019 U.S. LEXIS 966 (U.S. Sup. Ct. Feb. 19, 2019).

October 2, 2019 in Income Tax | Permalink | Comments (0)