Friday, May 24, 2019
During life, many farmers and ranchers are focused on building their asset base, making sure that the business transitions successfully to the next generation, and preserving enough assets for the next generation’s success. Historically, farm and ranch families haven’t widely used life insurance, but it can play an important role in estate, business and succession planning. It can also help protect a spouse (and dependents, if any) against a substantial drop in income upon the death of the farm operator. It can also provide post-death liquidity and fund the buy-out of non-farm heirs.
Planning with life insurance for farmers and ranchers – that’s the topic of today’s post.
A primary purpose of life insurance during the life of the insured farm operator is to provide for the family in the event of death. In that sense, life insurance can provide the necessary capital to build an estate. But, it can also protect income and capital of the farming or ranching business which could be threatened by the operator’s death. Selling off farm assets, including land, to pay debts after the operator’s death will threaten continuity of the business. Life insurance is a means of providing the necessary liquidity to protect against the liquidation of operating assets.
Unfortunately, my experience has been that many legal and tax professionals often overlook the usefulness of insurance as part of the overall plan. This can leave a gaping hole in the estate and business plan that otherwise need not be there. The result is that many farm and ranch families may feel that “the land is my life insurance.” But, what if funds are needed to be unexpected expenses at death? What about debt levels that have increased in recent years? Is it really good to have to liquidate a tract or tracts of land to pay off expenses associated with death and retire burdensome debt?
So how can life insurance be utilized effectively during life? That depends on the economic position of the operator, the asset value of the operation and the legal and tax rules surrounding the ownership of life insurance. Of course, the cost of life insurance must be weighed against options for accumulating funds for use post-death. Also, consideration must be given to the amount of insurance needed, the type of life insurance that will fit the particular situation, and who the insured(s) will be.
From an economic standpoint, life insurance tends to provide a lower return on investment than other alternative capital investments for a farmer or rancher. It’s also susceptible to inflation (not much of an issue in recent years) because of the potentially long time before there is a payout under the policy. But, also from an economic standpoint, life insurance proceeds are generally not included in the beneficiary’s gross income. I.R.C. §101(a)(1).
For younger farmers and ranchers, premium payments can be reduced by putting a term policy in place to cover the beneficiary’s premature death. The term policy can later be converted to a permanent policy. That’s a key point. The use of and plan for life insurance is not static. Life insurance wanes in importance as a mechanism to help build wealth as the farm operation matures and becomes more financially successful and stable. The usage and type of life insurance will change over the life cycle of the farm or ranch business.
From a tax standpoint, life insurance proceeds are included in the insured’s gross estate if the proceeds are received by or for the benefit of the estate. As such, they are potentially subject to federal estate tax. However, the current $11.4 million exemption equivalent of the unified credit (per person) takes federal estate tax off the table for the vast majority of farming and ranching estates. In addition, if the proceeds are payable to the estate, they also become subject to creditors’ claims as well as probate and estate administration costs. If the beneficiary is legally obligated to use the proceeds for the benefit of the estate, the proceeds are included in the estate regardless of whether the estate is the named beneficiary. It makes no difference who took the policy out or who paid the premiums. But, the proceeds are included in the decedent’s gross estate only to the extent they are actually used to discharge claims. See, e.g., Hooper v. Comr., 41 B.T.A. 114 (1940); Estate of Rohnert v. Comr., 40 B.T.A. 1319 (1939); Prichard v. United States, 255 F. Supp. 552 (5th Cir. 1966).
But, there is a possible way to have the funds available to cover the obligations of the decedent’s estate without having the insurance proceeds being included in the estate. That can be accomplished by authorizing the beneficiary to pay charges against the estate or by authorizing the trustee of a life insurance trust to use the proceeds to pay the estate’s obligations, buy the assets of the estate at their fair market value, or make loans to the estate. Treas. Reg. §20.2042-1(b)(1). In that situation, the proceeds aren’t included in the decedent’s estate because there is no legal obligation (i.e., duty) of the beneficiary (or trustee if the policy is held in trust) to use the proceeds to pay the claims of the decedent’s estate. See, e.g., Estate of Wade v. Comr., 47 B.T.A. 21 (1942). However, achieving this result requires careful drafting of policy ownership language along with the description of how the policy proceeds can be used to avoid an IRS claim that the decedent retained “incidents of ownership” over the policy at the time of death. I.R.C. §2042. In addition, the policy holder’s death within three years of transferring the policy can cause inclusion of the policy proceeds in the decedent’s estate. I.R.C. §2035.
Other Uses of Life Insurance
Loan security. Life insurance can be pledged as security for a loan. This means that a farmer or rancher can use it as collateral for buying additional assets to be used in the business. In this event, the full amount of the policy proceeds will be included in the decedent’s gross estate, but the estate can deduct any outstanding amount that is owed to the creditor, including accrued interest. It makes no difference whether the creditor actually uses the insurance proceeds to pay the outstanding debt.
Funding a buy-sell agreement. For those farming and ranching operations where the desire is that the business continue into subsequent generations as a viable economic unit, ensuring that sufficient liquid funds are available to pay costs associated with death is vitally important to help ease the transition from one generation to the next. Having liquid funds can also be key to buying out non-farm heirs so that they do not acquire ownership interests in the daily operational aspects of the business. Few things can destroy a successful generational transition of a farming or ranching business more effectively than a sharing of managerial control of the business between the on-farm and off-farm heirs. Life insurance proceeds can be used fund a buy-out of the off-farm heirs. How is this accomplished? For example, an on-farm heir of the farm operator could buy a life insurance policy on the life of the operator. The policy could name the on-farm heir as the beneficiary such that when the operator dies the proceeds would be payable to the on-farm heir. The on-farm can then use the proceeds to buy-out the interests of the off-farm heirs. In addition, the policy proceeds would be excluded from the operator’s estate.
There are other approaches to the addressing the transition of the farming/ranching business. Of course, one way to approach the on-farm/off-farm heir situation is for the parents’ estate plans to favor the on-farm heirs as the successor-operators. But, this can lead to family conflict if the younger generation perceives the parents’ estate plans as unfair. Whether this point matters to the parents is up to them to decide. Another approach is to leave property equally to the on-farm and the off-farm heirs. But, this approach splits farm ownership between multiple children and their families and can result in none of the families being able to derive sufficient income from their particular ownership interest. This causes the ownership interest to be viewed as a “dead” asset. Remember, off-farm heirs often prefer cash as their inheritance. Sentimental ownership of part of the family farming or ranching operation may last for a while, but it tends to not to be a long-term feeling for various reasons. Sooner or later a sale of the interest will be desired, real estate will be partitioned and the future of the family farming operation will be destroyed. A life insurance funded buy-out can be a means to avoiding these problems.
Today’s post merely introduced the concept of integrating life insurance in the estate/business plan of a farmer or rancher. Other considerations involving life insurance include a determination of the appropriate type of life insurance to be purchased, the provisions to be included in a life insurance contract, and the estate tax treatment of life insurance. Ownership planning is also necessary. As you can see, it gets complex rather quickly. However, the use of life insurance as part of an estate plan can be quite beneficial.
Wednesday, May 22, 2019
The question often arises with farm and ranch clients that engage in estate, business or succession planning as to what the optimal entity structure is for the business? There’s no easy, one-size-fits-all answer to that question. It simply depends on numerous factors. In fact, the question is best answered by asking a question in return – what do you want the farming or ranching business to look like after you and your spouse are gone? What are your goals and objectives. If planning starts from that standpoint, then it is often much easier to get set on a path for creating an “optimal” entity structure.
Some thoughts on structuring the farming or ranching business – that’s the topic of today’s post
Food For Thought
In many planning scenarios it is useful to create a checklist of points to consider that are relevant in the entity selection decisionmaking process. The next step would then be to apply those points to the goals and objectives of the parties. For starters, consider the following:
C corporations. The following are relevant to C corporations:
- A C corporation can be formed tax free if property is exchanged for stock; the transferors (as a group) hold 80 percent or more of the stock immediately after the exchange of property for stock; and the formation is for a business purpose.
- C corporate income is subject to tax at a flat rate of 21 percent.
- A C corporation is not eligible for the 20 percent qualified business income deduction of I.R.C. §199A that is available to a sole proprietor or the member of a pass-through entity (such as a partnership or S corporation).
- While gain that is realized on the sale of stock of a farming corporation can’t be excluded under the special rules that apply to qualified small business stock (I.R.C. §1202), if the stock is that of a corporation engaged in processing activities, the gain can be excluded. There are other rules that can limit (or eliminate) this capital gain exclusion.
- When a C corporation converts to S corporation status, the built-in gains (BIG) tax applies to the built-in gains on income items. I.R.C. §1374(a). The Tax Cuts and Jobs Act (TCJA) didn’t eliminate the BIG tax, but it did lower it to 21 percent.
- A C corporation has good flexibility in establishing its capitalization structure as well as how it allocates income, losses, deductions and credits.
- A C corporation is potentially subject to additional penalty taxes if too much earnings are accumulated without legitimate, well documented business reasons, or If too much income is passive.
- The alternative minimum tax presently doesn’t apply to C corporate income.
- A corporation for the farming operating entity will limit farm program payment limitations to a single $125,000 limit at the entity level. That amount will then be divided by the number of shareholders. If a pass-through entity is the operating entity, the number of payment limits will be determined by the number of members of the entity.
- A C corporation can deduct state income tax. This should be contrasted with the TCJA limitation on the deduction of such taxes for individuals that is pegged at $10,000 (including real property taxes on property that is not used in the conduct of the taxpayer’s trade or business). I.R.C. §164(b)(6).
- A C corporation can provide employees with the tax-free fringe benefits of meals (limited to 50 percent by I.R.C. §274(n)) and lodging that are supported by legitimate business reasons (and satisfy other conditions). This benefit is not available to sole proprietors and partners in a partnership. See, e.g., Rev. Rul. 69-184, 1969-1 C.B. 256. That is also the result for S corporation employees who own, directly or indirectly, more than 2% of the outstanding stock of the S corporation may not receive certain otherwise tax-free fringe benefits (including meals and lodging). See I.R.C. §1372. Attribution rules apply for determining who is considered to be an S corporation shareholder. I.R.C. §318.
- A farming or ranching C corporation can generally use the cash method of accounting.
- In some states, a C corporation cannot own or operate agricultural land unless members of the same family own a majority of the corporate stock. State laws differ on the specific rules barring C corporations from being involved in agriculture, and some states don’t have such rules.
- A C corporation faces the potential of a double layer of tax upon liquidation.
- The C corporation generally does provide good estate planning opportunities. In other words, it tends to be a good organizational vehicle for transitioning ownership from one generation to the next.
What About Income Tax Basis?
Given the currently high level of the federal estate tax exemption equivalent of the unified credit (11.4 million per decedent for deaths in 2019), income tax basis planning is high on the priority list. Thus, when federal estate tax is not a potential concern, planning generally focuses on making sure that property is included in a decedent’s estate. This raises some basic planning rules that must be considered:
- For property that is included in a decedent’s estate for purposes of federal estate tax, the basis of that property in the hands of the person inherits the property is generally the fair market value (FMV) as of the date of the decedent’s death. I.R.C. §Sec. 1014(a)(1)).
- But, the “stepped-up” basis rule (to the date-of-death value) doesn’t apply to property that is income in respect of a decedent (IRD) under §691. R.C. §1014(c). An item is IRD something that decedent was entitled to as gross income but wasn’t’ included in income due to death in accordance with the decedent’s method of accounting. See Treas. Reg. §1.691(a)-1(b). Farmers and ranchers have some common occurrences of IRD such as…
- Deferred gain to be reported from installment sales and deferred sales of crops and livestock;
- The portion (on a pro rata) basis or crop-share rentals due at the time of death;
- Receivables for a cash basis farmer;
- Unpaid wages;
- The value of commodities stored at an elevator (cooperative). Reg. §1.691(a)-2(b), Example 5 (canning factory and processing cooperative).
- Accrued interest income on Series E/EE bonds;
- When a decedent’s estate makes an election under I.R.C. §2032A to value ag land in the estate at its value as ag property (known as the “special use” value) rather than at its fair market value, the basis of the land in the hands of the heir is the special use value. There is no basis “step-up” to fair market value at the time of death. Treas. Reg. §§1014(a)(3); 1.1014-3(a).
- While the income of a pass-through entity is taxed only at the owner level, and the pass-through income increases the owner’s tax basis in the owner’s interest in the pass-through entity, a C corporation pays tax at the corporate level and then tax is also paid at the shareholder level on dividends or proceeds of liquidation. In addition, C corporate income does not increase the shareholder’s stock basis.
Just Starting Out – Creating a New Entity
If an organizational structure is initially being put into place, again there are numerous factors to consider in determining whether the farming or ranching business should operate as a C corporation or a pass-through entity. In addition, to those factors pointed out above, the following factors should also be considered:
- Is it anticipated that the primary or sole shareholder will hold the corporate stock until death?
- Where will the business be incorporated and do business? If the business will be a C corporation, does the state of incorporation or other states in which the corporation will do business have a state income tax?
- What tax bracket(s) will apply to the shareholders?
- If the underlying business of the corporation would qualify for the 20 percent qualified business income deduction of I.R.C. §199A, what’s the differential between the corporate tax rate of 21 percent and the individual rate less the 20 percent deduction? Will that full 20 percent deduction be available if the entity weren’t a C corporation? This can involve a rather complex analysis.
- What type of assets are involved? Will they appreciate in value? If so, the corporate tax rate of 21 percent plus the second layer of tax on gain of the appreciated asset value at the shareholder level upon liquidation (or on a qualified dividend) will exceed the maximum 23.8 percent capital gain rate that applies to an individual (20 percent rate plus an additional 3.8 percent on passive gain under Obamacare. I.R.C. §1411.
- Is it anticipated that the business will retain earnings or pay it out in the form of compensation, rents or other expenses? Growing businesses tend to retain earnings. Paid-out earnings of a C corporation are taxed again at the shareholder level.
- Is income expected to fluctuate widely? If so, remember that the C corporate tax rate is a flat 21 percent.
- Will there be sufficient funds to pay consistent income to the owners of the business? If so, that can mean that (if a C corporation structure is utilized) shareholder-employees can receive tax benefits at the individual level. If a corporate-level loss is incurred in doing so, that loss can be used to offset future taxable income.
- Under the TCJA, losses can offset up to 80 percent of pre-NOL taxable income.
- The loss (for a farming corporation) can be carried back two years. I.R.C. §172(b)(1)(B).
- From an accounting and tax planning standpoint, is a fiscal year desired? A C corporation can have a fiscal year-end and the individual shareholders can have a calendar year-end.
So, what is the best entity structure for your farming or ranching operation? The discussion above merely scratches the surface of a very complex matter. However, if you clearly articulate your goals and objectives for the future of your business to your planners, and provide complete information on assets, liabilities, land ownership, current arrangements, family data and dynamics, cropping and livestock history and tax history, then a good plan can be put in place that can, at least in the short-term satisfy your objectives. Then, there must be a commitment to routinely review and update the plan as necessary. There is no “one-size-fits-all” business plan, and plans aren’t static. There is cost involved, of course, but the successful operations realize that the cost is a small compared to the benefits.
Monday, May 20, 2019
For farmers and ranchers (and other rural landowners) owning agricultural land adjacent to railroads, the abandonment of an active rail line presents a number of real property issues. What is the legal effect of the abandonment? Does state or federal law apply? What about fencing? These (and others) are all important questions when a railroad abandons a line.
Abandoned rail lines and legal issues – that’s the topic of today’s post.
Legal Effect of Abandonment
During the nineteenth century, many railroad companies acquired easements from adjoining landowners to operate rail lines. In some instances, railroads acquired a fee simple interest in rights-of-way and in those situations, can sell or otherwise dispose of the property. In most situations, however, a railroad was granted an easement for railroad purposes, usually acquired from adjacent property owners. The general rule is that a right-of-way for a railroad is classified as a limited fee with a right of reverter if received from Congress on or before 1871, but is classified as an exclusive use easement if the right of way is received after 1871.
If the railroad held an easement, the abandonment of the line automatically terminates the railroad's easement interest, and the interest generally reverts to the owners of the adjacent land owning the fee simple interest from which the easement was granted. See, e.g., Penn. Central Corp. v. United States Railroad Vest Corp., 955 F.2d 1158 (7th Cir. 1992).
After abandonment, state law controls the property interests involved. Once abandonment occurs, federal law does not control the property law questions involved. The only exception is if the United States retained a right of reverter in the abandoned railway. Under the Abandoned Railroad Right of Way Act (43 U.S.C. § 912), land given by the United States for use as a railroad right-of-way in which the United States retained a right of reverter had to be turned into a public highway within one year of the railroad company’s abandonment or be given to adjacent landowners. Later, the Congress enacted the National Trails System Improvement Act of 1988 under which those lands not converted to public highways within one year of abandonment would revert back to the United States, not adjacent private landowners.
What About Recreational Trails?
In 1976, the Congress passed the Railroad Revitalization and Regulatory Reform Act in an effort to promote the conversion of abandoned lines to trails. Under the Act, the Secretary of Transportation is authorized to prepare a report on alternate uses for abandoned right-of-ways. The Secretary of the Interior can offer financial, educational and technical assistance to local, state and federal agencies. In addition, the Interstate Commerce Commission (ICC) was authorized to delay disposition of railroad property for up to 180 days after an order of abandonment, unless the property was first offered for sale on reasonable terms for public purposes including recreational use. The National Trails System Act amendments of 1983 authorized the ICC to preserve for possible future railroad use, rights-of-way not currently in service and to allow interim use of land by a qualified organization as recreational trails. Effective January 1, 1996, the Congress replaced the ICC with the Surface Transportation Board (STB), and gave the STB authority to address rail abandonment and trail conversion issues. The organizations operating the corridors as trails assume all legal and financial responsibility for the corridors. This is known as railbanking.
Under the 1983 amendments, a railroad must follow a certain procedure if it desires to abandon a line. A potential trail operator must agree to manage the trail, take legal responsibility for the trail and pay any taxes on the trail. The STB engages in a three-stage process for railroad abandonment. First, a railroad must file an application with the STB and notify certain persons of its planned abandonment. The application must state whether the right-of-way is suitable for recreational use. In addition, the application must notify government agencies and must be posted in train stations and newspapers giving the public a right to comment. Second,the STB then determines whether “present or future public convenience and necessity” permit the railroad to abandon. A trail organization then must submit a map and agreement to assume financial responsibility and the STB will then determine whether the railroad intends to negotiate a trail agreement. Third, if such a determination is made, the STB will issue a “certificate of interim trail use” or a certificate of abandonment. The parties have 180 days to reach this agreement. If no agreement is reached, the line is abandoned. Abandonment of a railroad right-of-way cannot occur without the prior authorization of the STB. See, e.g., Phillips Company v. Southern Pacific Rail Corp., 902 F. Supp. 1310 (D. Colo. 1995). But, once abandonment occurs, the STB no longer has any jurisdiction over the issue. See, e.g., Preseault v. Interstate Commerce Commission, 494 U.S. 1 (1990).
Before passage of the 1983 amendments, it was clear that when a railroad ceased line operation and abandoned the railway, the easement interest of the railroad in the line reverted to the adjacent landowners of the fee simple. See, e.g., Consolidated Rail Corp. Inc. v. Lewellen, 682 N.E.2d 779 (Ind. 1997). However, as noted, the 1983 amendments established a more detailed process for railroad abandonment and gave trail organizations the ability to operate an abandoned line. While most railroads hold a right-of-way to operate their lines by easement specifying that the easement reverts to the landowner upon abandonment, after passage of the 1983 amendments, a significant question is when, if ever, abandonment occurs. One court has held that the public use condition on abandonment does not prevent the abandonment from being consummated, at which time STB jurisdiction ends, federal law no longer pre-empts state law, and state property law may cause the extinguishment of the railroad's rights and interests. See, e.g., Fritsch v. Interstate Commerce Commission, 59 F.3d 248 (D.C. Cir. 1995), cert. denied sub. nom. CSX Transportation v. Fritsch, 516 U.S. 1171 (1996).
A more fundamental issue is whether a preclusion of reversion to the owner of the adjacent fee simple is an unconstitutional taking of private property. I will analyze the constitutional takings issue is a subsequent post. Suffice it to say, however, in 1990 the U.S. Supreme Court upheld the 1983 amendments as constitutional. Preseault v. Interstate Commerce Commission, 494 U.S. 1 (1990). But see Swisher v. United States, 176 F. Supp.2d 1100 (D. Kan. 2001).
Numerous issues (including issues associated with fencing) involving the abandonment of a rail line were front and center in a recent court decision from Kansas. In, Central Kansas Conservancy, Inc., v. Sides, No.119,605, 2019 Kan. App. LEXIS 29 (Kan. Ct. App. May 17, 2019), the Union Pacific Railroad acquired a right-of-way over a railroad corridor that it abandoned in the mid-1990s. At issue in the case was a 12.6-mile length of the abandoned line between the towns of McPherson and Lindsborg in central Kansas. A Notice of Interim Trail Use (NITU) was issued in the fall of 1995. The corridor was converted into a trail use easement under the National Trails System Act.
In 1997, Union Pacific gave the plaintiff a "Donative Quitclaim Deed" to the railroad’s easement rights over the corridor, with three-quarters of a mile of it running through the defendant’s property at a width of 66 feet. Pursuant to a separate agreement, the plaintiff agreed to quitclaim deed its rights back to the railroad if the railroad needed to operate the line in the future. By virtue of the easement, the plaintiff intended to develop the corridor into a public trail. In 2013, the plaintiff contacted the defendant about developing the trail through the defendant’s land. The defendant had placed machinery and equipment and fencing in and across the corridor which they refused to remove.
In 2015, the plaintiff sued to quiet title to the .75-mile corridor strip and sought an injunction concerning the trail use easement over the defendant’s property. The defendant admitted to blocking the railway with fencing and equipment, but claimed the right to do so via adverse possession or by means of a prescriptive easement. The defendant had farmed, grazed cattle on, and hunted the corridor at issue since the mid-1990s. The defendant also claimed that the plaintiff had lost its rights to the trail because it had failed to complete development of the trail within two years as the Kansas Recreational Trail Act (KRTA) required.
In late 2016, the trial court determined that the two-year development provision was inapplicable because the ICC had approved NITU negotiations before the KRTA became effective in 1996. The trial court also rejected the defendant’s adverse possession/prescriptive easement arguments because trail use easements are easements for public use against which adverse possession or easement by prescription does not apply. During the summer of 2017 the plaintiff attempted to work on the trail. When volunteers arrived, the defendant had placed equipment and a mobile home on the corridor preventing any work. The plaintiff sought a "permanent prohibitory injunction and permanent mandatory injunction." The defendant argued that he had not violated the prior court order because "[a]ll the Court ha[d] done [was] issue non-final rulings on partial motions for summary judgments, which [were], by their nature, subject to revision until they [were] made final decisions." Ultimately, the trial court granted the plaintiff’s request for an injunction, and determined that the defendant had violated the prior summary judgment order. The trial court also held that the plaintiff had not built or maintained fencing in accordance with state law.
On appeal, the appellate court partially affirmed, partially reversed, and remanded the case. The appellate court determined that the defendant did not obtain rights over the abandoned line via adverse possession or prescriptive easement because those claims cannot be made against land that is held for public use such as a recreational trail created in accordance with the federal rails-to-trails legislation. The appellate court also determined that the plaintiff didn’t lose rights to develop the trail for failing to comply with the two-year timeframe for development under the KRTA. The appellate court held that the KRTA two-year provision was inapplicable because a NITU was issued before the effective date of the KRTA.
However, the appellate court determined that the plaintiff did not follow state law concerning its duty to maintain fences. The appellate court held that Kan. Stat. Ann. §58-3212(a) requires the plaintiff to maintain any existing fencing along the corridor and maintain any fence later installed on the corridor. In addition, any fence that is installed on the corridor must match the fencing maintained on the sides of adjacent property. If there is no fencing on adjacent sides of a landowner’s tract that abuts the corridor, the plaintiff and landowner are to split the cost of the corridor fence equally. The appellate court remanded the case for a determination of the type and extent of fencing on the defendant’s property, and that the plaintiff has the right to enter the defendant’s property to build a fence along the corridor. Any fence along the corridor is to be located where an existing fence is located. If no existing fence exists along the corridor, the corridor fence is to be located where the plaintiff’s trail easement is separated from the defendant’s property. The appellate court remanded to the trial court for a reconsideration of its ruling on fence issues.
Abandoned rail lines create numerous legal issues for adjacent landowners, including a mix of federal and state law. In addition, fencing issues get involved and those may be handled not under the general fence laws of the particular state, but in accordance with fencing provisions specific to the conversion of abandoned rail lines to trails. In any event, for those that believe they have been negatively impacted by a rail line abandonment, seeking good legal counsel is a must to protect whatever landowner rights remain.
Thursday, May 16, 2019
The markets for the major ag products in the U.S. are highly concentrated. This is the case in the markets for hogs and poultry as well as food processing and the market for genetic characteristics of corn, soybeans and cottonseed. The retail sector involving many ag products is also highly concentrated. This raises economic and legal questions as to whether the conduct that such concentration makes possible improperly denies farmers a proper share of the retail food dollar and simultaneously increase prices to consumers. In other words, does the conduct associated with market concentration at these various levels negatively impact commodity prices, and result in producers receiving less of the retail food dollar while consumers simultaneously pay more for food? If so, what can a farmer or rancher do about it? Does antitrust law provide a remedy? Does it matter that a farmer/rancher is not a directly injured party? The U.S. Supreme Court recently decided a case involving the Apple Co. and IPhone users that involves some of these concepts. Does it have implications for farmers and ranchers?
That’s the topic of today’s post – the ag implications of the recent Supreme Court decision involving Apple Inc. and IPhone users. I have asked Peter Carstensen, Professor of Law Emeritus at the University of Wisconsin School of Law to collaborate with me on today’s post. Peter is a Senior Fellow of the American Antitrust Institute, and formerly worked in the antitrust division of the U.S. Department of Justice. You will find rather interesting his thoughts on the implications of this week’s Supreme Court decision for agriculture.
Antitrust and Indirect Purchasers
The 1977 U.S. Supreme Court decision. The questions posed above are interesting. From a legal standpoint, what can a farmer or rancher do if they believe that they have been improperly harmed by anticompetitive conduct? In 1977, the U.S. Supreme Court held in Illinois Brick Co. v. Illinois, 431 U.S. 720 (1977), that a plaintiff cannot claim damages when the plaintiff is not the party that was directly injured. In other words, even if an antitrust violation can be established that results, for example, in ag product prices being lower than a competitive market would produce, Illinois Brick bars the farmer/rancher from suing for damages due to lack of standing because they haven’t been directly injured – there is a processor in-between. For example, assume manufacturers or food retailers operate in a concentrated market and agree to fix the prices of their products and then sell those products to wholesalers or retailers (their direct customers). The wholesalers and retailers then resell the goods either to other entities down the supply chain or to end consumers (i.e., indirect purchasers). It’s those indirect purchasers that the 1977 Supreme Court decision bars from seeking damages because the court feared that defendants would be exposed to multiple claims for recovery and there would be complications in apportioning damages among the plaintiffs in the supply chain. The same reasoning has been applied to farmer claims where the alleged source of harm is a downstream conspiracy by retailers. Indirectly injured parties can still seek injunctive relief, but private lawyers are unlikely to take such cases despite the statutory right to a reasonable attorney’s fee if they succeed. Since 1977, most states have enacted laws or have judicial opinions that reject the Illinois Brick decision (which are not preempted by federal law – see California v. ARC America, 490 U.S. 93 (1989)). In these states, indirect purchasers can seek recovery under state antitrust laws.
Recent Supreme Court opinion. In Apple Inc. v. Pepper, et al., No. 17-204, 2019 U.S. LEXIS 3397 (U.S. Sup. Ct. May 13, 2019), IPhone users sued Apple Inc. over its operations of the App Store. The trial court held that the consumers in the case were indirect purchasers that lacked standing due to Illinois Brick. The Ninth Circuit reversed (Pepper v. Apple Inc., 846 F.3d 313 (9th Cir. 2017)) and the U.S. Supreme Court agreed to hear the case (Apple Inc. v. Pepper, 138 S. Ct. 2647 (2018). On May 13, the Supreme Court affirmed the Ninth Circuit decision by a 5 to 4 vote. Thus, the plaintiffs could pursue their claims against Apple for allegedly monopolizing access to apps for Apple’s iPhones and imposing monopoly prices. Apple had constructed its arrangement with the app developers so that formally the developers set the prices charged to buyers and Apple took a 30 percent commission from that price before remitting the remainder to the developer. Thus, as a formal contract matter, Apple was only the agent of the developer although the customers could only deal with Apple to get apps.
The majority took the view that Apple was a retailer of apps with an alleged monopoly over the supply. In this view the formal contract relationship between the developer and Apple was irrelevant to the question of whether the buyers were the first victim to Apple’s alleged monopoly. The opinion acknowledged that there could be some difficult issues as to damages because if Apple took a lower commission (mark-up) on the apps, the app seller might have raised its prices. Hence, the actual damages to the buyers might be difficult to calculate. Moreover, the opinion pointed out that the developers could have a claim for damages as a result of lost sales resulting from the excessive commission charge if they would have kept a lower retail price.
The dissent argued that the better interpretation of Illinois Brick was to focus on the party setting the price, here the developers. Hence, they alone should have standing to claim that any Apple monopoly had harmed them as the first victim. The dissent stressed the problems of determining damages for both upstream and downstream victims given that the majority had held that both could sue.
Thus, the court was unanimous that the Illinois Brick rule should remain. It rejected the argument of a group of 30 states set forth in an Amicus Brief urging the Court to reverse Illinois Brick and allow indirect purchasers with damage claims to have access to the federal courts. However, the majority decision appears to reject the use of formal contracts to determine who is the first buyer. This is consistent with historic practice in antitrust where courts have looked to the substance and not the form of the conduct. However, to determine who is the first seller, the majority focused on transactional characteristics that seem very formal. But it repeatedly characterized Apple as a classic retailer that selected the goods it would sell, and generally controlled the marketing of the goods. In contrast, there are real “agents” who function as independent contractors to deliver goods for others and remit the payments. The decision does not make this distinction explicitly but its repeated characterization of Apple as a retailer suggests that the majority was taking a realistic, functional view of the relationship. A more nuanced analysis of this point would have been very helpful.
Implications for Agriculture
The following are Prof. Carstensen’s thoughts on the ag implications of the Pepper decision:
Because the decision leaves the Illinois Brick rule in place, it fails to give farmers any direct expansion of their right to damages under federal law. Of greater significance for agriculture where the concern is exploitation of monopsony or oligopsony power, the majority opinion is clear that both downstream customers and upstream suppliers (e.g., farmers) can sue the buyer/seller engaged in anticompetitive conduct causing harm. This is helpful with respect to poultry and (potentially) hog cases brought on behalf of farmers providing growing services. It confirms their independent right to claim damages. This declaration is also relevant to the continuing disputes over the interpretation of the Packers and Stockyards Act (PSA) condemnation of unfair and discriminatory conduct. 7 U.S.C. §§182 et seq. The courts have imposed an interpretation that holds that the PSA is an antitrust statute which requires competitive injury before there can be a violation. In addition, the decisions have required that there be an adverse effect on consumers and not just producers. The Pepper decision re-emphasizes the well-established antitrust principle that both upstream and downstream harms are independent antitrust injuries. In future PSA cases proof of harm to producers should establish “harm to competition.” Of course, a better understanding of the PSA, consistent with its application in various contexts such as buyer defaults and false weighing, is that its purpose is to protect individual farmers from unfair and discriminatory conduct. But that issue must await a court willing to interpret the PSA’s provisions correctly.
Another implicit but important underlying assumption of the case is that Illinois Brick applies to exploitive conduct (i.e., either excessive prices imposed on buyers, or under payment to sellers). The implication is that this rule has no bearing on cases involving exclusion or predation where the illegal conduct harms the victims but does not create a direct gain to the wrongdoer. Unlike the exploitation cases, the predatory wrongdoer is not sitting on a “pot of money” resulting from its illegal deeds; rather it has expended resources to exclude rivals or entrench its market position in some way. In such cases the measure of harm is the loss to the victim and not the gain to the wrongdoer. This is important because usually the harm results from some market manipulation or exclusionary practice in which the wrongdoer causes the harms without directly dealing with the victim. Where farmers are victims of such exclusionary practices even if the harm is inflicted indirectly, they would still have standing to seek damages as well as injunctions in federal court.
In Pepper, the Supreme Court reaffirmed the Illinois Brick rule. However, it employs a functional analysis to identify the first buyer (seller). This may improve slightly the chances of farmers getting damages in federal court when buyers engaged in unlawful exploitation have used agents or other specious means to avoid direct dealings. But the rule remains a major barrier to getting damages for farmers harmed indirectly by exploitive practices by downstream buyers. Where the farmers’ harm stems from exclusionary or predatory conduct, the decision reinforces the position that the rule does not apply to such damages. But, it also provides a further correction to the misinterpretations of competitive harm invoked in PSA cases.
The Pepper decision is not much of a crack in the (Illinois) brick house. A small dent perhaps, but not a foundational crack. “Ow…a brick house.”…
Tuesday, May 14, 2019
This summer Washburn Law School is sponsoring its summer national ag tax and estate and business planning conference in Steamboat Springs, Colorado on August 13-14. The event will be held at the beautiful Steamboat Grand Hotel, and is co-sponsored by the Department of Agricultural Economics at Kansas State University and WealthCounsel. Registration is now open for the two-day event, and onsite seating is limited to the first 100 registrants. However, the event will be live streamed over the web for those who can’t make it to Steamboat.
Key Ag Tax and Planning Topics
The QBID. As we historically have done at this summer event, we devote an entire day to ag income tax topics and an entire second day to planning concepts critical to farm and ranch families. Indeed, on Aug. 13, myself and Paul Neiffer will begin the day with a dive back into the qualified business income deduction (QBID) of I.R.C. §199A and take a look at the experience of the past filing season (that largely continues uninterrupted this year). For many clients, returns were put on extension in hopes that issues surrounding the QBID, or the DPAD/QBID for patrons of cooperatives would get resolved. Plus, software issues abounded, and the IRS issued conflicting (and some incorrect) information concerning the QBID. In addition, the season began with errors in Pub. 225, the Farmers’ Tax Guide. Some states even piggy-backed the IRS errors for state income tax purposes and coupling. That made matters very frustrating.
On the QBID discussion, we will take a close look at the rental issue. That seems to be a rather confusing matter for many practitioners. Is there an easy way to separate rental situations so that they can be easily analyzed? We will break it down as simply as possible and explain when to use the safe-harbor – it’s probably not nearly as often as you think. What is an I.R.C. §162 trade or business activity? How do the passive loss rules interact with the QBID?
For farmers that are patrons of ag cooperatives, how is the DPAD/QBID to be calculated? What information is needed to properly complete the return? Where does what get reported? My experience so far this tax season in seminars is that it is taking me about three hours just to recap and review the QBID and go through practitioner questions that came in during tax season and share how they were answered. The discussion has been great, and at the end of the discussion, you will have a better handle on how the QBID works for your clients. Is it really as complicated as it seems?
Selected ag topics. After a brief break following the QBID discussion, we will get into various ag-related tax topics and how the changes brought about by the TCJA impact ag returns. What were the problem areas of applying the new rules during the filing season? What are the key tax issues that farm and ranch clients are presently facing. Currently, disaster issues loom large in parts of the Midwest and Plains. Also, Farm Bill-related issues associated with CCC loans and the impact on the PLC/ARC decision are important. What about how losses are to be treated and reported? Those rules have changed. Depreciation rules have also been modified. But, is it always in a client’s best interests to maximize the depreciation deduction? What about trades? The reporting of personal property trades has changed dramatically. How do those get reported now? What are the implications for clients?
Cases and Rulings
Of course, the day wouldn’t be complete without going through the key rulings and cases from the prior year. There are always many important developments in the courts and with the IRS. Some are even amusing! It’s always insightful to learn from the mistakes of others, and from others that are blazing the trail for others to follow. We will work through all of the key ag-related cases and rulings from the past 12-18 months.
We will have specific session focusing on depreciation, the passive loss rules (and how to report on the return); ag disasters; and the 2018 Farm Bill. Day 1 will be a full day.
Ag Estate and Business Planning
On August 14, we turn our attention to planning concepts for the farm and ranch family. Joining me on Day 2 will be Stan Miller, the founder of WealthCounsel, LLC. In addition to providing estate and business planning education, WealthCounsel, LLC also provides drafting software. In addition, Timothy O’Sullivan joins the Day 2 teaching team. Tim has a longstanding practice in Wichita, Kansas, where he focuses on estate planning and the administration of trusts and estates.
Recent developments. Day 2 begins with a rapid summary of the development that impact estate and business planning. For most clients, the issue is not tax avoidance given the presently high levels of the applicable exclusion. Rather, the issue is including property in the estate to achieve a stepped-up basis. I will go through recent developments impacting the basis planning issue and other developments impacting charitable giving as well as retirement planning.
Other issues. Tim O’Sullivan will devote a session to dealing with family disharmony and how to keep it from cratering a good estate plan. Tim will also have a separate session on incorporating good long-term care planning into the overall family estate and business plan. This is a very important topic for many farm and ranch families – particularly those that want to keep the family business in tact for future generations. I will have separate sessions on charitable giving; planning for second (and subsequent) marriages; and common estate planning mistakes. To round out Day 2, Stan Miller will devote a session to techniques that can professionals can implement to preserve family held farms and ranches for future generations. This will be a timely topic given the many variables that farmers and ranchers must handle to help their operations continue to be successful.
For more information about the event and to register, click here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
A room block for the conference is available at the Steamboat Grand Hotel and is accessible from the page at the link provide above or here: https://group.steamboatgrand.com/v2/lodging-offers/promo-code?package=49164&code=WASH19_BLK
If you can’t attend, the conference is live streamed. Information about signing up for the live streaming is also available on the first link provided above.
Conservation Easement Seminar
I will also be presenting at another CLE/CPE event in Steamboat on Monday, August 12 immediately preceding our two-day conference. That event is sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust, and focuses on the legal, real estate and tax issues associated with conservation easement donations. I will provide more information about that event as it becomes available.
This two-day seminar is a high-quality event this summer in a beautiful location. If you are in need of training on ag tax and planning related issues, this is the event for you. In addition, the full day on conservation easements preceding the two-day conference is an excellent opportunity to dig into a topic that IRS is looking at closely. It’s important to complete these transactions properly and this conference will lay out the details as to how to do it properly.
I hope to see you either in-person in Steamboat Springs later this summer or via the web. It will be a great event for your practice!
Friday, May 10, 2019
It’s been a while since I have devoted a post to recent developments, so that’s what today’s post is devoted to. There are always many significant developments in ag law and tax. I was pleased recently when one of my law students, near the conclusion of the course, commented on how many areas of the law that agricultural law touches and how often the rules as applied to farmers and ranchers are different. That is so true. Ag law is daily life for a farmer, rancher, rural landowner, and agribusiness in action.
Recent development in ag law and tax – that’s the topic of today’s post.
Chapter 12 Plan Not Feasible
As I have written in other posts, when a farmer files Chapter 12 bankruptcy, the reorganization plan that is proposed must be feasible. That means that the farmer must estimate reasonable crop yields and revenue based on historical data, and also provide reasonable estimates of expenses. Courts also examine other factors to determine whether a reorganization plan is feasible.
In, In re Jubilee Farms, 595 B.R. 546, 2018 Bankr. LEXIS 4080 (Bankr. E.D. Ky. Dec. 28, 2018), the debtor, a farm partnership operated by two brothers, farmed primarily corn and soybeans. The Debtors filed Chapter 12 bankruptcy in early 2018. In May of 2018, the Debtors filed a joint Chapter 12 plan, but the secured creditors, FCMA and FCS, objected. The debtors filed an amended Chapter 12 plan providing FCMA with a fully secured claim of roughly $2.7 million and FCS with a fully secured claim of roughly $180,000. The plan provided for periodic payments funded primarily by the debtor’s farming income and supplemented by custom trucking and combining revenue. Additional funding in the first year would come from crop insurance and anticipated federal aid for farmers affected by political activity upsetting foreign crop sales.
The creditors and the Trustee objected to the confirmation of the amended plan on various grounds, but the main argument raised was that the amended plan was not feasible, because the debtor’s one-year income and expense projections were limited and unrealistic compared to the debtor’s historical income and expenses. An evidentiary hearing was held to present projected revenue and expenses for the farm and thus determine the feasibility (whether the debtor could make all plan payments and comply with the plan) of the amended plan.
The court analyzed the projected revenues and expenses for the coming year, and the concluded that the plan was not feasible because the debtors had failed to prove that the plan was feasible beyond March 2019. The court stated that if the debtors only had to prove they could make the payments required up to March 2019, the debtors would prevail because the testimony created a reasonable belief that the receipts necessary to make payments up to that time either had or would soon occur. However, beyond March 2019 that was not the case. The court compared the debtors’ projections to calculations using the yield and price per acre that was supported by the record. The record showed that the debtors could only pay anticipated operating expenses and plan payments after March 2019 if the debtor’s unsupported projections were used. The projections using the bushels per acre and price per bushel only showed revenue of $592,000 to $736,000 with expenses of $872,000. Given this lack of ability to pay combined with the debtor’s projections overstating revenue from soybean production during the 2019 crop year the court found that the debtors anticipated receipts simply did not cover the debtors’ obligations to pay operating expenses and plan payments beyond March 2019. Thus, the plan was not feasible and the court denied confirmation of the amended plan.
Grazing Scam Results in Fraud Convictions
There are various scams that one can get caught up in, but they don’t often involve cattle grazing. However, a recent case did involve a cattle grazing scam. In United States v. Hagen, No. 17-3279, 2019 U.S. App. LEXIS 6109 (8th Cir. Feb. 28, 2019), the defendant and his ex-wife set up a company to provide custom grazing in 2004. The ex-wife obtained grazing leases on tribal land from the Bureau of Indian Affairs ("BIA"). The defendant worked with ranchers to set up custom grazing contracts. In 2011, the BIA issued letters to the defendants for non-compliance with leasing procedures. In 2012, the defendants had leased enough pasture to sustain 57.92 cow-calf pairs but contracted to graze with three cattle producers for the lease of 100 cow-calf pairs and 200 heifers. That summer, 70 pairs were grazed for the full term of the grazing contract, and 33 pairs belonging to another rancher were grazed for a day. A third rancher was forced to find other pasture for his heifers. In 2013, the defendants had leased pasture for 91.26 pairs and had contracted with six different producers to graze a total of 380 pairs. A total of $126,500 was paid upfront by the producers. Not a single pair was grazed that summer and no rancher was reimbursed.
In 2014, the defendants had leased pasture for 6.67 pairs and again over-contracted with three ranchers for 300 pairs, who paid $102,500 up front. No pairs grazed during the summer of 2014 and the ranchers were not reimbursed. The defendants were charged with three counts of wire fraud, four counts of mail fraud, and one count of conspiracy to commit mail and wire fraud for their fraudulent contracting/leasing practices. The ex-wife plead guilty to the conspiracy count and testified against the her ex-spouse at trial. He was convicted by a jury on all eight counts. Sentencing included 46 months imprisonment and 3 years of supervised release on each count, restitution in the amount of $236,000, and a $100 special assessment on each count. The defendant appealed on the basis that the evidence was insufficient to prove he had the requisite intent to defraud, and that the two mailings were not in furtherance of any fraud.
The appellate court affirmed the defendant’s conviction of conspiracy to commit mail and wire fraud, but vacated the conviction and special assessments on the other five substantive counts. The appellate court determined that sufficient evidence supported the jury verdict that the ex-husband had conspired to commit fraud by contracting with twelve different cattle producers to graze cattle. Only one of those contracts had been filled, and the defendants failed to issue refunds on the other contracts for the the 2012-2014 grazing seasons. The appellate court also found sufficient evidence to support the jury’s verdict of use of mail and wire to defraud. One of the ranchers had mailed the defendant a $35,000 check, as full payment for the grazing contract and the defendant had cashed the check using a wire transmission a week later. There was a pasture visit where a rancher was assured that the pasture could support 200 pairs. Another contract was signed by the rancher’s son, and another $35,000 check was written to the defendant. This second contract brought the total contracted to graze with the defendant to 200 pairs for $70,000. It later became evident that the defendant only had 40 acres leased, enough to sustain 6.67 pairs. When it came time for delivery, the defendant did not return any calls. The ranch did not graze any cattle that season nor issued refunds for their payments. The appellate court determined that the evidence was sufficient for the jury to conclude that the defendant knowingly only had enough pasture to graze 6 pairs but nonetheless contracted to graze 200 pairs with this rancher. However, the appellate court vacated the convictions and special assessments tied to specific instance of fraud against different ranchers. The dry conditions that limited the length of the grazing season likely lead to a breach of contract for early termination, rather than an intent to defraud. Other mailings by the defendants containing offers to graze cattle were not in furtherance of fraud, and the convictions and special assessments related to these mailings were vacated.
Fences, Boundary Lines and Adverse Possession
Fences and boundary issues present many court cases. It is certainly true that good fences make good neighbors. Bad fences and boundary disputes tend to bring out the worst in neighbors. A recent Alabama case illustrates the issues that can arise when fences and boundary issues are involved. In Littleton v. Wells, No. 2170948, 2019 Ala. Civ. App. LEXIS 20 (Civ. App. Feb. 22, 2019), a predecessor sold 82 acers to the defendants in 2015. This land had been in the same family for generations, however the seller had only been on the property “maybe twice” since 1989. The plaintiffs received title to their property from their parents, who had been there since 1964. There were three fences between the party’s properties. The defendant relied on a 1964 survey when making his purchase, thinking the property line was the middle fence. No survey was completed at that time.
In 2000, the mapping office notified the parties of a “conflict.” The office determined the actual boundary to be closer to the fence on the defendant’s property rather than the middle fence. However, this determination was for tax purposes and was not a substitute for a survey. The plaintiffs also treated the third fence line, like the map office, as the boundary line.
The plaintiffs grazed cattle up to the furthest fence and maintained all the ground between the fences as their own. The plaintiff also testified as to working on the furthest fence as a child in the 1960’s. The plaintiffs also showed that they held annual gatherings and the kids would play in the creek on the disputed ground. There was also evidence that the plaintiffs leased the disputed ground to others. The plaintiffs did not present all the witnesses as to the family’s use of the property up to the furthest fence. Nor was the employee of the map office testimony heard in court.
The trial court determined that the property line was to be the closer center fence, not the third fence as the plaintiffs claimed. The court ordered an official survey to their findings and entered that survey as the final order. The plaintiffs appealed. The appellate court reversed and remanded. The plaintiffs’ challenged the trial court’s denial of their adverse possession claim and determination of the location of the boundary line. The court looked at all the evidence on record from trial, when analyzing the plaintiff’s adverse possession claim. The appellate court held that the record showed that the plaintiffs had been in actual, hostile, open, notorious, exclusive, and continuous possession of the disputed property for more than ten years (the statutory timeframe). The plaintiffs had presented evidence to support every one of those elements and the defendants have not rebutted any element. The only evidence the defendant presented to rebut the plaintiffs’ evidence was a “belief” that he owned up to the second fence. Since the lower court was erroneous in determining the adverse possession claim, the appellate court did not need to analyze the boundary line determination. The court remanded to create a new boundary line that included the property that the plaintiffs had adversely possessed.
There’s never a dull moment in agricultural law. It’s everyday reality in the life of a farmer, rancher, rural landowner and agribusiness.
Wednesday, May 8, 2019
In recent months, several court decisions have involved the issues of executors and beneficiaries of an estate being held personally liable for the unpaid taxes of the estate. Sometimes a statute of limitations defense can be raised to fend off personal liability. Sometimes it cannot be raised. The matter can also be complicated when the estate makes an election to pay the estate tax in installment over (essentially) 15 years rather than filing the return and paying the federal estate tax nine months after the decedent’s death.
Personal liability of heirs for unpaid federal estate tax – that’s the topic of today’s post
Family trust. In United States v. Johnson, No. 17-4083, 2019 U.S. App. LEXIS 9317 (10th Cir. Mar. 29, 2019), the decedent died in 1991, survived by her four children. Before death, the decedent had established a trust that named two of her children as the successor trustees of her trust and the personal representatives of her estate. The decedent funded the trust with stock in a closely-held corporation that operated a hotel with a Nevada gambling license. Her will directed that the residue of her estate after payment of expenses and claims be transferred to the trust and administered in accordance with the trust’s terms. The children were also the beneficiaries of the decedent’s life insurance policies value at approximately $370,000. The decedent died on September 2, 1991.
Installment payment election. As reported on a timely filed federal estate tax return, the gross estate was valued at almost $16 million and the estate tax liability was approximately $6.9 million. The federal estate tax paid with the estate tax return was $4 million. An installment payment election was made in accordance with I.R.C. §6166 for the balance of the estate tax liability which allowed that portion of the tax to be paid in 10 annual installments starting in 1997 (after five years of interest-only payments) and ending in 2006. Upon receiving the filed estate tax return, the IRS took note of the election and assessed the estate for unpaid estate tax on July 13, 1992. In late 1992, all of the remaining trust assets (primarily hotel stock) were distributed to the children. The hotel stock was distributed to the trust beneficiaries because Nevada law governing casino ownership via trust required it. All of the children entered into a distribution agreement (governed by Utah law) acknowledging that they were equally responsible for the unpaid federal estate tax as it became due and equally liable for any additional tax that might result from an audit.
IRS lien. In 1995, the IRS took the position that the estate’s gross value had been underreported by approximately $3.5 million. Ultimately, a settlement was reached whereby the estate agreed to pay additional federal estate tax of $240,381. In 1997, shortly before the due date of the first estate tax installment, the IRS informed the personal representatives of alternatives to personal liability for unpaid deferred estate tax. As a result, the personal representatives executed an I.R.C. §6324A lien which all four children signed along with an agreement restricting the sale of stock in a hotel which comprised the largest asset of the decedent’s estate. That restriction was to be in effect while the lien was in effect. In 2002, the hotel filed bankruptcy and a sale of all hotel assets was approved. In 2003, the IRS informed the personal representatives that if they defaulted, the entire balance of estate tax would be immediately due. Shortly thereafter the estate defaulted on its federal estate tax liability after having paid a total of $5 million of the amount due. After attempting to collect via levies against the estate, trust and the children, and learned of the distribution agreements in mid-2005. The IRS filed suit in 2011 naming all of the children as defendants and seeking to recover over $1.5 million in unpaid federal estate tax from them personally.
Litigation. The trial court held that the heirs who received trust distributions were not liable as beneficiaries or transferees under I.R.C. §6324(a)(2). However, the trial court also determined that the personal representatives could be liable under 31 U.S.C. §3713 and I.R.C. §2036(a) as successor trustees up to the value of the trust assets that were included in the decedent’s gross estate via I.R.C. §2034-2042. The personal representatives claimed that the assets were included in the estate via I.R.C. §2033. The trial court determined that the assets were included in the estate via I.R.C. §2033 because the decedent never lost the beneficial ownership of them during her lifetime (i.e., the assets had not been transferred as required by I.R.C. §2036). Thus, the personal representatives were not personally liable for the unpaid estate tax as trustees. In addition, the court determined that the personal representatives were not liable under 31 U.S.C. §3713 because liability was discharged upon execution of the I.R.C. §6324 lien. The IRS also claimed it had rights as a third-party beneficiary of the 1992 distribution agreement whereby they agreed to be equally liable for any additional taxes resulting from an audit. The trial court determined this claim was untimely under Utah law (6-year statute of limitations) and rejected the IRS claim that federal law should apply.
Tenth Circuit decision. On appeal, the appellate court held that federal law applied on the contract-based claim and was governed by the 10-year statute of limitations of I.R.C. §6502. That’s because the court concluded that the government was acting in its sovereign capacity. Accordingly, the 10-year statute of limitations applied. When the federal government is enforcing its rights, it is not bound by a state’s statute of limitations even with respect to lawsuits that are brought in state courts. It makes no difference whether the claim at issue arose under federal or state statutes or the common law.
Likewise, the transferee liability claim was timely because the limitations period applicable to the I.R.C. §6324(a) transferees was the same as the limitations period that applied to the estate. Because the 10-year limitations period that normally applies to the collection of estate tax was suspended by the installment payment election, the government’s claim was timely. See, e.g., §6503(d); United States v. Botefuhr, 309 F.3d 1263 (10th Cir. 2002). The appellate court also held that the children were liable for unpaid estate tax to the extent of any life insurance proceeds they received from the estate. United States v. Johnson, No. 17-4083, 2019 U.S. App. LEXIS 9317 (10th Cir. Mar. 29, 2019). The appellate court also held, reversing the trial court, that the beneficiaries weren’t entitled to attorney fees and costs because the government’s position was “substantially justified under I.R.C. §7430(c)(4)(B). Indeed, the government received a judgment for the full amount of the estate tax liability asserted.
It’s worth noting that the decedent in Johnson died in 1991. The Tenth Circuit’s decision was in 2019. That show’s how long matters can get drawn out if an installment payment election is made and there is unpaid tax liability. The government is not simply going to go away.
Monday, May 6, 2019
Nuisance lawsuits in agriculture are often triggered by offensive odors that migrate to neighboring rural residential landowners. While there aren’t any common law defenses that an agricultural operation may use to shield itself from liability arising from a nuisance action, courts do consider a variety of factors to determine if the conduct of a particular farm or ranch operation is a nuisance. See, e.g., Valasek v. Baer, 401 N.W.2d 33 (Iowa 1987); Spur Industries, Inc. v. Del E. Webb Development Co., 108 Ariz. 178, 494 P.2d 700 (1972). Of primary importance are priority of location and reasonableness of the operation. Together, these two factors have led courts to develop a “coming to the nuisance” defense. This means that if people move to an area they know is not suited for their intended use, they should be prohibited from claiming that the existing uses are nuisances. But, what if the ag nuisance comes to you? Is the ag operation similarly protected in that situation?
The coming-to-the-nuisance defense in reverse – that’s the topic of today’s post.
In general. Every state has enacted a right-to-farm law that is designed to protect existing agricultural operations by giving farmers and ranchers who meet the legal requirements a defense in nuisance suits. It may not be only traditional row crop or livestock operations that are protected. For example, the Washington statute also applies to “forest practices” which has been held to not be limited to logging activity, but include the growing of trees. Alpental Community Club, Inc., v. Seattle Gymnastics Society, 86 P.3d 784 (Wash. Ct. App. 2004).
The basic thrust of a particular state's right-to-farm law is that it is unfair for a person to move to an agricultural area knowing the conditions which might be present and then ask a court to declare a neighboring farm a nuisance. Thus, the basic purpose of a right-to-farm law is to create a legal and economic climate in which farm operations can be continued. Right-to-farm laws can be an important protection for agricultural operations. But, to be protected, an agricultural operation must satisfy the law's requirements. To be granted the protection of a statute, the activity at issue must be a farming activity. For example, in Hood River County v. Mazzara, 89 P.3d 1195 (Or. Ct. App. 2004), the state statute that protected farms against nuisance actions was held to bar a lawsuit against a farmer for noise from barking dogs. The use of dogs to protect livestock was held to be farming practice.
Types. Right-to-farm laws are of three basic types: (1) nuisance related; (2) restrictions on local regulations of agricultural operations; and (3) zoning related. While these categories provide a method for identifying and discussing the major features of right-to-farm laws, any particular state's right-to-farm law may contain elements of each category.
The most common type of right-to-farm law is nuisance related. This type of statute requires that an agricultural operation will be protected only if it has been in existence for a specified period of time (usually at least one year) before the change in the surrounding area that gives rise to a nuisance claim. See, e.g., Vicwood Meridian Partnership, et al. v. Skagit Sand and Gravel, 98 P. 3d 1277 (Wash. Ct. App. 2004). This type of statute essentially codifies the “coming to the nuisance defense,” but does not protect agricultural operations which were a nuisance from the beginning or which are negligently or improperly run. For example, if any state or federal permits are required to properly conduct the agricultural operation, they must be acquired as a prerequisite for protection under the statute.
Subsequent changes – what’s going on in Indiana? While right-to-farm laws try to assure the continuation of farming operations, they do not protect subsequent changes in a farming operation that constitute a nuisance after local development occurs nearby. See, e.g., Davis, et al. v. Taylor, et al., 132 P.3d 783 (Wash. Ct. App. 2006); Trickett v. Ochs, 838 A.2d 66 (Vt. 2003); Flansburgh v. Coffey, 370 N.W.2d 127 (Neb. 1985). If a nuisance cannot be established, a right-to-farm law can operate to bar an action when the agricultural activity on land changes in nature. For instance, in Dalzell, et al. v. Country View Family Farms, LLC, No. 1:09-cv-1567-WTL-MJD, 2012 U.S. Dist. LEXIS 130773 (S.D. Ind. Sept. 13, 2012), the land near the plaintiffs changed hands. The prior owner had conducted a row-crop operation on the property. The new owner continued to raise row crops, but then got approval for a 2800-head sow confinement facility. The defendant claimed the state (IN) right-to-farm law as a defense and sought summary judgment. The court held that state law only allows nuisance claims when “significant change” occurs and that transition from row crops to a hog confinement facility did not meet the test because both are agricultural uses. The court noted that an exception existed if the plaintiffs could prove that the hog confinement operation was being operated in a negligent manner which causes a nuisance, but the plaintiffs failed to prove that the alleged negligence was the proximate cause of the claimed nuisance. Thus, the exception did not apply and the defendant’s motion for summary judgment was granted. The court’s decision was affirmed on appeal. Dalzell, et al. v. Country View Family Farms, LLC, et al., No. 12-3339, 2013 U.S. App. LEXIS 13621 (7th Cir. Jul. 3, 2013).
Similarly, in Parker v. Obert’s Legacy Dairy, LLC, No. 26A05-1209-PL-450, 2013 Ind. App. LEXIS 203 (Ind. Ct. App. Apr. 30, 2013), the defendant had expanded an existing dairy operation from 100 cows to 760 cows by building a new milking parlor and free-stall barn on a tract adjacent to the farmstead where the plaintiff’s family had farmed since the early 1800s. The plaintiff sued for nuisance and the defendant asserted the state (IN) right-to-farm statute as a defense. The court determined that the statute barred the suit. Importantly, the court determined that the expansion of the farm did not necessarily result in the loss of the statute’s protection. The expanded farm remained covered under the same Confined Animal Feeding Operation permit as the original farm. In addition, the conversion of a crop field to a dairy facility was protected by the statute because both uses simply involved different forms of agriculture. The court also noted that the Indiana statute at issue protected one farmer from suit by another farmer for nuisance if the claim involves odor and loss of property value. Not all state statutes apply to protect farmers from nuisance suits brought by other farmers.
The coming-to-the-nuisance defense in reverse – recent case. A recent case again involving the Indiana right-to-farm statute was decided. In Himsel v. Himsel, No. 18A-PL-645, 2019 Ind. App. LEXIS 181 (Ind. Ct. App. Apr. 22, 2019), the defendants were three individuals, their farming operation and a hog supplier. In 2013, the individual defendants petitioned the County Area Plan Commission to rezone a 58.42-acre tract from agricultural/residential to agricultural/intense. The land had been in the family for over 20 years and had been used for ag purposes since at least 1941. From 1994-2013, the property was cropland. The zoning change would allow for the operation of a Concentrated Animal Feeding Operation (CAFO). The plaintiffs were two married couples, one of whom built their non-farm residence in 1971 and the other who started using their home as a non-farming residence in 2000 after deciding to retire from farming and sell most of the farmland that the husband had grown up on and lived on since the early 1940s. The plaintiffs attended the hearing and opposed the petition. The retired farmer plaintiff had raised about 200 head of hogs and 200 head of cattle in an area directly adjacent to his home. There also was a confinement building about 700 feet from the plaintiff’s home that contained up to 400 hogs that was used for two years until it burnt down. The area around the plaintiffs’ homes is predominated by agriculture uses, and there are other hog barns near the plaintiff’s property. The Commission approved the zoning change and the defendant obtained the necessary permits to build an 8,000-head CAFO one quarter of a mile from the retired farmer plaintiff’s home. The plaintiffs did not appeal.
In late 2015, the plaintiff sued the defendant (the retired farmer plaintiff’s cousin and two nephews) for nuisance and negligence and challenged the state’s Right-to-Farm Act (RTFA) as unconstitutional. The plaintiff also claimed that another part of state law (known as the “Agricultural Canon”) which requires state law to be construed to “protect the rights of farmers to choose among all generally accepted farming and livestock production practices, including the use of ever-changing technology,” was unconstitutional. The defendant asserted the RTFA as a defense, and the state joined the suit to defend the constitutionality of the Agricultural Canon.
The trial court granted the defendant summary judgment. On appeal, the appellate court affirmed, holding that the plaintiffs’ nuisance, negligence, and trespass claims were barred by the RTFA. The appellate court also determined that the plaintiffs’ various claims that the RTFA was unconstitutional were futile. As to the RTFA, the appellate court determined that the retired farmer plaintiff essentially “came to the nuisance” when they retired and switched their farming and livestock operation to purely residential with full knowledge of the surrounding ag uses. This plaintiff came to the nuisance by not moving away before the CAFO was built.
As to the rural residential plaintiff (as well as the retired farmer plaintiff), the court noted that a 2005 amendment to the RTFA meant that the change in the nature of the individual defendants’ farming operation from crops to a large-scale confinement hog operation was not a significant change that would make the RTFA inapplicable.
The appellate court also determined that the defendant was not operating the confinement facility negligently which would have eliminated the RTFA as a defense. In addition, the defendant also had obtained all necessary permits to operate the CAFO. The appellate court also upheld the constitutionality of the RTFA, finding that it was within the legislature's legitimate constitutional authority, and determined that the RTFA had not “taken” the plaintiffs property. While the plaintiff may have experienced a reduction in value due to the presence of the nearby CAFO, existing caselaw did not indicate that this amounted to a taking. On this point, the court noted that the plaintiff continued to live in his home and alleged no distinct, investment-backed expectations that the CAFO had frustrated. The plaintiff also claimed that the RTFA unconstitutionally separated rural dwellers into those engaged in ag operations on land that has been consistently farmed for at least the prior year, and those living in rural areas that don’t farm. Under the RTFA, farmers can sue either other farmers or non-farmers for nuisance, but non-farmers can only sue other non-farmers for nuisance. The appellate court determined that the distinction was not unconstitutional because the state had a rational basis for the distinction in terms of conserving, protecting, and encouraging the development and improvement of agricultural land for the production of food and other agricultural products, and that the distinction was applied uniformly. The appellate court did not rule on the constitutionality of the Agricultural Canon for lack of jurisdiction.
Several observations about the case can be made.
- The appellate court in Himsel, determined that the RTFA applied because the change in the nature of the defendant’s hog operation from row crop farming to a CAFO operation involving 8,000 hogs was “not a significant change” that would make the RTFA inapplicable. In other words, 8,000 hogs in a confinement building raised by a contracting party that likely doesn’t make management decisions concerning the hogs, may or may not report the associated contract income as farm income on Schedule F, doesn't report building rent as farm income, and cannot pledge the hogs as loan collateral, was somehow not significantly different from 200 hogs and 200 head of cattle raised by a farmer with associated crop ground who managed the diversified operation. Just the sheer number of hogs alone stands out in stark contrast.
- Unlike the Obert’s Legacy Dairy case where the expansion of the dairy farm did not require a new permit, the hog operation in Himsel required a change in the existing zoning of the tract.
- The plaintiffs in Himsel were found to have essentially come to the nuisance because one of them chose to retire from farming and remain on the land that he had lived on for nearly 80 years, and the other didn’t move from the rural home they built in 1971. In reaching this conclusion the court determined that an 8,000-head hog confinement operation and the presence of 3.9 million gallons of untreated hog manure was comparable to farming in this area in 1941.
- The Himsel court determined that a “taking” had not occurred because the plaintiff had not sold his home and moved away from the place where he grew up and lived all of his life. The court did not address the implications of whether its opinion essentially granted the CAFO an easement to produce odors across the plaintiffs’ property.
It is possible that the Himsel decision could be transferred to the Indiana Supreme Court for review. It’s also possible that the Indiana legislature could revisit the RTFA and the 2005 amendment that appears to have resulted in a construction that allows a CAFO of any size to be built in any place with a history of agricultural activity at any time in the past that predates the plaintiff’s use. While the original idea behind right-to-farm legislation in general was to protect and incentivize multi-generation farming operations that are often significantly tied to the land and the local communities, the Himsel decision is difficult to square with those ideals. That’s the case even though the court may be right in its construction of the statutory language at issue. If that’s correct, the policy of the Indiana RTFA and the future of the Hoosier rural countryside is up to the legislature.
Thursday, May 2, 2019
If a farmer or rancher buys a product and the product turns out to be defective, can the manufacturer be held liable on a product liability claim for defective product? In general, the answer is “yes.” However, there are some exceptions to that general rule. One of those may involve an acetylene tank and a torch.
A limitation on the ability to sue a manufacturer on a product liability claim – that’s the topic of today’s post.
Manufacturer’s Liability – In General
Historically, a manufacturer or seller of defective chattels was not liable to persons injured using the product unless a contractual relationship existed. This rule limited a manufacturer's liability to immediate purchasers if a product turned out to be defective, dangerous or hazardous to health. This rule, known as the “privity limitation,” dates back to the 1843 English case of Winterbottom v. Wright, 10 M. & W. 109, 152 Eng. Rep. 402 (Ex. 1842). In Winterbottom, the plaintiff purchased a ticket to ride the stage and as the stage was being driven, a wheel with rotten spokes collapsed. The ensuing crash injured the plaintiff. The plaintiff sued the defendant who had undertaken to provide a mail coach to carry the mail bags. The English court ruled that the plaintiff could not sue the defendant because the plaintiff did not have a contract with the defendant.
Winterbottom became a leading case, not only in England, but also in the United States. The requirement of privity of contract in product liability cases continued in the United States until 1916. In a 1916 case, MacPherson v. Buick Motor Co., 217 N.Y. 382, 111 N.E. 1050 (1916), the plaintiff bought a Buick from a retail dealer. The plaintiff was injured while driving the car when the wooden spokes on one of the wheels crumbled into fragments. The defective wheel had been supplied to Buick Motor Co. by a parts manufacturer. There was evidence tending to show that a reasonable inspection by Buick would have disclosed the defective wheel, but that Buick failed to make such an inspection. Buick defended on the basis that the plaintiff purchased the car from a retail dealer and, therefore, did not have privity of contract with Buick. The New York Court of Appeals upheld the trial court and rejected Winterbottom v. Wright. The Court held that Buick owed a duty of care to the plaintiff as the ultimate purchaser of the automobile from an independent distributor. Precedent drawn from the days of stagecoach travel no longer squared with the needs of a modern commercial society.
The MacPherson decision marked the beginning of the consumer movement. Consumers could now sue manufacturers and hold them accountable for negligence in manufacturing faulty products as well as negligence in design. For the first several years after MacPherson, the question was limited to negligence in manufacturing. More recently, the focus has expanded to include negligence in design. Both come within the rule. No longer is privity of contract required before a manufacturer can be sued.
MacPherson spawned a great deal of products liability litigation. Much of the early litigation dealt with food and beverage products. See, e.g., Pillars v. R.J. Reynolds Tobacco Company, 117 Miss. 490 (1918); Coca-Cola Bottling Company v. Burgess, 195 S.W.2d 392 (Tex. Ct. Civ. App. 1946).
Since the early 1960s, manufacturer's liability law has changed greatly. The recent trend is away from a negligence approach and toward strict liability. In many instances, an injured party is not required to show that the manufacturer was negligent. While a strict liability approach is not the same as absolute liability, in many instances, manufacturer's liability has become so favorable for plaintiffs that many manufacturers have complained of the inability to afford liability insurance coverage.
Under the modern approach, the injured party is required to prove five elements in order to recover from a manufacturer on a product liability claim.
- First, the injured party must show that the defendant sold the product and was engaged in the business of selling the product. This requirement is typically easy to satisfy.
- Second, the injured party must show that the product was in a defective condition. See, e.g., Russell v. Deere & Co., 61 P.3d 955 (Or. Ct. App. 2003). This, likewise, is not usually very difficult to establish.
- Third, the injured party must show that the defective condition was unreasonably dangerous to an ordinary user during normal use. Normal use includes all intended uses and foreseeable misuses of the product. See, e.g., Ellis v. Weasler Engineering, Inc., 258 F.3d 326 (5th Cir. 2001). This requirement is somewhat more difficult to satisfy than the first two, and a few courts do not require this element. If this element is required, a product may be deemed to be unreasonably dangerous if the manufacturer fails to warn of dangers inherent in the product's normal use that is not obvious to an ordinary user. If the product bears an adequate warning, the product is deemed not to be in defective condition in those states whose product liability act follows Comment j of the Restatement (Second) of Torts § 402A. However, some states follow Comment i of the Restatement (Third) of Torts § 2, which provides that an adequate warning does not foreclose a finding that a product is defectively designed. See, e.g., Delaney v. Deere and Company, 268 Kan. 769, 999 P.2d 930 (2000), rev’d, 219 F.3d 1195 (10th Cir. 2000). In these states, a manufacturer cannot simply warn of open and obvious dangers. The belief in these states is that Comment j allows an adequate warning to absolve the manufacturer of its duty to design against dangers when a reasonably safer design could have been adopted that would have reduced or eliminated the risk remaining after a warning is provided. But, under either approach, foreseeable misuse of the product remains an issue. See, e.g., Mallery v. International Harvester Company, 690 So. 2d 765 (La. Ct. App. 1996).
- The fourth element that an injured party must prove to recover from a manufacturer on a product liability claim is that the product was expected to reach the user without substantial change in condition and, in fact, did so.
- The fifth requirement is that the product defect was the proximate cause of the plaintiff's injury or damage. This requirement is the most difficult to show and involves proving one of the elements of negligence.
There are at least three situations that a particular farmer or rancher may face in which they will be limited in their ability to sue a manufacturer on a product liability claim. One involves the situation when purchased equipment is altered or when multiple component parts are purchased individually, but are then later combined to make a complete system. If the component parts are not defective, but when combined produce a defective system, the manufacturers of the component parts do not have a duty to warn or properly instruct about the use of the system. See,e.g., Shaffer v. A.O. Smith Harvestore Products, Inc., 74 F.3d 722 (6th Cir. 1996). When purchased equipment is altered, the manufacturer is generally released from liability unless the manufacturer could have reasonably foreseen that purchasers would alter the equipment in the manner that resulted in injury. For example, in Hiner v. Deere & Co., 340 F.3d 1190 (10th Cir. 2003), rev’g, 161 F. Supp. 2d 1279 (D. Kan. 2001), the farmer altered a front-end loader resulting in injury. The court determined that the farmer’s alterations presented a fact issue for the jury to sort out on the plaintiff’s strict liability claim as to whether the defendant could have reasonably foreseen the alteration. See, also, Brinkman v. International Truck and Engine Corp., 351 F. Supp. 2d 880 (W.D. Wisc. 2004).
So, when you buy a product and take it home to the farm or ranch, or have it delivered, sometimes the tendency is to modify the item to fit the specs of the situation. But, once an alteration is made (perhaps by cutting and welding) and the product fails to operate as expected, that alteration can remove the ability to recover from the manufacturer on a defective product claim.
Just something else to think about on the farm or ranch from the world of agricultural law.
Tuesday, April 30, 2019
A good number of the readers of this blog are tax practitioners. As a result, during tax season, significant developments tend to go unnoticed if they don’t directly impact client tax prep work currently. With today’s post, I take a brief look at what happened in federal tax while the tax season was raging on.
Some current developments in federal tax – that’s the topic of today’s post.
Obamacare Individual Mandate
For those of you who attended a tax seminar that I did last year, you heard me discuss the pending litigation concerning the constitutionality of Obamacare. Because Chief Justice Roberts hinged the Constitutionality of the law on the individual mandate (contained in I.R.C. §5000A) being a tax and, therefore, within the taxing authority of the Congress, if that tax is eliminated the law becomes Constitutionally suspect. National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012). At least that’s the argument that I mentioned was being made in court and that we could expect a federal court decision on that issue. The reason for the court challenge, of course, was because of the elimination by the Tax Cuts and Jobs Act (TCJA) of the individual mandate “tax” effective for months beginning after 12/31/18. Indeed, that opinion came out in late 2018 before the tax season began in Texas v. United States, No. 4:18-cv-00167-O, 2018 U.S. Dist. LEXIS 211547 (N.D. Tex. Dec. 14, 2018). The court noted that the payment was distinct from the individual mandate and determined that the individual mandate was no longer constitutional as of 1/1/2019 because it would no longer trigger any tax. In addition, because the individual mandate was the linchpin of the entire law, the provision could not be severed from the balance of the law. As a result, the court reasoned, as of January 1, 2019, Obamacare no longer has any constitutional basis and is invalidated as unconstitutional. The case is on appeal.
Since this ruling in December, two other courts have determined that the individual mandate is a tax. In re Cousins, No. 18-10739, 2019 Bankr. LEXIS 1156 (Bankr. E.D. La. Apr. 10, 2019), held that the provision was a tax for purposes of the bankruptcy Code. The Bankruptcy Code, in accordance with 11 U.S.C. §1328(a), allows a debt to be discharged unless it is listed as a priority claim in 11 U.S.C. §507(a). Priority taxes cannot be discharged, but a penalty amount is dischargeable. In this case, the debtors (a married couple) filed a proof of claim that included a $2,085 mandate assessment which the debtors claimed was dischargeable as a penalty. The IRS disagreed, citing National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012) in which the U.S. Supreme Court concluded that the assessment was a tax for constitutional purposes and cited the Bankruptcy Code in making its determination. The court also found that refusing to purchase health insurance and instead paying an assessment didn't constitute an "unlawful act," which was a strong indication that the individual mandate was not a penalty. In addition, the legislative history implied that the individual mandate was a tax since Congress referred multiple times to how it would raise revenue, the court said. Thus, the assessment was a nondischrgeable tax and was entitled to priority under 11 U.S.C. §507(a)(8) and the court denied the debtors’ objection to the IRS claim. The same result was reached in United States v. Chesteen, No. 18-2077, 2019 U.S. Dist. LEXIS 29346 (E.D. La. Feb. 25, 2019).
IRS Provides “Guidance” on How Farm Income Averaging Interacts With the QBID
In an item posted to its website shortly after the tax filing deadline, the IRS attempted to provide guidance on the Qualified Business Income Deduction (QBID) and a farmer (or fisherman) that makes an election under I.R.C. §1301 to average income. Under a farm income averaging election, a farm taxpayer’s income tax liability is the sum of the I.R.C. §1 tax computed on taxable income reduced by “elected farm income” (EFI) plus the increase in tax imposed by I.R.C. §1 that would result if taxable income for the three prior years were increased by an amount equal to one-third of the EFI. The IRS has stated that "[i]n figuring the amount [of the]... Qualified Business Income Deduction, income, gains, losses, and deductions from farming or fishing should be taken into account, but only to the extent that deduction is attributable to your farming or fishing business and included in elected farm income on line 2a of Schedule J (Form 1040)."
This appears to be saying that if an income averaging election is made, the taxpayer must use EFI to calculate the QBID. With the “guidance,” the IRS appears to be attempting to construe I.R.C. §199A(c)(3)(A)(ii) in this situation. The IRS may need to issue a further clarification. Elected Farm Income May Be Used To Figure Qualified Business Income Deduction, IRS Website, Apr.19, 2019
S Corporations and the Self-Employed Health Insurance Deduction
Just a few days ago, the IRS confirmed the position that many tax practitioners believed was correct with respect to S corporations and the deduction for self-employed health insurance. I.R.C. §1372 says that, for purposes of applying the provisions of the I.R.C. that relate to employee fringe benefits, an S corporation is treated as a partnership. Likewise, any 2 percent (as defined in I.R.C. §318 as owning more than two percent of the corporate stock) S corporation shareholder is treated as a partner in the partnership in accordance with I.R.C. §1372. An S corporation can deduct the cost of accident and health insurance premiums that the S corporation pays for or furnishes on behalf (i.e., reimburses) of its 2 percent shareholders. The two percent shareholders must include the amounts in gross income in accordance with Notice 2008-1, 2008-2 IRB 251 (i.e., the S corporation reports the amounts as wages on the shareholder’s W-2) provided that the shareholder meets the requirements of I.R.C. §162(l) and the S corporation establishes the plan providing medical care coverage.
Under the facts of C.C.A. 2019012001 (Dec. 21, 2019), a taxpayer owned 100 percent of an S corporation which employed the taxpayer’s family member. The family member is a two-percent shareholder under the attribution rules of I.R.C. §318. The S corporation provides a group health plan for all employees, and the amounts paid by the S corporation under the plan are included in the family members gross income. Provided the requirements of I.R.C. §162(l) are satisfied, the IRS determined that the family member could claim a deduction for the amounts the S corporation paid. Thus, the family member could convert what might be a nondeductible expense (because of either the 10 percent floor for medical expenses or because the family member takes the standard deduction) into an above-the-line deduction.
SALT Deduction Guidance
In early April, the IRS provided guidance on how the $10,000 limitation on the deduction of state and local taxes (SALT) under the TCJA and I.R.C. §280A work in conjunction with each other. For a taxpayer with SALT deductions at or exceeding $10,000, or who chooses to take the standard deduction, none of the SALT relating to the taxpayer’s business use of the home are treated as expenses under I.R.C. §280A(b). However, expenses relating to the taxpayer’s exclusive use of a portion of the taxpayer’s personal residence for business purposes remain deductible under I.R.C. §280A(b) or (c) or under another exception to the general rule of disallowance in I.R.C. §280A. The same rationale applies to other deductions that are subject to various limitations or disallowances, including home mortgage interest and casualty losses. For instance, interest on a mortgage balance exceeding the acquisition debt limitations becomes an I.R.C. §280A(c) limited expense when claiming a home office deduction. IRS Program Manager Technical Advice 2019-001 (Dec. 7, 2018).
Ministerial Housing Allowance
In mid-March, the appellate court issued it’s decision on the Constitutionality of the ministerial housing allowance of I.R.C. §107(2) that excludes from gross income a minister's rental allowance paid to the minister as part of compensation for a home that the minister owns. The plaintiff, an atheist organization, challenged the constitutionality of the provision. The trial court agreed, but the appellate court reversed. The appellate court noted that while the exclusion of housing provided for the convenience of the employer provision was not made available to ministers of the gospel, the Congress soon provided an exclusion for church-provided ministerial housing as well as the cash allowance provision of I.R.C. §107(2) at issue in this case. The appellate court determined that the provision was simply an additional provision providing tax exemption to employees that having a work-related housing requirement. The appellate court viewed a categorial exemption for ministers as requiring much less government “entanglement” in religion than lumping ministers under the general employer-provided housing exclusion of I.R.C. §119. The appellate court also noted the long history of tax exemption for religious organizations, and deemed this long history of significance and that I.R.C. §§107(1)-(2) continued that history. Gaylor, et al., v. Mnuchin, No. 18-1277 (7th Cir. Mar. 15, 2019), rev’g., Gaylor v. Mnuchin, 16-cv-215-bbc, 2017 U.S. Dist. LEXIS 165957 (W.D. Wisc. Oct. 6, 2017).
That’s just a bit of what happened in federal tax during tax season while many of you had your head down plowing through this trying tax season.
Friday, April 26, 2019
This summer, Washburn University School of Law will be sponsoring a two-day Farm and Ranch Tax and Estate/Business Planning Seminar in Steamboat Springs, CO. The event will be on August 13-14 at the Steamboat Grand Hotel. This seminar presents an extensive, in-depth coverage and analysis of tax and estate/business problems and issues involving farm and ranch clients over two-days. Attendance can either be in-person or via online over the web.
In today’s post, I outline the coverage of the topics at the seminar and the presenters as well as related information about registering. Steamboat Springs – Summer of 2019!
Topics and Speakers
On Day 1 (August 13), Paul Neiffer (CPA with CliftonLarsonAllen and author of the FarmCPA blog) will be presenting with me. We will start the day with a discussion of the I.R.C. §199A (QBI) deduction. Many issues surfaced during the 2018 tax filing season concerning the QBI deduction. The IRS produced contradictory statements concerning the deduction and the tax software companies also struggled to keep the software up with the developments. During this opening session, Paul and I will walk through QBI deduction issues as applied to farm and ranch clients and address many questions with detailed answers – a very real “hands-on” approach that is practitioner-friendly.
During the next session on Day 1, I Paul and I will take two hours to cover a potpourri of selected farm income tax topics. Those issues that are the present “biggies” will be addressed as well as current issues that practitioners are having with the IRS involving ag clients.
After lunch on Day 1, I will highlight some of the most important recent cases and rulings for farm and ranch taxpayers, and what those developments mean as applied on the farm and in the farm economy. Any new legislation will also be addressed, whether it’s income tax or other areas of the law (such as bankruptcy) that impact ag clients.
We will then devote an hour to common depreciation issues and how the rules have changed and are to be applied post-TCJA. What are the best depreciation planning techniques? We will work through the answers.
Following the afternoon break, I will dive into the passive loss rules. What do they mean? How do they apply to a farm client? How do they interact with the QBI deduction? What is a real estate professional? How to the grouping rules work? These questions (and more) will be answered and numerous examples will show how the rules work in various contexts.
Day 1 finishes out with Paul covering tax and planning issues associated with the 2018 Farm Bill and the choices farm clients have and how the new rules work. I will then cover the tax rules associated with ag disasters and casualties. There are many of those issues for clients that will show up during the 2019 tax filing season, especially for farm/ranch clients in the Midwest and Plains states.
On Day 2, our focus turns to farm and ranch estate and business planning. I will begin the day with an update of the key recent developments that impact the estate and succession planning process. What were the key cases of the past year? What about IRS rulings and pronouncements? I will cover those and show you how they apply to your clients.
Day 2 then continues with a key session on how to use estate planning concepts to minimize family disharmony. This session is presented by Tim O’Sullivan with Foulston Siefken LLP in Wichita, KS. Tim has a broad level of experience in estate planning and the handling of decedent’s estates. This is a “must attend” session for estate planners and deals with a topic that is often overlooked as an element in putting together a successful estate and business transition plan.
After the morning break on Day 2, I will cover the tax and legal issues associated with the use of trusts. Trusts are an often-used tool for farm and ranch clients, but what is the correct type for your client? The answer to that question is tied to the facts. Also, can a state tax a trust beneficiary or the trust itself if there isn’t any physical connection with the state? It’s an issue presently before the U.S. Supreme Court. By the time of the seminar, we will likely have an answer to that question.
How does the TCJA impact charitable giving? What are the new charitable planning techniques? What factors are important? I will address these questions and more in the session leading up to lunch.
After the lunch break on Day 2, I will deal with an unfortunate, but important topic- what is appropriate estate and business planning in second marriage situations? If the plan doesn’t account for this issue, significant disruptions can occur, and expectations may not be met. This is an important session dealing with a topic that tends to be overlooked.
I will then provide a breather from some heavy topics with a lighter (and fun) one – what are common estate and business planning mistakes? What classic situations have you dealt with in your practice over the years? Mistakes are frequent, but some seem to occur over and over. Can they be identified and prevented? That’s the goal of this session.
Tim O’Sullivan then returns for another session. This time, Tim does a deep dig into long-term health care planning. How can farm and ranch assets and resources be preserved? What are the applicable rules? What if only one spouse needs long-term care? Should assets be transferred? If so, to whom? This is a very important session designed to give you the tools you need for your long-term care planning toolbox.
Day 2 finishes with a key session by Stan Miller on how estate and business planning concepts can be used to help make sure the family farm survives for families that want it to survive as a viable economic unit. Stan is a founder of WealthCounsel, LLC and a principal in the company. Stan has a long background in estate and business planning. He is also a partner with ILP + McChain Miller Nissman in Little Rock, Arkansas. This session is a great capstone session for the day that will bring the day’s discussion together and get down to how the concepts discuss throughout the day can be used to help the farming and ranching business of a client survive the ups and downs of the economy, as well as family situations.
The seminar will be held on Tuesday and Wednesday, August 13-14 at the Steamboat Grand Hotel, in Steamboat, Colorado. It is co-sponsored by the Kansas State University Department of Agricultural Economics and WealthCounsel, LLC. You can find more registration information here: http://washburnlaw.edu/employers/cle/farmandranchtax.html
On another note, on Monday, August 12, also in Steamboat, I will be participating in another seminar (also in Steamboat Springs) sponsored by the Colorado Cattlemen’s Agricultural Land Trust, the Eagle Valley Land Trust, and the Yampa Valley Land Trust. Half of the day will concern legal issues associated with conservation land trusts. The other half of the day will address real estate issues associated with conservation land trusts. These issues are very important in many parts of the country in addition to Colorado. As further details are provided, I will pass those along. This all means that there will be three full days of tax and legal information available this coming August in Steamboat Springs.
As I noted above, the seminar can be attended either in-person on online via the web. Registration will open up soon, so get your seat reserved. Steamboat Springs, CO is a beautiful area on the western slope of the Colorado Rockies.
Hope to see you there!!
Wednesday, April 24, 2019
Recently, it was reported that astronomers captured the first ever images of a black hole – an abyss they say that is so deep that not even light can escape it. Tax law has its own “black-hole.” It has to do with tax refund claims. But, an appellate court has found light coming from this tax “black- hole.” In addition, the manner in which the appellate court decided the case may shed light on how courts could construe unclear statutory provisions of the Tax Cuts and Jobs Act (TCJA).
Refund claims and statutory construction – these are the topics of today’s post.
The Tax Court has jurisdiction to determine the amount of any overpayment of tax if the taxpayer paid the amount to be refunded within a “look-back” period. I.R.C. §6512(b)(3)(B). That “look-back” period is specified as three years after the return was filed or two years after payment. I.R.C. §6511(b)(2). Wait too long to file or pay and it may be too late. In addition, the flush language (language not accompanied by a number or letter and is flush against the margin) at the end of I.R.C. §6512(b)(3)(B) says that, “In a case described in subparagraph (B) where the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of the tax and no return was filed before such date, the applicable period under subsections (a) and (b)(2) of [I.R.C. §6511] shall be 3 years.”
Confused? Let’s take a look at how this provision was applied in a recent case.
In Borenstein v. Comr., No. 17-3900, 2019 U.S. App. LEXIS 9650 (2d Cir. Apr. 2, 2019), rev’g., 149 T.C. 263 (2017), the taxpayer’s return for 2012 was due on April 15, 2013. At the taxpayer’s request, she received a six-month extension of time to file the return. That made the due date October 15, 2013. But, she still had to pay. When an extension of time to file is granted, that doesn’t extend the time to pay. Thus, she made several tax payments for 2012 totaling $112,000 that were all deemed to be made on April 15, 2013 in accordance with I.R.C. §6513. However, she didn’t file the return by October 15, 2013. In fact, she didn’t file a return for the next 22 months. That got the attention of the IRS. IRS then sent the taxpayer a statutory notice of deficiency (SNOD) on June 19, 2015, for her 2012 return. She then filed her 2012 return on August 29, 2015. On that return, she reported a tax liability of $79,559. The IRS agreed that the $79,559 was the taxpayer’s correct tax liability and that she had overpaid by $32,441. But, the kindler, gentler IRS said it was so sorry that it couldn’t issue her a credit or refund of the $32,441 because she made the overpayment outside the applicable look-back period tied to the SNOD. According to the IRS, the parenthetical phrase "with extensions" contained in the statute modified "due date." That meant, according to the IRS, the "due date (with extensions) for filing the return of tax" was October 15, 2013, pursuant to the automatic extension that the taxpayer received to file her 2012 return. Thus, the "third year" after that date, the IRS said, began on October 15, 2015. However, the IRS mailed the SNOD on June 19, 2015 – during the second year and not the third year "after the due date (with extensions) for filing the return." In addition, the IRS claimed, the last sentence of I.R.C. §6512(b)(3) did not apply. In essence, the parties were arguing over what “with extensions” means in I.R.C. §6512(b)(3) in terms of whether the Tax Court had jurisdiction to authorize a refund to the taxpayer.
The Tax Court, agreeing with the IRS, trotted out the statutory language of I.R.C. §6512(b)(3), which says the Tax Court has jurisdiction to order a refund of overpayments made during the three years immediately preceding the mailing of the notice of deficiency (i.e., a three‐year look‐back period) if the taxpayer failed to file a return before the mailing of the notice of deficiency and “the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of tax.” The Tax Court held that “(with extensions)” was unambiguous and modified only “due date” and had the effect of delaying by six months the beginning of the “third year after the due date.” The flush language and it’s three-year look-back period didn’t apply. That meant that there were only two years remaining from the date the SNOD was issued. Thus, the taxpayer’s overpayment was outside the two-year look-back by two months and the Tax Court determined it didn’t have jurisdiction to order the refund. Remember, there was no question the taxpayer was entitled to the refund. The IRS was taking the position that the Tax Court couldn’t order the IRS to issue the refund and the Tax Court agreed. The tax black-hole!
On appeal, the U.S. Court of Appeals for the Second Circuit reversed. The appellate court held that “with extensions” in I.R.C. §6512(b)(3) extended by six months the “third year after the due date.” Thus, the look-back period was three years rather than two and the Tax Court had jurisdiction to order the refund. Importantly, the appellate court said that I.R.C. §6512(b)(3) was unclear and, as a result, legislative history should be examined. That history, the appellate court determined, was in the taxpayer’s favor and that uncertain statutory language should be resolved against the government. The flush language, the appellate court noted, was intended to increase the Tax Court’s jurisdiction to order refunds to taxpayers that didn’t file a return before the mailing of the SNOD. No more black-hole.
Application to the TCJA?
Does Borenstein have any application to the tax provisions contained in the TCJA. It could. As noted, the appellate court said that uncertain tax provisions are to be construed against the government. There are more than a few unclear provisions in the TCJA. Even the IRS is struggling to come up with consistent interpretations of various TCJA provisions. In addition, there is very little legislative history concerning the bulk of the TCJA provisions. That could ultimately work in taxpayers’ favor if future courts construing TCJA provisions take the same position on statutory construction as did the appellate court in Borenstein.
The refund black-hole issue has been the subject of a couple of cases decided in recent months. At least in the Second Circuit the black-hole has disappeared. That’s Connecticut, New York and Vermont. The Borenstein decision is persuasive authority, but not binding, on the IRS outside the Second Circuit.
Monday, April 22, 2019
Last week’s post on the self-rental rule of Treas. Reg. §1.469-2T(f)(6) generated a lot of interest. As noted in that post, the self-rental rule bars a taxpayer with passive losses from artificially creating passive income from another activity to offset the passive losses. One way to potentially do this is to self-rent property. Questions were raised as to the rule’s application to S corporations. In addition, there were additional questions raised as to how the rule applied with respect to the net investment income tax (NIIT) of I.R.C. §1411 and whether self-rentals are eligible for a qualified business income deduction (QBID) under I.R.C. §199A.
Digging a bit deeper on the self-rental rule – it’s the topic of today’s post.
In general. In prior posts last year and earlier this year, I wrote on the various aspects of the QBID. The QBID was created under the Tax Cuts and Jobs Act and is effective for tax years beginning after 2017 and before 2026. The QBID is a 20 percent deduction for noncorporate taxpayers against qualified business income (QBI). QBI is the net amount of items of income, gain, deduction and loss with respect to a trade or business. A qualified trade or business is any trade or business other than a specified service trade or business (SSTB) or the business of performing services as an employee. An SSTB is a trade or business involving performance of services in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Taxpayers who own an SSTB may still qualify for the deduction if a taxpayer’s taxable income (for 2019) does not exceed $321,400 for a married couple filing a joint return, or $160,700 for all other taxpayers except that married filing separate taxpayers have a $160,725 threshold.
Rental activities. To be eligible for the QBID, a rental activity must rise to the level of trade or business in accordance with I.R.C. §162. That is a different (and more stringent) standard than that utilized for purposes of the passive loss rules of I.R.C. §469, and it requires regularity and continuity in the activity. There are many decided cases involving the issue of whether a trade or business exists under the I.R.C. §162 standard with the courts utilizing numerous factors such as the type and number of properties rented; how involved the taxpayer is in the business; whether any ancillary services are provided under the lease and, if so, the type; and, the type of the lease. These factors are also listed in the preamble to the I.R.C. §1411 regulations.
In August of 2018 QBID proposed regulations were released. The proposed regulations defined “self-rentals” as a “trade or business.” Thus, the income from a self-rental will qualify for the QBID if the self-rental is being leased through a passthrough business that is under “common control.” Common control is necessary to combine rentals with other business activities and is defined when the same person or group, directly or indirectly own 50% or more of each trade or business.
Seth Poole is the sole owner of an S corporation that is engaged in manufacturing widgets. Seth also owns an office building that he holds in his single member limited liability company (LLC). The LLC leases the office building to the S corporation under a triple-net lease (a lease agreement where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees such as rent, utilities, etc.). Because the office building is leased between entities that are under common control, and the S corporation is carrying on a trade or business, the triple-net lease activity qualifies as eligible for the QBID.
The “takeaway” from the proposed regulations was that self-rentals between entities that are under common control can produce a significant QBID.
In mid-January of 2018, the Treasury released the QBID final regulations. Issued along with those final regulations was Notice 2019-07 providing safe harbor rules for rental activities on the trade or business issue. In essence, to qualify for the safe harbor, a rental real estate activity is a QBI-qualifying trade or business under I.R.C. §199A if the taxpayer provides at least 250 hours of services during the tax year. But, it is important to remember that the safe-harbor is just that – a safe-harbor. A rental activity can qualify as an I.R.C. §162 trade or business without meeting the safe harbor requirements if the facts and circumstances support such a finding.
Under the final regulations, a self-rental constitutes an I.R.C. §162 trade or business for QBID purposes if the rental involves commonly controlled entities (either directly or via attribution under I.R.C. §§267(b) or 707(b)) where the self-rental income is not received from a C corporation. The final regulations also bar taxpayers from shifting SSTB income to non-SSTB status by using a self-rental activity where property or services are provided to an SSTB by a trade or business with common ownership. Under the rule, a portion of the trade or business that provides property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties if there is at least 50 percent common ownership.
A group of CPAs own a building. They lease 80 percent of the building space to the CPA firm and 20 percent of the building to an unrelated chiropractor. The 20 percent would be classified as non-SSTB income while the 80 percent would be treated as SSTB income. The general rule is that a rental real estate trade or business is not treated as an SSTB, subject to the taxable income limitations. However, that rule changes if there is common ownership exceeding 50 percent. If there is, the rental income attributable to the commonly controlled SSTB is treated as if it were SSTB income.
Even though the passive loss rules of I.R.C. §469 don’t specify that they apply to S corporations, the Tax Court has held that the self-rental rule applies to rentals by S corporations. In Williams v. Comr., T.C. Memo. 2015-76, the taxpayers (a married couple) owned 100 percent of an S corporation and 100 percent of a C corporation. The husband worked full-time for the C corporation during 2009 and 2010, and materially participated in its activities. Neither of the taxpayers materially participated in the S corporation or the rental of commercial real estate to C corporation. They also were not engaged in a real estate trade or business. In 2009 and 2010, the S corporation leased commercial real estate to the C corporation so that the C corporation could use it in its business. For those years, the S corporation had net rental income that the taxpayers reported as passive income on Schedule E which they then offset with passive losses. The IRS disagreed and recharacterized the rental income as non-passive under the self-rental rule.
In upholding the IRS position, the Tax Court determined that passthrough entities are subject to I.R.C. §469 (which included the taxpayers’ S corporation) even though not specifically mentioned by the statute. They did not need to be mentioned, the Tax Court reasoned, because they were not taxpayers. The Tax Court also rejected the taxpayers’ argument that the self-rental rule didn’t apply because the S corporation did not participate in the C corporation’s trade or business. It was enough that the husband personally provided material participation in the C corporation’s business to trigger the application of the self-rental rule. The rental income from the lease was non-passive.
The 3.8 percent NIIT applies to taxpayer’s with passive income that exceeds $250,000 on a joint return ($125,000 married filing separately; $200,000 for other filing statuses). Generally, the passive loss rules apply in determining whether an I.R.C. §162 trade or business is passive for NIIT purposes. Thus, if a taxpayer has rental income from an activity in which the taxpayer materially participates, the NIIT will not apply. But, what about the self-rental recharacterization rule? Treas. Reg. §1.1411-5(b)(2) specifies that, “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.”
Thus, if the self-rental recharacterization rule applies, it will cause the trade or business at issue to not be passive for NIIT purposes only with respect to the recharacterized income or gain. Treas. Reg. §1.1411-5(b)(2)(iii). When gross rental income is treated as not being derived from a passive activity because of a grouping a rental activity with a trade or business activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Thus, the NIIT would not apply. Treas. Reg. §1.1411-4(g)(6)(i).
For purposes of the NIIT, the self-rental rule is applied on a person-by-person basis. Thus, there can be situations involving multiple owners in a rental entity where some will be subject to the NIIT and others who will not be subject to the NIIT based on individual levels of participation in the activity.
The self-rental rules involve numerous traps for the unwary. For taxpayers with such scenarios, seeking competent tax counsel is a must.
Thursday, April 18, 2019
In recent weeks, I have written a couple of posts on various aspects of the passive loss rules contained in I.R.C. §469. Indeed, over the past two years, I have written six posts on the various aspects of the passive loss rules and their application to farm and ranch taxpayers. With today’s post, I add to those numbers by examining another aspect of the passive loss rules and how it applies to a common tax and business planning technique of farmers and ranchers – renting the farm/ranch land to the farm/ranch operating entity.
The “self-rental” limitation of the passive loss rules – it’s the topic of today’s post.
Passive Loss Rules - Basics
As noted in prior posts, to deduct passive losses (the amount by which the taxpayer’s aggregate losses from all passive activities for the tax year exceed aggregate income from those activities), an investor must have passive income. Stated another way, a passive activity loss can only offset passive income (with a few exceptions). The rule makes it quite difficult for a taxpayer to deduct passive losses unless they have another activity that is generating passive income.
Avoiding Passive Losses
Materially participate. There are two ways to approach the limitation of passive loss rules. One is to not be engaged in passive activities. A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. §469(c). Under the general rule, rental activities are passive. I.R.C. §469(c)(2). But, as noted in prior posts, there are exceptions. In addition, the activity is not a passive activity if the taxpayer is involved in it on a basis that is regular continuous and substantial. Basically, the taxpayer has to be involved in the daily management of the activity for a sufficient amount of time. The regulations provide seven tests for material participation. Treas. Reg. §1.469-5T(a)(1)-(7).
Create passive income and the risk of recharacterization. The other approach is be involved in activity that generates passive income that could then be offset by passive losses from another activity. Indeed, when the passive loss rules became law, there was immediate interest in creating what came to be known as passive income generators (PIGs). These are investment activities that throw off passive income, allowing the investor to match the passive income from the activity against passive losses. The IRS anticipated this and published regulations in the mid-1980's that recharacterized, or gave the IRS the power to recharacterize, passive income as non-passive income which was ineligible to offset passive losses. This became known as the “slaughter of pigs.” There are ten categories of recharacterization.
Bare land leases. One recharacterization rule applies to bare land leases. Treas. Reg. §1.469-2T(f)(3). Under this recharacterization rule, net income from a rental activity is considered not from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Id. The rule converts both net rental income and any gain on disposition from passive income to portfolio income (i.e., income from investments, dividends, interest, capital gains). But, the recharacterization rule only applies if there is net income from the rental activity. If there is a loss, the loss remains passive.
Example: Dr. Sawbones owns interests in multiple limited partnerships that have suspended losses. In an attempt to use those losses, Sawbones bought farmland for $400,000. $100,000 of the purchase price was allocated to fences, tile lines, grain bins and other depreciable property. Sawbones cash leased the land to his cousin via a cash rent lease in an attempt to generate passive income that he could offset with the suspended passive losses. However, because only 25 percent of the unadjusted basis is attributable to depreciable property, the cash rent income is recharacterized (for passive loss rule purposes) as portfolio income and will not offset the suspended passive losses from the limited partnerships. However, if the cash rent produces a net loss after taxes, interest and depreciation, the loss is a passive loss. This is not the result that Sawbones was hoping to achieve. The regulation has been upheld as valid. See, e.g., Wiseman v. Comr., T.C. Memo. 1995-303.
Self-rentals. Farmers and ranchers sometimes structure their businesses in multiple entities for estate and business planning (and tax) purposes. Such a structure may involve the individual ownership of the land that is then rented to the operating entity that the landlord also has an ownership interest in. Alternatively, the land may be held in some type of non-C corporation entity and rented to the operating entity. If the land lease does not involve the landlord’s material participation and the rental amount is set at fair market value (or slightly less), self-employment tax is avoided on the rental income even though the landlord materially participates in the operating entity as an owner. See Martin v. Comr., 149 T.C. 293 (2017). However, it’s also a classic self-rental situation that trips another recharacterization rule for passive loss purposes. Under this rule, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, just like the recharacterization rule mentioned above for bare land leases, recharacterization only applies if there is net income from the self-rental activity. If a loss occurs, the loss remains passive. While an exception exists for rentals in accordance with a written binding contract entered into before February 19, 1988, that lease must have been a rather long-term lease at the time it was entered into for the grandfathering provision to still apply. Treas. Reg. §1.469-11(c)(1)(ii). It’s not possible to renew or draft an addendum to the original lease and come within the exception. See, e.g., Krukowski v. Comr., 114 T.C. 366 (2000), aff’d., 239 F.3d 547 (7th Cir. 2002). It also applies to S corporations. Williams v. Comr., No. 15-60341, 2016 U.S. App. LEXIS 1756 (5th Cir. Feb. 5, 2016), aff’g., T.C. Memo. 2015-76.
Example: For estate and business planning purposes, Mary put most of her farmland in an entity that she is the sole owner and employee of. Mary continued to own her livestock buildings, a machine shed and additional farmland, and rented them to the entity under a cash lease. Mary reported the rental income on Schedule E (Form 1040). However, because the rental income is derived from a business in which Mary materially participates, she cannot carry the rental income to Form 8582 (the passive activity loss Schedule) within her Form 1040. Instead, the net rental income is treated as coming from a non-passive activity. Mary will have to carry the net rental income from Schedule E directly to page one of her Form 1040. If Mary has passive losses from other sources, she will not be able to use those losses to offset the rental income.
It’s not possible to make a grouping election to overcome the self-rental regulation. See, e.g., Carlos v. Comr., 123 T.C. 275 (2000). As I noted in a prior post on the passive loss rules, a taxpayer can make an election to group multiple rentals as a single activity for passive loss rule purposes if the rental activities represent an appropriate economic unit. Treas. Reg. §1.469-4(c). But, even with such a grouping election the self-rental rule will still apply.
Example: Bill and Belinda are married and file a joint return. They own two tracts of farmland and cash lease each tract to the farming entity (an S corporation) that they own and operate. One of the tracts generates cash rental income of $200,000. The other tract produces an $80,000 loss. On their Schedule E for the tax year, they group the two tracts together as a single activity with the result that the net rental income reported is $120,000. Under the self-rental regulation, the IRS could separate the two rental tracts with the result that the $200,000 of income from one tract is recharacterized as non-passive and the $80,000 loss remains passive and cannot offset the $200,000 income. The $80,000 loss will be a suspended passive activity loss on Form 1040.
One option might be for Bill and Belinda to group the land rental activity that produces a loss with their operating entity. They can do that if the rental activity is “insubstantial” in relation to the business activity. Treas. Reg. §1.469-4(d)(1). In addition, they could group the rental activity that produced a loss with the operating entity (business activity) if they each have the same percentage ownership in the operating entity that they do in the rental activity. Such a grouping will result in the rental activity loss not being passive if they materially participate in the operating entity.
One more point on grouping – can a self-rental be grouped (“aggregated”) with the farming entity to maximize an I.R.C. §199A deduction? I.R.C. §199A is the new 20 percent deduction available for sole-proprietors and pass-through businesses on qualified business income. The answer is that as long as the farming entity and the land rental are part of a common group and have the same tax year, the rent will be aggregated with the farm income. That can optimize the use of the 20 percent deduction.
The passive loss rules are tricky. The cases are legion. Rentals are tricky, and the IRS can recharacterize rental activities to eliminate hoped-for passive income generators. Make sure you understand how the rules apply.
Tuesday, April 16, 2019
When we think of the Constitution, we tend to think of freedom of religion or freedom of the press. Maybe due process or equal protection comes to mind. Hardly ever does the right to not have soldiers quartered in our homes during peace time without consent ever cross one’s mind. Neither does soil erosion. But, is there a connection?
Soil erosion and the Constitution – that’s the topic of today’s post.
In terms of quantity, sediment - the soil or mineral material transported by water and deposited in streams or other bodies of water - is the worst pollutant of the nation's waters. While the non-farm media tends to pin the blame on agriculture, and it is true that a significant portion of it results from soil erosion of farmland, much of the sediment comes from nonagricultural activities. In either situation, the most effective way of controlling soil erosion is by the use of proper soil conservation practices and techniques. The nation’s farmers and ranchers are to be commended for utilizing them. The few “bad apples” that exist give a bad rap to the vast majority who carefully and thoughtfully utilize good husbandry practices.
Federal regulation. The federal government has long been concerned with the problem of soil erosion. Two major agencies within the United States Department of Agriculture (USDA) that have substantial soil erosion responsibilities are the Natural Resource Conservation Service (NRCS) and the Farm Service Agency (FSA). In general, the federal soil conservation programs are limited to conservation incentives in the form of technical assistance and cost sharing. The Soil Conservation Service (SCS) was created in 1935 to be the primary federal agency involved in soil erosion control. Its programs, consisting mainly of technical assistance, are administered in cooperation with local soil and water conservation districts. The Agricultural Stabilization and Conservation Service (forerunner of the FSA) was created at approximately the same time as the SCS, but for a different purpose. The original purpose of the ASCS was to be the vehicle for administering the Agricultural Adjustment Act (AAA) of 1938, an act that provided for a series of direct payments to farmers in exchange for their participation in acreage reduction programs. When the initial acreage reduction program was held unconstitutional in United States v. Butler, 297 U.S. 1 (1936), a temporary program was instituted to provide payments to farmers for planting cover crops to conserve soil, a backdoor means of lowering the production of certain agricultural commodities, and thereby increasing crop prices. That program was continued in the Soil Bank and continues presently in the form of the Conservation Reserve Program .
State regulation. Many states also have soil erosion and sediment control statutes that require landowners to take certain actions designed to minimize soil erosion. In some states, such as Kansas, the burden is placed upon local county commissioners to take action designed to minimize soil erosion.
1979 Iowa case. Landowners occasionally have challenged the validity of state soil erosion laws on the basis that the statutes are an unconstitutional exercise of the state's police power. In an Iowa case, Woodbury County Soil Conservation District v. Ortner, 279 N.W.2d 276 (Iowa 1979), one landowner filed a complaint against an adjacent landowner with the plaintiff (county soil conservation district) claiming that his farm was being damaged by water and soil erosion from the defendant’s land. Ultimately, complaint was settled without the plaintiff taking any action. However, the next year the same landowner filed another complaint claiming similar damage. This time the county soil conservation district investigated in accordance with state law and found that the soil loss on both adjoining farms exceeded the statutory limit. The plaintiff ordered both landowners to remedy the situation within six months and gave them two options: 1) seed the land to permanent pasture or hay; or 2) terrace the land. They did nothing, and the county soil conservation district sued to enforce its order. It was undisputed that terracing would cost the defendant about $12,000 and the adjoining landowner approximately $1,500. In addition, some of each landowner’s farmland would become untillable. While seeding the ground to pasture or hay was less expansive, some of the farmland would be removed from crop production. There was a dispute concerning whether either alternative would decrease the value of the land. The defendant challenged the soil conservation statute under which the county soil conservation district acted as unconstitutional – it amounted to a taking of private property without just compensation as the Fifth Amendment required. The defendant also claimed that the state law was an unreasonable and illegal exercise of the state’s “police power.”
The trial court agreed with the defendant and struck the state statute down. The law, the trial court said, placed an unreasonable burden on the defendant that was unduly oppressive and deprived them of their rights under the Fifth and Fourteenth Amendments of the U.S. Constitution and comparable provisions of state law.
On appeal, the Iowa Supreme Court reversed. The Supreme Court noted that the state had a vital interest in protecting its soil “as the greatest of natural resources” and that it has a right to do so based on the declared purpose of the statute at issue. Under that language, it is the duty of each landowner to establish and maintain soil and water conservation practices or erosion control practices, in accordance with soil conservation district regulations. Ultimately, the Supreme Court determined that the sate law was reasonably related to carrying out its announced purpose of soil control, and that control of soil erosion was a proper exercise of the state’s police power. The Supreme Court also noted that the state was willing to cost-share with the landowners to the tune of about three-fourths of the total bill. The Supreme Court said that the fact that a person must incur substantial expenditures to comply with valid regulations did not raise a constitutional issue. The defendants still had the use and enjoyment of their property.
The Iowa Supreme Court's opinion in Ortner upheld the neighbor's private property right to be free from damage caused by an adjacent farm's excessive water and soil erosion. In essence, the state can enact legislation to prevent a nuisance resulting from excessive soil and water erosion.
In Brown v. United States, No. 18-801L, 2019 U.S. Claims LEXIS 231 (Fed. Cl. Mar. 15, 2019), the plaintiff operated a sod farm on land the plaintiff owned in Oklahoma along a river. The river is south of a lake. In 1974, the federal government completed the lake dam, which has a spillway that releases water when it floods. The spillway discharges water and sediment downstream, directly across from plaintiff’s property. Since 1986 (the first use of the spillway) the spillway has been used 17 times. In 1990 the plaintiffs first complained of the water from the spillway eroding their property where they operate a sod farm. The plaintiff contacted the U.S. Army Corps of Engineers (COE) in 2003, 2004, 2007, 2008, 2009, 2011, 2015, and 2016 concerning the erosion. The COE continually maintained that it "will not—and cannot—mitigate the erosion," explaining that "there is no program that authorizes the “COE” to directly address the [plaintiff’s] situation.”
In 2015, the erosion rendered the plaintiff’s center pivot inoperable. The plaintiff spent approximately $10,000 on new irrigation equipment to continue business operations and approximately $15,000 on riprap to prevent further erosion. In 2018, the plaintiff filed sued, claiming that over eight acres of the plaintiff’s land had been lost due to erosion from the water released from the spillway. The plaintiff sought compensation under the Fifth Amendment as a compensable taking of their property.
The Government moved to dismiss this claim, but the court denied the motion on the basis that the “continuing claims” doctrine applied. Under that doctrine, the court concluded, each release of water through the spillway constituted a discreet takings claim. The Government claimed that the court lacked subject matter jurisdiction on the basis that the plaintiffs’ claim was barred by the statute of limitations as it accrued in 1990 when the plaintiffs first noticed the erosion. However, the plaintiffs asserted that the statute of limitations did not begin to run until 2015 when their operation had to be altered because of the erosion. Further, the plaintiffs asserted that the “continuing claims” doctrine should extend their claim because each use of the auxiliary spillway constituted a new breach of duty by the Government.
The court agreed with the plaintiff, and also pointed out that erosion-type takings involve an act of “taking” that occurs over a long period of time. Thus, the statute of limitations does not begin to run until the situation “stabilizes.” Ultimately, the court held that the record had not been developed sufficiently for the court to determine when the erosion stabilized. Hence, the Government’s motion to dismiss was denied for further development of the record.
Soil erosion issues loom large in agriculture. Sometimes, the Constitution gets involved in the mix. When it does, some interesting issues are involved.
Friday, April 12, 2019
The negligence concept is the great workhorse of tort law. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court.
But, what is a reasonable and prudent farmer? What is a farmer presumed to have knowledge of? These are important questions when the issue is negligence.
The reasonably prudent farmer – it’s the topic of today’s post.
Negligence – In General
More than 90 percent of all civil liability problems relate to negligence. The negligence system is a system designed to provide compensation to those who suffer personal injury or property damage. The negligence system is a fault system. For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained.
The first condition is that of a legal duty giving rise to a standard of care. If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case. Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause). For a plaintiff to prevail in a negligence-type tort case, the plaintiff bears the burden of proof to all four elements by a preponderance of the evidence (just over 50 percent).
The “Reasonably Prudent” Standard
The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors. For example, the standard applicable to a professional veterinarian in diagnosing or treating animals is what a reasonable and prudent veterinarian would have done under the circumstances, not what a reasonable and prudent person would do.
The issue of what a farmer is presumed to know was at issue in a recent case. In Perkins v. Fillio, No. 18A-PL-2278, 2019 Ind. App. LEXIS 73 (Ind. Ct. App. Feb. 19, 2019), the defendant owned a small farm where she kept various animals including sheep and goats. The defendant spent roughly half her time at the farm and half her time in Florida. In 2016, the defendant was in Florida and left her half-brother (Slate) in charge of caring for her animals while she was gone, including feeding and watering them. While the defendant was in Florida, one of the goats (a ram) got sick, and because Slate had little experience with farm animals, he contacted a neighbor, the plaintiff, to come and help with the sick goat.
As the plaintiff bent over the ill goat head-butted her, causing her to fall and break her arm/wrist. The plaintiff then sued the defendant on three theories of negligence; premises liability, negligent entrustment and/or supervision, and vicarious liability. Under Indiana law, tort liability based on negligence requires that the defendant owe a plaintiff a duty; that the duty was breached; and that the plaintiff was injured as a result of the breach of the duty. At issue were whether a duty existed and whether the defendant had violated that duty. The plaintiff presented expert testimony to show that rams are generally territorial and tend to defend themselves, their territory, and the females that they perceive to be in their herd by headbutting unfamiliar animals or persons, and that tendency is generally known by farmers. The plaintiff claimed that when she went into the pen to care for the sick goat, she did not realize it was a ram because it had no horns, and she had never been warned that a ram might be protective and territorial.
Both parties moved for summary judgment on the liability question, and the trial court found in favor of the defendant because, in part, there was a lack of evidence indicating that the defendant knew the plaintiff would be on her real estate and, in particular, be inside the pen where the defendant kept the ram. There was also no evidence that the ram had been aggressive toward anyone in the past. Accordingly, the trial court found that the defendant had not violated a duty of care to the plaintiff. The plaintiff appealed.
On the premises liability question, the appellate court found that a duty to protect against harm caused by domestic animals could be established by either (1) a defendant’s knowledge that a particular animal has a propensity for violence and/or (2) a defendant’s ownership of a member of a class of animals that are known to have dangerous propensities, as the owner of such an animal is bound to have knowledge of that potential danger. The appellate court held that the plaintiff had presented sufficient evidence to establish that rams have dangerous tendencies as a class of animals, and the defendant was bound to have knowledge of that propensity. This evidence was enough to create a genuine issue of fact as to whether the defendant took reasonable measures to prevent the ram from causing harm to invitees, such as the plaintiff. Based on this standard, the appellate court held that the trial court had erred in granting summary judgment on the premise liability issue.
However, the plaintiff did not present sufficient evidence to create a genuine issue of material fact as to the remaining theories of negligence, and therefore the appellate court did not reverse on those rulings. Accordingly, the appellate court remanded to the trial court for further proceedings on the issue of premises liability.
Farmers have a great deal of skill and knowledge in many matters. For conduct that falls below the standard or reasonableness for a prudent farmer, tort liability may apply. That standard is difficult to determine and depends on the facts of each particular case. In the recent Indiana case, the farmer, even though part-time but as a keeper of animals (including sheep and goats) was presumed to know of the tendency of rams to butt.
Think through how the reasonably prudent person standard might apply in your situation.
Wednesday, April 10, 2019
The donation of a permanent conservation easement on farm or ranch land can provide a significant tax benefit to the donor. The rules are complex and must be carefully complied with to obtain the tax benefits that are possible – qualified farmers and ranchers can deduct up to 100 percent of their income (i.e., the contribution base). For others, the limit is 50 percent of annual income.
The IRS has a history of not showing a great deal of appreciation for the provision. After all, the donor is getting a significant tax deduction and can still farm or graze the property, for example. So, the technical requirements must be paid close attention to and strictly complied with.
Now legislation has been introduced that would eliminate the tax deduction associated with the donation of permanent conservation easements via a syndicated partnership. In addition, the IRS recently designated syndicated conservation easement transactions as being on its list of the “Dirty Dozen” tax scams of 2019.
The trouble with permanent conservation easement donations – it’s the topic of today post.
Permanent Conservation Easement Donations
In general. The donation of a permanent conservation easement is accomplished via a transaction that involves a legally binding agreement that is voluntarily entered into between a landowner and qualified charity – some form of land trust or governmental agency. Under the agreement, the landowner allows a permanent restriction on the use of the donated land so as to protect conservation characteristics associated with the tract. See I.R.C. §170(h). But, all of the applicable tax rules must be precisely complied with in order to generate a tax deduction. This is one area of tax law where a mere “foot-fault” can be fatal.
IRS Concerns. The key to securing a tax deduction for the donation of a permanent conservation easement is the proper drafting of the easement deed (as well as an accurate and detailed appraisal of the property). That’s the instrument that conveys the legal property interest of the easement to the qualified charity (qualified land trust, etc.). This document must be drafted very precisely. For example, the donor must not reserve rights that are conditioned upon the donee’s consent. This is termed a deemed consent provision and it will cause the donated easement to fail to be a perpetual easement – one of the requirements to get a charitable contribution deduction. See Treas. Regs. §§1.170A-14(e)(2); 1.170A-14(g)(1); 1.70A-14(g)(6)(ii).
Another requirement of securing a charitable deduction for a donated conservation easement is that the charity must be absolutely entitled to receive a portion of any proceeds received on account of condemnation or casualty or any other event that terminates the easement. This is required because of the perpetual nature of the easement. But, exactly how the allocation is computed is difficult to state in the easement deed. The basic point, however, is that the allocation formula cannot result in what a court (or IRS) could deem to be a windfall to the taxpayer. See, e.g., PBBM-Rose Hill, Ltd. v. Comr., 900 F3d 193 (5th Cir. 2018); Carroll v. Comr., 146 T.C. 196 (2016). In addition, the allocation formula must be drafted so that it doesn’t deduct from the proceeds allocable to the donee an amount that is attributable to “improvements” that the donor makes to the property after the donation of the permanent easement. If such a reduction occurs, the IRS presently takes the position that no charitable deduction is allowed because the specific requirements of the proceeds allocation formula are not satisfied. This seems counter-intuitive, but it is an IRS audit issue with respect to donations of permanent conservation easements.
If the donee acquires the fee simple interest in the real estate that is subject to the easement, the donee’s ownership of both interests would merge under state law and thereby extinguish the easement. This, according to the IRS, would trigger a violation of the perpetuity requirement. Consequently, deed language may be included to deal with the merger possibility. But, such language is problematic if it allows the donor and donee to contractually agree to extinguish the easement without a court proceeding. Leaving merger language out of the easement deed would seem to result in the IRS not raising the merger argument until the time (if ever) the easement interest and the fee interest actually merge.
The IRS also takes the position that the perpetuity requirement is not met if a mortgage on the property is not subordinated. For instance, in Palmolive Building Investors, LLC v. Comr., 149 T.C. 380 (2017), a charitable deduction was denied because the mortgages on the property were not subordinated to the donated façade easements as Treas. Reg. §1.170A-14(g)(2) requires. In addition, the deed at issue stated that the mortgagees had prior claims to extinguishment proceeds. That language violated the requirement set forth in Treas. Reg. §1.170A-14(g)(6)(ii). A savings clause in the deed did not cure the defective language because the requirements of I.R.C. §170 must be satisfied at the time of the easement is donated.
The caselaw also supports the IRS position that development rights and locations for development cannot be reserved on the property subject to the easement if it changes the boundaries for the easement. In other words, the IRS position is that the easement deed language must place a perpetual encumbrance on specifically defined property that is fixed at the time of the grant. However, if the easement only allows the boundary of potential development to be changed on a portion of a larger parcel that is subject to the easement restrictions and neither the acreage of potential development nor the easement is enhance, the perpetuity requirement remains satisfied. See, e.g., Bosque Canyon Ranch II, L.P. v. Comr., 867 F.3d 547 (5th Cir. 2017); Treas. Reg. §1.170A-14(f).
Another problem with easement deeds that the IRS watches for is whether the deed language allows the donor and donee to mutually agree to amend the deed. If this reserved right is present, the IRS takes the position that the easement is not perpetual in nature and does not satisfy the perpetuity requirement of I.R.C. §170(h)(2)(C). But, there is an exception. Amendment language is allowed if any subsequent transfer by the donee (via amendment language in the deed) facilitates the conservation purpose of the original transfer to the donee organization. Treas. Reg. 1.170A-14(c)(2); see also Butler v. Comr., T.C. Memo. 2012-72.
Syndicated Easement Donations
The IRS has also been aggressive at auditing donated conservation easements accomplished via a syndicated partnership. These transactions involve either an individual or an entity buying undeveloped property and then transferring it to a partnership. Partnership interests are then sold to “investors.” After the land appreciates in value, the partnership donates a conservation easement on the land to a qualified land trust with the charitable deduction flowing to the investors. This strategy made it on the 2019 IRS list of the “Dirty Dozen” tax scams and the Congress is taking action to eliminate the technique. In the U.S. Senate, The “Charitable Conservation Easement Program Integrity Act of 2019” has been introduced to end syndicated partnership easement donations. It also contains provisions that are effective retroactively and bars deductions when the value of the associated property has appreciated in value more than 2.5 times the initial investment.
I.R.C. §170(h) has been around for almost 40 years. It was enacted with the purpose of incentivizing landowners who wanted to bar development on their land and simultaneously provide a conservation benefit. It wasn’t designed with the intent that it become a profit-making venture. But, in recent years inappropriate and unsupportable property valuations have raised IRS and court scrutiny. In addition, the technical requirements for the deed language are very detailed and must be followed precisely. But, done correctly (and not via a syndicated partnership) the donation of a permanent conservation easement can provide substantial conservation benefits and a tax break for donors.
With the donation of permanent conservation easements it’s wise to remember that, “pigs get fat, but hogs get slaughtered.
Monday, April 8, 2019
Recently, I devoted a blog post to the benefits of a farming or ranching operation from the utilization of a cost segregation study. https://lawprofessors.typepad.com/agriculturallaw/2019/03/cost-segregation-study-do-you-need-one-for-your-farm.html. That post generated a great deal of nice comments and input and a request for another post looking at the risks of using a cost segregation study. Indeed, in 2018, the IRS issued a Chief Counsel Advice (CCA) discussing when the preparers of cost segregation studies could be subjected to penalties.
Issues and risks associated with cost segregation studies – that’s the topic of today’s post.
As pointed out in my prior post, cost segregation is the practice of taking a large asset (such as a building) and splitting its structural component parts into a group or groups of smaller assets that can be depreciated over shorter lives. See Treas. Reg. §1.48-1(e)(2)(provides guidance on the definition of a “structural component”). A primary emphasis of a cost segregation study is to classify assets as depreciable personal property rather than as depreciable real estate (or classify depreciable personal property (e.g., structures) separate from non-depreciable real estate). In tax lingo, the studies often result in the construction of rather detailed lists of individual assets that distinguish I.R.C. §1245 property with shorter depreciable recovery periods from I.R.C. §1250 property that has a longer recovery period. See, e.g., Hospital Corporation of America & Subsidiaries, 109 T.C. 21 (1997), acq. and non-acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. But see, Amerisouth XXXII, Ltd. v. Comr., T.C. Memo. 2012-67 (involving residential rental property). This technique will generate larger depreciation deductions in any particular tax year. The Tax Cuts and Jobs Act (TCJA) of late 2017, at least indirectly, makes the practice of cost segregation more beneficial by providing for the immediate expensing of up to $1 million ($1,020,000 for 2019) of most personal property that is found on a farm or ranch, and also by allowing first-year 100 percent “bonus” depreciation on used (in addition to new) assets. These changes make it more likely that a cost segregation study will provide additional tax benefits.
Because of the additional depreciation incentives included in the TCJA, the “placed-in-service” date of an asset is of primary importance. When is an asset deemed to be placed in service for depreciation purposes? The answer is when the asset is in a condition or state of readiness and availability for a specifically assigned function such as use in the taxpayer’s trade or business. See Treas. Reg. §1.167(a)-11(e)(1)(i); see also Treas. Regs. §§1.46-3(d)(1)(ii) and 1.46-3(d)(2); Von Kalinowski v. Comr., 45 F.3d 438 (9th Cir. 1994), rev’g. T.C. Memo. 1993-26. In practice, the determination of when an asset is placed in service is highly fact-dependent. In addition, the answer to the question can turn on the type of asset that is involved. As applied to commercial buildings, for example, the IRS tends to use the date on a certificate of occupancy as a factor in determining the placed-in-service date of the building or a portion of the building. But, in Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. 2015), the court held that the two buildings of a retail operation at issue in the case were placed in service in the year when they were ready and available to store equipment and contained racks, shelving and merchandise. The court viewed it as immaterial that the certificates of occupancy for the buildings did not allow public access until the next year. The placed-in-service date was important in Stine because the taxpayer sought to have the buildings placed in service in 2008 (rather than 2009) to be eligible to deduct Gulf Opportunity Zone bonus depreciation on the buildings. The IRS issued a non-acquiescence in Stine. A.O.D. 2017-02 (Apr. 10, 2017). The IRS said that it will continue to litigate the placed-in-service issue on the basis of its position that a retail store isn’t placed in service until it is open for business.
IRS Audit Approach
The IRS has posted to its website a very detailed audit technique guide (ATG) concerning cost segregation studies. See https://www.irs.gov/businesses/cost-segregation-audit-techniques-guide-table-of-contents. The guide is useful in terms of the information it provides practitioners concerning its view on what constitutes a properly conducted cost segregation study. In the ATG, IRS auditors are advised to closely scrutinize cost segregation studies that are conducted on a contingency fee basis. The IRS believes that such fee structures incentivize the maximization of I.R.C. §1245 costs through “aggressive legal interpretations” or by inappropriate cost or estimation techniques. As a result, firms performing cost segregation studies may be better off billing the work based on the size of the project plus out-of-pocket expenses. Auditors are also advised to conduct in-depth reviews of cost segregation studies to determine the appropriateness of property depreciation classifications and determine if there are any land or non-depreciable land improvements that the study has classified as depreciable property. This could be a particularly important issue for cost segregation studies involving farm and ranch taxpayers.
In the ATG, IRS examiners are to closely look at the classification of I.R.C. §1245 and I.R.C. §1250 property. On this distinction, taxpayer records and documentation are critical. IRS will look to see whether a building component designated as I.R.C. §1245 can actually be used for other pieces of equipment. If it can, it will likely be classified as part of the building. The ATG also notes that IRS examiners can use sales tax records of the taxpayer as guidance on the proper allocation between I.R.C. §1245 and §1250 property. Other key points on the I.R.C. §1245/I.R.C. §1250 distinction involve whether the cost segregation study used cost estimates or actual cost records or a residual approach to determine the actual cost of I.R.C. §1245 items. What IRS is looking for is whether the cost of I.R.C. §1245 property has been set too high.
Another specific area of examination involves when depreciable and non-depreciable property are acquired in combination for a lump sum. The ATG points out to examiners that the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of the acquisition bears to the value of the entire property at that time. See Treas. Reg. §1.167(a)-5. Thus, examiners are to look at the fair market values of the properties at the time of acquisition. The fair market value of the land is to be based on its highest and best use as vacant land even if it has improvements on it. Thus, the ATG states that it is not correct for a cost segregation study to estimate land value by subtracting the estimated value of improvements from the lump sum acquisition price. Doing so, according to the IRS, results in an overstatement of the basis of depreciable improvements.
The ATG instructs examiners to reconcile total project costs (in terms of cost basis) in the taxpayer’s records with the total project costs in the cost segregation study. Thus, the IRS can be expected to request a copy of the taxpayer’s general ledger data. A key question will be whether costs that should have been in the taxpayer’s building account, for example, are showing up in another account or were expensed. Likewise, the ATG states that examiners should see if costs associated with site preparation, grading and land contouring have been properly (in the IRS view) allocated to land basis rather than being allocated to the overall building cost.
Preparer and Aiding and Abetting Penalties?
In 2018 the IRS issued a CCA taking the position that the preparers of cost segregation studies could be subjected to penalties. CCA 201805001(Oct. 26, 2017). The CCA involved a set of facts where an engineer/consultant prepared a cost segregation study without having any direct role in preparing tax returns. The engineer/consultant simply provided the completed study to the taxpayer so that the taxpayer could use it in the preparation of the taxpayer’s returns. The cost segregation study divided a 39-year property into component parts, many of which were assigned five-year MACRS lives. On audit, the IRS disagreed with the structural building components being classified as five-year property. Simply correcting the improper classification on the taxpayer’s returns was not enough. The IRS took the position that I.R.C. §6701 could serve as the basis for penalties against the study’s preparer for aiding and abetting the understatement of tax liability. The IRS position was that the engineer/consultant, by preparing the cost segregation study, was aiding or advising in the preparation of the taxpayer’s return. That satisfied I.R.C. §6701(a)(1). Accordingly, the engineer/consultant either knew or had reason to know that the study would be used “in a material matter relative to the IRC.” That satisfied I.R.C. §6701(a)(2). In addition, the IRS argued that the engineer/consultant had actual knowledge that the cost segregation study would result in an “understatement of the tax liability of another person” under I.R.C. §6701(a)(3). This last point is important. If the preparer of a cost segregation study knows that the study inflates depreciation deductions that will result in an understated tax liability, liability is present given that the fist two elements of potential liability under I.R.C. §6701 are practically presumed present.
The IRS determined that the engineer/consultant was liable for the $1,000 penalty for aiding and abetting the misstatement of individual tax forms. Had a misstated corporate form been involved, the penalty would have been $10,000. However, the IRS took the position that the $1,000 penalty should be imposed multiple times because the cost segregation study contributed to five returns misstating income as a result of the classification of 39-year property as five-year property. Why the IRS didn’t take the position that six $1,000 penalties should be imposed was not clear. Five-year MACRS property results in six-years of depreciation deductions (one-half year’s depreciation in each of year one year six under the one-half year convention). The IRS cited In re Mitchell, 977 F.2d 1318 (9th Cir. 1992) to support its position that multiple penalties should be imposed.
The favorable depreciation rules contained in the TCJA certainly create incentives for the greater use of cost segregation studies. In addition, care should be taken by the preparer(s) of a cost segregation study. The recent CCA indicates that the IRS is looking to establish that a study author has actual knowledge (under the preponderance of the evidence standard) that the study would result in an understatement of tax liability. See, e.g., Mattingly v. United States, 924 F.2d 785 (8th Cir. 1991). Actual knowledge must be shown. If a cost segregation study is prepared in accordance with the general guidance of Hospital Corporation of America & Subsidiaries, penalties should be avoided. But, ambiguities will very likely exist on the distinction between I.R.C. §1245 and I.R.C. §1250 property.
As Sergeant Esterhaus would say, ”Let’s be careful out there.”
Thursday, April 4, 2019
Last month, another jury has determined that Bayer-Monsanto was liable for damages caused by its Roundup weed killer. Roundup contains glyphosate, the most heavily used herbicide worldwide. According to the USDA, about 240 million pounds of glyphosate were sprayed in the U.S. in 2014, and traces of it can be found in air, water, soil and food products.
The most recent jury verdict awarding $81 million in damages to a plaintiff who developed non-Hodgkin lymphoma came about eight months after a different jury (also in California) awarded a different plaintiff almost $300 million for his claim that Roundup caused his cancer. In that 2018 case, however, the judge reduced the damages to about a third of what the jury awarded.
Do these verdicts and the thousands of other cases that have been filed in the Roundup litigation mean anything to a farming or ranching operation?
The implications of the Roundup litigation on a farming or ranching operation– that’s the topic of today’s post.
The Roundup Litigation
The Roundup litigation is an important matter for agriculture. Roundup is used heavily on genetically modified corn and soybeans as well as oats. It is presently sold in more than 160 countries. The patent on glyphosate expired in 2001 with generic versions being sold virtually worldwide. Presently, over 11,000 cases involving Roundup have been filed and are waiting trial and adjudication. The basic claim in each case is that the use of Roundup caused some sort of physical injury to the plaintiff. In many of the cases, the claim is that physical injury occurred after usage (usually over a long period of time) of Roundup. Indeed, both of the cases involving plaintiff jury verdicts involved the spraying of Roundup over many years.
Studies have reached differing conclusions on the safety of glyphosate. The Environmental Working Group (EWG) claims that glyphosate is present in many oat-based cereals and breakfast bars. The EWG believes that there is a causal connection between glyphosate and cancer, but others differ. In 2015, the International Agency for Research on Cancer classified glyphosate as a “probable human carcinogen.” That classification spurred lawsuits against Monsanto. But, the U.S. Environmental Protection Agency asserts that glyphosate is safe for humans when used in accordance with label directions. In addition, the World Health Organization has stated that glyphosate is “unlikely to pose a carcinogenic risk to humans from exposure through the diet.”
Vince Chhabria has been selected to oversee the Roundup lawsuits and has deemed the case resulting in last month’s jury verdict as one of the “bellweather” (test) cases. Judge Chhabria is a judge on the bench at the U.S. District Court for the Northern District of California. He was nominated to the bench by the President in 2013.
What Does the Litigation Mean For My Farm/Ranch?
While the temptation may be great to dismiss the recent verdicts as the result of raw emotion and passion by juries that don’t have much, if any, relation to or understanding of agriculture, that temptation should be resisted. It is true that juries tend to react based on emotion to a greater degree than do judges (indeed, the judge in the 2018 case significantly reduced the jury verdict), but that doesn’t mean that there aren’t some “take-home” implications for farming and ranching operations at this early stage of the litigation.
Things to ponder. Farming and ranching operations should at least begin to think about the possible implications of the Roundup litigation.
- What about lease agreements? Farmers and ranchers that lease out farmland and pasture may want to reexamine the lease terms. Consideration should be given as to whether the lease should incorporate language that specifies that the tenant assumes the risk of claims arising from the use of Roundup or products containing glyphosate. Relatedly, perhaps language should be included that either involves the tenant waiving potential legal claims against the landlord or provides for the landlord to be indemnified by the tenant for any and all glyphosate-related claims. Should language be included specifying that the tenant has the sole discretion to select chemicals to be used on the farm and that any such chemicals shall be used in accordance with label directions and any applicable regulatory guidance? How should the economics of the lease be adjusted to reflect this type of lease language? The tenant is giving up some rights and will want compensation for the loss of those rights. If the lease isn’t in writing, perhaps this is a good time to reduce it to writing.
- Is the comprehensive liability policy for the farm/ranch sufficient to cover glyphosate-related claims? Many farm comprehensive general liability policies contain “pollution exclusion” clauses. Do those clauses exclude coverage for glyphosate-related claims? How is “pollution” defined under the policy? Does it include pesticides and herbicides and associated claims? Does it cover loss to livestock that consume corn and/or soybeans that were grown with the usage of chemicals containing glyphosate? Can a rider be obtained to provide coverage, if necessary? These are all important questions to ask the insurance agent and an ag lawyer trained in reading farm comprehensive liability policies.
- If the farm employs workers, should that arrangement be modified from employer/employee to independent contractor status? If employee status remains and an employee sues the employer for alleged glyphosate-related damages, what can be done? Will enrolling the farm in the state workers’ compensation program provide sufficient liability protection for the farming/ranching operation?
What About Food Products?
To date, the cases have all involved the use of Roundup directly over a long period of time. At some point will there be cases where consumers of food products claim they were harmed by the presence of glyphosate in the food they ate? If those cases arise, given the use of production contracts in agriculture and the possibility of tracing back to the farm from which the grain in the allegedly contaminated food product was grown, does the farmer have liability? If you think this is far-fetched, remember that there is presently a member of the U.S. House that is proposing the regulation (if not elimination) of cows with flatulence. Relatedly, there are certain segments of the population that are opposed to the manner in which modern, conventional agriculture is conducted. These persons/groups would not hesitate in trying to pin liability all the way back down the chain to the farmer.
The Roundup litigation shouldn’t be ignored. It may be time to start thinking through possible implications and modifying certain aspects of the way the typical farm or ranch does business in order to provide the greatest liability protection possible.
Just some additional things to think about as you deal with low crop and livestock prices, flooding in the Midwest and Plains, and tax season! Also, a special “hat tip” to Jeremy Cohen, a lawyer in the Denver, Colorado area who put the bug in my ear about writing on this issue. Jeremy and I started our legal careers together in North Platte, NE nearly 30 years ago with Don Kelley – an iconic name in farm and ranch estate and business planning circles.
Tuesday, April 2, 2019
To be valid a will must satisfy certain requirements. One of those requirements is that the will is the product of the decedent’s intent. No one else can be allowed to unduly influence the decedent’s intent.
In ag settings, challenges to wills sometimes arise. The battles frequently involve the disposition of farmland that has been held in the family for many years or perhaps generations. As a result, tensions and emotions run high because the future of the family farm may be at stake. But, what does “undue influence” mean? In what situations may it be present?
Will challenges and undue influence – that’s the topic of today’s post.
Basic Will Requirements
Every state has statutory requirements that a will must satisfy in order to be recognized as valid in that particular jurisdiction. For example, in all jurisdictions, a person making a will must be of sound mind; generally must know the extent and nature of their property; must know who would be the natural recipients of the assets; must know who their relatives are; and must know who is to receive the property passing under the will. A testator lacking these traits is deemed to not have testamentary capacity and is not competent to make a will. These persons are more susceptible to being influenced by family members and others desirous of increasing their share of the estate of the decedent-to-be. If that influence rises to the level of being “undue,” the will resulting from such influence will not be validated.
Testamentary Capacity and Undue Influence
Cases involving will challenges are common where the testator is borderline competent or is susceptible to influence by others. However, the fact that the testator was old or in poor health does not, absent other evidence, give rise to a presumption that the testator lacked testamentary capacity or was subject to undue influence. For example, in a 2008 Wyoming case, Lasen v. Andersen, et al., 187 P.3d 857 (Wyo. 2008), the decedent’s daughter and her husband sued to quiet title to the decedent’s farm. Other family members asserted various defenses and also claimed an interest in the farm. A bank was also involved in the litigation. The trial court ruled against the daughter and granted the bank’s counterclaim. The trial court determined that the daughter and her husband had unduly influenced the decedent by continually pressing the decedent to change his will in their favor. The trial court also determined that the daughter and her husband had improperly pressured the decedent to change his power-of-attorney and execute the deed to the farm at issue in the case. The appellate court agreed, noting that the daughter was the party that executed the second deed involving the farm and that her husband did not obviate the first deed that had been executed and delivered.
But, undue influence was not established in In re Estate of Rutland, 24 So. 3d 347 (Miss. Ct. App. 2009). In this case, the court held that the trial court improperly set aside the decedent’s 2002 will which devised an 88-acre farm. The court determined that the decedent had testamentary capacity based on the evidence presented and that the evidence was insufficient to support a finding of undue influence and there was no abuse of a confidential relationship. If a confidential relationship had been present, a presumption of undue influence would have arisen.
In a 1993 Kansas case, In re Estate of Bennett, 19 Kan. App. 2d 154, 865 P.2d 1062 (1993), the court held that a person challenging the will must establish undue influence by clear and convincing proof and that the decedent possessed testamentary capacity despite being unable to comprehend the purchasing power of her estate. The surviving widow received approximately $50 million from her husband’s estate after they had lived as near paupers for many years. She changed her will after inheriting the vast sum and the disaffected family members sued on the basis that the subsequent will was the product of undue influence. It was not.
Recent case. In In re Estate of Caldwell, No. E2017-02297-COA-R3-CV, 2019 Tenn. App. LEXIS 114 (Tenn. Ct. App. Mar. 7, 2019), the decedent executed a will in 1999 that named the plaintiff, his son, as a devisee of his farm along with his nephew. At the time the will was executed, the plaintiff and nephew lived on the farm. Approximately nine years later the defendant, the decedent’s daughter, began to reestablish a relationship with the decedent and the plaintiff. The defendant did not learn that the decedent was her biological father until she was 35 years old and that she was a half-sister of the plaintiff by virtue of having the same father – the decedent.
In 2012 the decedent suffered a stroke that slowed his speech and resulted in limited mobility in one arm. The plaintiff took care of the decedent during the evenings and farmed during the day. The defendant often prepared meals and cleaned for the decedent. In November of 2012 the decedent executed a second will. The 2012 will revoked the 1999 will and devised the farm to the defendant. The 2012 will also named the defendant the executor of the estate. The defendant would drive the decedent to the attorney’s office but did not stay for the meetings. The attorney noted that the decedent spoke slower, but had no issue expressing his intent. The decedent wished to keep the property in the family and wanted the defendant and nephew to always have a place to live. The decedent also desired to make amends with the defendant for not playing a role in the first 35 years of her life. The 2012 will was properly witnessed and executed in late November. In January of 2013 the decedent quitclaim deeded the farm to the defendant. Again, at this time the attorney did not believe that the decedent had any mental capacity issues.
The decedent died in 2015 and the plaintiff submitted the 1999 will to probate. The defendant submitted the 2012 will to probate, and the plaintiff responded by bringing legal action for conversion; fraud; misrepresentation and deceit; unjust enrichment; and breach of fiduciary duty. The plaintiff sought punitive damages and injunctive relief that would prevent the defendant from taking any action against the estate. After a three-day bench trial, the trial court determined that the decedent had the requisite testamentary capacity and that the 2012 will was not a product of undue influence.
On appeal, the appellate court affirmed. The appellate court found that the evidence showed that decedent was of sound mind and had testamentary capacity at the time the 2012 will was executed – he knew what property he owned and understood how he wanted to dispose of it at his death. On the plaintiff’s undue influence claim, the appellate court determined that a confidential relationship did not exist between the defendant and the decedent based on a clear and convincing standard. As such, undue influence would not be presumed and the evidence demonstrated that the decedent received independent advice and was not unduly influenced in executing the 2012 will.
Family fights over the family farm are never a good thing. Sometimes the matter may involve claims of undue influence or lack of testamentary capacity to execute a will that is the linchpin of the estate plan. Care should be taken to avoid situations that can give rise to such claims.