Wednesday, August 31, 2016

Air Emissions, CWA and CERCLA

Agriculture is subject to some significant environmental regulation.  That fact has become a recent focus of some of the political debate in this fall’s Presidential campaigns.  Two of the “biggies” at the federal level are the Clean Water Act (CWA) and the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).  We’ve heard a lot about the CWA recently with the EPA’s attempt to broaden its regulatory reach over private land with its “waters of the U.S.” (WOTUS) rule, but both the CWA and CERCLA might also have a significant impact on agricultural operations where there could be air emissions of a pollutant that finds its way into a WOTUS or “disposal” via air of a hazardous substance. 

The CWA imposes upon the federal government the responsibility for eliminating pollution from point sources by establishing federal restrictions on discharges from these sources, and enforcing them by means of a federal permit system.  This federal permit system, known as the National Pollutant Discharge Elimination System (NPDES) is the chief mechanism for control of discharges.  No one may discharge a “pollutant” from a point source into the “navigable waters of the United States” without a permit from the EPA. The NPDES system only applies to discharges of pollutants into surface water.  Discharges of pollutants into groundwater are not subject to the NPDES permit requirement even if the groundwater is hydrologically connected to surface water.

Importantly for agriculture, irrigation return flows are not considered point source pollutants.  In addition, agricultural stormwater discharges are excepted from the NPDES as nonpoint source pollutants.  The CWA also has important implications for farming operations that fall within the definition of a confined animal feeding operation (CAFO).  For example, in one recent case involving a West Virginia poultry CAFO, the EPA had issued an order that the CAFO obtain an NPDES permit for stormwater discharges on the basis that a regulable discharge occurred when dust, feathers and dander were released through ventilation fans and then came into contact with precipitation. Alt, et al. v. United States Environmental Protection Agency, No. 2:12-CV-42, 2013 U.S. Dist. LEXIS 65093 (W.D. W. Va. Apr. 22, 2013).    Such discharges, EPA claimed, were not within the agricultural stormwater discharge exemption because the exemption only applied to land application areas where crops are grown.  The CAFO was threatened with significant fines and challenged the EPA’s position in court.  In response, the EPA withdrew its order and motioned to dismiss the case.  The court refused the EPA’s motion, and later determined that that the litter and manure that washed from the CAFO to navigable water by precipitation were an ag stormwater discharge that was exempt from the CWA’s NPDES permit requirement. Alt v. United States Environmental Protection Agency, 979 F. Supp. 2d 701 (N.D. W. Va. 2013).

That case involved the novel theory that air emissions could require a stormwater discharge permit.  In another case that is the first of its kind, the federal district court for the Eastern District of Washington kept alive a lawsuit filed by seven environmental groups alleging that the BNSF Railway Company violated the CWA. Sierra Club, et al. v. BNSF Railway Co., No. 2:13-cv-00272, 2014 U.S. Dist. LEXIS 1035 (E.D. Wash. Jan. 2, 2014).  The plaintiffs claimed that while transporting coal on its tracks “adjacent to” and “in proximity to” waters of the United States,” the railway discharged coal dust without a permit through holes in its cars and through the open tops of its cars.  Basically, the claim is that a rail car is a “point source” pollutant and that a federal discharge permit was required for such discharges, and that each and every rail car transporting the coal constitutes a “point source.”  In addition, the plaintiffs claimed that each discharge from each car on each separate day constitutes a separate CWA violation.  The railway asked the judge to dismiss the claims that alleged the release of coal dust to land, not water, arguing that the plaintiff was not asserting that such pollution reached the water through a “confined, discrete conveyance.”  The plaintiffs asserted that they only needed to trace the pollutant back to a single, identifiable source, the coal cars.  The court agreed that, regardless of where pollution originates, “a plaintiff must prove that the pollutant reached the water through a confined, discrete conveyance.” Even so, the court denied the railway’s motion to dismiss, and granted the plaintiff an opportunity to attempt to develop facts “to show that the railway illegally introduced pollutants into navigable waters without a permit.” The court noted that the “issue appears to be whether coal from rail cars that falls onto land, rather than directly into the waters, offends the CWA.”  The court stated that it was giving the plaintiff an opportunity to develop facts that would allow their claims to either stand or fall, “based on the statutory definition of a point source discharge.”  The future success of plaintiffs’ claims will likely depend on whether the court treats the coal dust like manure discharged onto fields near a river (which does create a point source discharge if ultimately flowing into the river) or like waste rocks that eventually make their way to surface waters from waste rock pits (which are not point sources under the CWA because the water seepage is “not collected or channeled”).  Because this coal dust is not entering any waterway through any channeled process, it seems unlikely these claims will survive summary judgment.  If they are successful, however, the impact on the U.S transportation system would be monumental.


Most recently, on July 8, 2016, BNSF asked the court to compel the plaintiffs to provide documentation to support their claims that the BNSF train cars released coal into CWA jurisdictional waters. 

Relatedly, the Ninth Circuit in Pakootas v. Teck Cominco Metals, Ltd., No. 15-35228, 2016 U.S. App. LEXIS 13662 (9th Cir. Jul. 27, 2016), said that air emissions of hazardous waste don’t create CERCLA liability. Under the facts of the case, the defendant operated a smelter approximately 10 miles into Canada north of the Washington border. In a prior action, the state of Washington and an Indian tribe obtained a court decision that the defendant could be held liable under CERCLA for discharges of hazardous waste that cross into the United States. As a result, the plaintiffs amended their complaint to claim that the defendant arranged for disposal and thereby triggered CERCLA liability via emissions from its facility that the wind carried and deposited into the Columbia River. The trial court denied the defendant’s motion to dismiss on the basis that the air emission amounted to a “disposal” under CERCLA once deposited onto land or water. On appeal, while the court noted that the plaintiffs had posited a reasonable construction of CERCLA.  The court cited its prior decision in Center for Community Action and Environmental Justice v. BNSF Railway Co,764 F.3d 1019 (9th Cir. 2014).  In that case, the court held that diesel particulate emissions “transported by wind and air currents” were not a “disposal” of waste within the meaning of the Resource Conservation Recovery Act, and also referenced its prior decision in Carson Harbor Village, Limited v. Unocal Corporation, 270 F.3d 863 (9th Cir. 2001) where the court held that mere passive migration does not constitute a disposal under CERCLA. Thus, air emissions are excluded from regulation under CERCLA. 

This is an nteresting issue that agriculture will have to keep an eye on.  Air emissions are big in livestock agriculture, and the issue could potentially impact row-crop operations and chemical application.

August 31, 2016 in Environmental Law | Permalink | Comments (0)

Monday, August 29, 2016

Proper Reporting of Crop Insurance Proceeds

One of the issues of interest at the farm income tax seminars in North Dakota last week involved how to report crop insurance proceeds on the tax return.  This was particularly the case at the Grand Forks seminar because the sugar beet crop in that area and points north has been exceedingly wet with the result that producers will likely be receiving payments under their policies.  I mentioned to the group that one of the blogposts this week would address the issue.  So, here goes.

In general, the proceeds from insurance coverage on growing crops are includible in gross income in the year actually or constructively received.  In effect, destruction or damage to crops and receipt of insurance proceeds are treated as a “sale” of the crop.  But, taxpayers on the cash method of accounting may elect to include crop insurance and disaster payments in income in the taxable year following the crop loss if it is the taxpayer's practice to report income from sale of the crop in the later year.  I.R.C. §451(d).  Included are payments made because of damage to crops or the inability to plant crops.  The deferral provision applies to federal payments received for drought, flood or “any other natural disaster.”

The election is made by attaching a separate, signed statement to the income tax return for the tax year of damage or destruction or by filing an amended return, and it covers insurance proceeds attributable to all crops representing a trade or business.  Based on Rev. Rul. 74-145, 1974-1 C.B. 113, to be eligible to make an election, the taxpayer must establish that a substantial part of the crops (more than 50 percent) has been carried over into the following year.  If multiple crops are involved, the “substantial portion” test must be met with respect to each crop if each crop is associated with a separate business of the taxpayer.  Otherwise, the 50 percent text is computed in the aggregate if the crops are reported as part of a single business.  Also, a taxpayer may not elect to defer only a portion of the insurance proceeds to the following year.

A significant issue is whether the deferral provision also applies to new types of crop insurance such as Revenue Protection (RP), Revenue Protection with Harvest Price Exclusion (RPHPE), Yield Protection (YP) and Group Risk Plan (GRP). As mentioned above, to be deferrable, payment under an insurance policy must have been made as a result of damage to crops or the inability to plant crops. Other than the statutory language that makes prevented planting payments eligible for the one-year deferral, the IRS position as stated in Notice 89-55, 1989-1 C.B. 698 is that agreements with insurance companies providing for payments without regard to actual losses of the insured, do not constitute insurance payments for the destruction of or damage to crops.  Accordingly, payments made under the types of crop insurance that are not directly associated with an insured's actual loss, but are instead tied to low yields and/or low prices, may not qualify for deferral depending upon the type of insurance involved.  For example, RP policies insure producers against yield losses due to natural causes such as drought, rain, hail, wind, frost, insects and disease, as well as revenue losses tied to the difference between harvest price and a projected price.

Only the portion attributable to physical damage or destruction to a crop is eligible for deferral.  RPHPE, YP and GRP policies tie payment to price and/or yield and amounts paid under such policies are less likely to qualify for deferral.  While the IRS has not specified in regulations the appropriate manner to be utilized in determining the deferrable and non-deferrable portions, the following is believed to be an acceptable approach:

Consider the following example:


Al Beback took out an insurance policy (RP) on his corn crop. Under the terms of the policy the approved corn yield was set at 170 bushels/acre, and the base price for corn was set at $6.50/bushel. At harvest, the price of corn was $5.75/bushel. Al’s insurance coverage level was set at 75 percent, and his yield was 100 bushels/acre. Al’s final revenue guarantee under the policy is 170 bushels x $6.50 x .75 = $828.75/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($5.75/bushel) which equals $575/acre. Al’s insurance proceeds is the guaranteed amount ($828.75/acre) less the calculated revenue ($575/acre), or $253.75/acre.  His physical loss is the 170 bushel/acre approved yield less his actual yield of 100 bushels/acre, or 70 bushels/acre. Multiplied by the harvest price of $5.75/bushel, the result is a physical loss of $402.50/acre. Al’s price loss is computed by taking the base price of $6.50/bushel less the harvest price of $5.75/bushel, or $.75/bushel. When multiplied by the approved yield of 170 bushels/acre, the result is $127.50/acre. 

So, to summarize, Al has the following:

  • Total loss: (1) anticipated income/acre [170 bushels/acre @ $6.50/ bushel = $1105/acre] less (2) actual result [100

bushels/acre @ $5.75/acre = $575.00] for a result of $530.00/acre.

  • Physical loss: 70 bushels/acre x $5.75/bushel harvest price = $402.50/acre
  • Price loss: 170 bushels/acre x $.75/bushel = $127.50
  • Physical loss as percentage of total loss:  $402.50/530 = .7594
  • Insurance payment: $253.75/acre
  • Insurance payment attributable to physical loss (which is deferrable):  $253.75 x .7594 = $192.70/acre
  • Portion of insurance payment that is not deferrable: $253.75 – $192.70 = $61.05/acre

But, what if the harvest price exceeds the base price?  Then the above example can be modified as follows:

Assume now that the harvest price of corn was $7.50/bushel. Al’s final revenue guarantee under the policy is 170 bushels/acre x $7.50 x.75 = $956.25/acre. Al’s calculated revenue is his actual yield (100 bushels/acre) multiplied by the harvest price ($7.50/bushel) which equals $750.00/acre. Al’s insurance proceeds are the guaranteed amount ($956.25/acre) less the calculated revenue ($750.00), or $206.25/acre.  His yield loss is the 70 bushels/acre which is then multiplied by the harvest price of $7.50/bushel, for a physical loss of $525/acre.  Al’s price loss is zero because the harvest price exceeded the base price.

So, to summarize, Al has the following:

  • Total loss (per acre): $525.00 (physical loss) + $0.00 (price loss)
  • Physical loss as percentage of total loss:  $525/525 = 1.00
  • Insurance payment: $206.25/acre
  • Insurance payment attributable to physical loss (which is deferrable):  $206.25 x 1.00 = $206.25/acre
  • Portion of insurance payment that is not deferrable: $206.25 – 206.25 = $0.00

Reporting crop insurance on the return can be tricky.  Paul Neiffer (the author of blog) and myself will be covering this issue and others at farm tax seminars in South Sioux City, NE, West Des Moines, IA (webinar also) and Bettendorf, IA this week.   The seminars are sponsored by the Iowa Society of CPAs.  Maybe we’ll see you there or maybe you’ll join us by webinar.  If you attend, let us know what you think of either this blog or Paul’s.  We’d love to hear your input.

August 29, 2016 in Income Tax | Permalink | Comments (0)

Thursday, August 25, 2016

Claiming “Bonus” Depreciation on Plants

An issue that we have been teaching at farm tax seminars this spring and summer (and, for me, at the farm income tax course at Washburn Law School this past May) involves new I.R.C. §168(k)(5) which was added to the Internal Revenue Code by “The Protecting Americans From Tax Hikes Act of 2015” (PATH Act) in late 2015.  That provision provides for an election that allows first-year “bonus” depreciation for certain plants equal to 50 percent of their cost (for 2016) that are planted or grafted after 2015.  The 50 percent continues through 2017, but drops to 40 percent for 2018 and 30 percent for 2019 and is presently set at zero after 2019. 

What type of plant is eligible?  Under the provision a “specified plant” is any tree or vine which bears fruit or nuts, and any other plant which will have more than a single yield of fruits or nuts and which generally has a pre-productive period of more than two years from the time of planting or grafting to the time at which the plant begins bearing fruits or nuts.  That definition leaves some uncertainty.  Does it include the plant plus all I.R.C. §263A pre-productive costs incurred for the year of planting?  If it does, then the amount that is available for bonus depreciation in the year of planting will include those costs.  On the other hand, if that definition only includes the cost of the plant, then pre-productive costs that are associated with developing the plant might not be included.  Perhaps the IRS will clarify the precise costs beyond the purchase cost of the plant that would be eligible for bonus depreciation in the year placed in service before 2020.

Let’s look at an example (thanks to Paul Neiffer in the Kennewick and Yakima offices of CliftonLarsonAllen, LLP and author of the blog) to illustrate why additional clarity from the IRS is needed:

Gary plants a vineyard in April of 2016.  The cost of the plants is $100,000.  He also incurs pre-productive costs during the year of another $175,000.  The plants have their first marketable crop in 2019 after incurring additional pre-productive costs of $400,000 in 2017-2019.

Alternative # 1 – Pre-productive costs are included as part of “specified plant”

Gary makes the election to take 50% bonus depreciation on $275,000 of plants purchased in 2016 (including capitalized pre-productive costs) on the 2016 tax return.  This deduction is not added to his capitalized pre-productive costs.  He reduces the capitalized costs by this amount. In 2019, he places in service total capitalized costs of $537,500 ($100,000 + $175,000 -$137,500 + $400,000). During that year, bonus depreciation is not allowed, because he may claim bonus depreciation only once on the specified plant. The trellis and irrigation system are separate assets; bonus depreciation is available for the year the assets are placed in service, if before 2020.

If Gary did not make the election, he would have no deduction in 2016 (giving up a $137,500 deduction) and in 2019, he would place in service $675,000 ($100,000 + $175,000 + $400,000) that would be eligible for 30% bonus depreciation of $202,500. 

By making the election, Gary claims $137,500 of bonus depreciation in 2016 and normal depreciation on the balance, beginning in 2019. If he had not made the election, he would have a deduction of $202,500 for bonus depreciation in 2019 and normal depreciation on the balance, beginning in 2019.

However, if the first marketable harvest was not until 2020, then not making the election would prevent Gary from deducting any bonus depreciation (however I.R.C. §179 would still be available).

Alternative # 2 – Pre-productive costs are not included as part of “specified plant”

Gary makes the election to take 50% bonus depreciation on $100,000 of plants purchased in 2016 (does not include capitalized pre-productive costs) on the 2016 tax return.  This deduction is not added to his capitalized pre-productive costs.  He reduces the capitalized costs by this amount. In 2019, he places in service total capitalized costs of $625,000 ($100,000 - $50,000 + $175,000 + $400,000). During that year, bonus depreciation is not allowed on $50,000 of specified plant costs, but is allowed on the remaining $575,000 of capitalized pre-productive costs, because he may claim bonus depreciation only once on the specified plant.

With the second alternative, bonus depreciation is claimed (at least in part) two times (in the year of planting and on the capitalized costs in the year placed in service).  That may be too much of a stretch for the IRS in terms of interpreting the Code provision at issue and may not be the ultimate result (assuming that IRS does issue some guidance on the matter).

If Gary did not make the election, he would have no deduction in 2016 (giving up a $50,000 deduction) and in 2019, he would place in service $675,000 ($100,000 + $175,000 + $400,000) that would be eligible for 30% bonus depreciation of $202,500.  However, if the first marketable harvest was not until 2020, then not making the election would prevent Gary from deducting any bonus depreciation (however  I.R.C. §179 would still be available).

So, as you can see, timing and planning projections are key to determining the proper position to take on the tax return when starting a vineyard (or other type of business involving “specified plants”).  In addition, taxpayers won’t know exactly how to evaluate their options until IRS clarifies the extent of the costs that are included as part of the “specified plant.” 

Keep in mind also, that this is just a thumbnail sketch of the issue.  There are other issues that space on this blog does not allow us to address. 

Today, I will get into this issue (and others) for a great group of CPAs in Grand Forks, North Dakota.  Next week the farm income tax tour continues in Iowa at Sioux City, West Des Moines (also webcast) and Bettendorf where I will be speaking with Paul Neiffer.

August 25, 2016 in Income Tax | Permalink | Comments (0)

Tuesday, August 23, 2016

Texas Mineral Estates, Groundwater Rights, Surface Usage and the “Accommodation Doctrine”

Land ownership includes two separate estates in land – the surface estate and the mineral estate.  The mineral estate can be severed from the surface estate with the result that ownership of the separate estates is in different parties.  In some states, the mineral estate is dominant.  That means that the mineral estate owner can freely use the surface estate to the extent reasonably necessary for the exploration, development and production of the minerals beneath the surface.  If the owner of the mineral estate has only a single method for developing the minerals, many courts will allow that method to be utilized without consideration of its impact on the activities of the surface estate owner.  See., e.g., Merriman v. XTO Energy, Inc., 407 S.W.3d 244 (Tex. 2013).  But, under the accommodation doctrine, if alternative means of development are reasonably available that would not disrupt existing activities on the surface those alternative means must be utilized.  For example, in Getty Oil co. v. Jones, 470 S.W.2d 618 (Tex. 1971), a surface estate owner claimed that the mineral estate owner did not accommodate existing surface use.  To prevail on that claim, the Texas Supreme Court, determined that the surface owner must prove that the mineral estate owner’s use precluded or substantially impaired the existing surface use, that the surface estate owner had no reasonable alternative method for continuing the existing surface use, and that the mineral estate owner has reasonable development alternatives that would not disrupt the surface use.  A question left unanswered in the 1971 decision was whether the accommodation doctrine applied beyond subsurface mineral use to the exercise of groundwater rights.  Recently, the Texas Supreme Court answered the question.

The recent case involved a 26,000-acre cattle ranch with some irrigated cropland as the plaintiff. The ranch sits atop the Ogallala aquifer in northwest Texas. The defendant, the city of Lubbock, Texas, bought groundwater rights from the plaintiff in 1953 and the plaintiff deeded its groundwater to the defendant with the reserved right in the plaintiff to use groundwater for domestic wells, livestock watering, oil and gas production and irrigation for agricultural purposes. The defendant had the right of ingress and egress to drill water wells and test existing wells. The defendant also had the right to use as much of the ranch as necessary to take, produce, treat, transmit or deliver groundwater. The defendant also had the right to construct water lines, fuel lines, power lines, access roads and anything else incidental to accessing and making use of its water right. For those rights, the defendant was to pay rent for any surface area that its facilities occupied. The defendant also was required to pay for surface property damages it caused and was required to install gates and cattle guards for roads.

In 2012 the defendant announced its intent to drill 20 test wells and up to 60 additional wells on the ranch. Until that time, the defendant had only drilled seven wells. The plaintiff sought to enjoin the defendant from drilling more wells on the basis that, under common law, the defendant could only use so much of the surface that was reasonably necessary to its operations and then only with due regard to the plaintiff’s rights with respect to the surface – the “accommodation” doctrine. The defendant asserted that its rights under the deed language controlled and that the accommodation doctrine only applied to mineral owners (e.g., oil and gas) as opposed to water. The trial court applied the accommodation doctrine and issued the injunction. The result was that the defendant had to stop drilling test wells without going over potential negative impacts on the ranch with the plaintiff. The defendant was also enjoined from erecting power lines to proposed well fields. On appeal, the court of appeals reversed, noting that the accommodation doctrine had never been extended to groundwater. The plaintiff appealed.

The Texas Supreme Court reversed the appellate court and held that the accommodation doctrine applied to groundwater. Thus, the doctrine would apply in situations where the owner of the groundwater impairs an existing surface use, the surface owner has no reasonable alternative to continue surface use, and the groundwater owner has a reasonable way to access and produce water while simultaneously allowing the surface owner to use the surface. The Court held that the deed language governed the rights of the parties, but that the deed didn’t address the core issues presented in the case. For example, the Court determined that the deed was silent on the issue of where drilling could occur and the usage of overhead power lines and facilities associated with water development. The Court determined that water and minerals were sufficiently similar such that the accommodation doctrine should also apply to water – both disappear, can be severed, subject to the rule of capture, etc. The court also concluded that groundwater estates severed from the surface estate enjoy an implied right to use as much of the surface as is reasonably necessary for the production of groundwater. The Court also extended the accommodation doctrine to the owner of the groundwater right. Thus, unless the parties have a written agreement detailing all of the associated rights and responsibilities of the parties, the accommodation doctrine would apply to resolve disputes and sort out rights. The Court lifted the injunction that had been imposed against the defendant.

A concurring opinion believed that the deed language was clear as to the location of well drilling and the accommodation doctrine would not apply as to well location. However, as to access roads and power lines, the concurrence opined that the deed was unclear and the accommodation doctrine would apply.

I asked David Pierce, a professor of law at Washburn School of Law to add his thoughts on the Texas case for today’s blog post.  David is the Norman R. Pozez Chair in Business and Transactional Law and is the Director of the Oil and Gas Center.

Here are Professor Pierce’s comments:

Although something called accommodation doctrine sounds fair and reasonable, the Texas oil and gas version of the doctrine has been used to simply take rights away from the easement owner and give them back to the servient estate owner. Two aspects of the doctrine cause the problem. First, "existing" use is a moving target. In Texas surface owners have been able to assert new uses to further reduce the mineral developer's rights. Second, "accommodate" means the dominant estate owner must pay to accomplish the accommodation. For example, it was the oil and gas lessee in the Getty Oil Co. v. Jones case that had to pay the cost of putting its pump jacks into concrete cellars to accommodate the center pivot irrigation system.

As one looks for fairness in this area they should consider the Restatement (Third) of Property: Servitudes where a limited accommodation right is recognized -- but it is the servient estate owner that must pay for the extra expense associated with the accommodation.

The accommodation doctrine is not designed to substitute for common sense reasonableness when the dominant estate owner has two clear options for doing something that involve the same cost. If one option is more disruptive to the surface owner, inherent limits of reasonable use dictate use of the less disruptive option.

These issues typically arise with "floating easements" where the mineral owner has an easement to use the surface to develop without any further specification. Accommodation is less likely an issue when the easement holder has more precise rights. For example, if it would have been specified in the Coyote document that the water owner could drill one well in the center of each acre of land the accommodation doctrine would not have been triggered -- as to the number of wells.

When the mineral owner is required to accommodate -- at the servient estate owner's expense (as required by the Restatement) -- it avoids having the servient estate owner triggering accommodation claims merely to get back some of the rights it sold when the easement was created.

The case is Coyote Lake Ranch, LLC v. City of Lubbock, No. 14-0572, 2016 Tex. LEXIS 415 (Tex. Sup. Ct. May 27, 2016).

August 23, 2016 in Real Property | Permalink | Comments (0)

Friday, August 19, 2016

Handling Depreciation on Asset Trades

When a business (including an agribusiness or farm operation) buys an asset that has a useful life of more than a year, the business gets to depreciate the asset’s cost over its life in order to recover the asset’s gradual deterioration or obsolescence.  If the business later sells the depreciated asset, it could be a taxable event if the asset is sold for more than its depreciated value.  When that could happen, taxpayers often look for ways to avoid reporting gain including trading the asset in a non-taxable exchange.  Computing depreciation on the property received in the exchange can be tricky, and accounting for depreciation recapture complicates the matter. 

Today’s blogpost on this topic is authored by guest blogger Chris Hesse.  Chris is a Principal in the National Tax Office of CliftonLarsonAllen, LLP, Minneapolis, MN.  Chris is also a member of the AICPA Tax Executive Committee and a former chair of the AICPA S Corporation Technical Resource Panel and of the AICPA National Agriculture Conference.

Here are Chris Hesse's thoughts on the matter:

Sales of assets which have been depreciated often result in taxable gain. The taxpayer may have elected to write-off some or the entire purchase price  under I.R.C. §179, may have claimed bonus depreciation on new assets together with regular MACRS depreciation, or some combination of all three. In high income years, many taxpayers likely claim the I.R.C. §179 deduction in the year of purchase, resulting in no future depreciation deductions. Since the tax basis was fully expensed, the sale of the asset generates gain.  That gain would normally be capital gain, but it is treated as ordinary income (due to depreciation recapture).

Most taxpayers want to avoid gain. A popular way to defer gain recognition is to exchange the asset in accordance with I.R.C. §1031.  Asset exchanges can be very informal.  For example, a simple exchange can involve  a trade-in of equipment. Agricultural equipment qualifies for tax-deferred exchanges for replacement agricultural equipment. Thus, a combine may be exchanged for a tractor and tillage equipment. Real estate qualifies for exchange treatment for other real estate, as long as neither the property given up nor the property received in the exchange is held as inventory for sale or as inventory of a developer. Whether a simple trade-in of equipment or a more formal exchange of real estate, both result in the deferral of taxable income under I.R.C. §1031.

So, how is the depreciation computed on the replacement property? There are two methods:

  • Add the remaining tax basis (i.e., the undepreciated portion) of the old property to the cost (after trade-in allowance) of the new property.  Then, the replacement property is depreciated as one asset, placed in service when acquired. Or—
  • Continue depreciating the old property over its remaining life, and depreciate the cost (after trade-in allowance) of the new property as a separate asset.

The total depreciation to claim over the life of the replacement asset is the same under both methods. If the old asset was fully depreciated, there is no difference in the timing of depreciation deductions. However, if the old asset was not fully depreciated, the second method will provide depreciation deductions sooner than the first method.

What is the effect, however, when the replacement asset is later sold? Let’s say that the tractor traded-in has substantial value, but was nearly fully depreciated due to bonus depreciation. The replacement tractor ends up with very low tax basis on the depreciation schedule. If it is sold for an amount greater than the amount reflected as cost, does the farmer have I.R.C. §1231 gain, taxable as capital gain? Depreciation claimed on equipment is recaptured upon the sale of the equipment, up to the amount of the total gain (I.R.C.§1245). Gain in excess of the depreciation recapture is I.R.C. §1231 gain, which may be taxed as capital gain.


John purchased a tractor some time ago with a cost of $250,000. He traded it in when its basis was $40,000. The trade-in allowance was $150,000. Replacement tractor has a list price of $200,000; John pays $50,000 after the trade-in. The replacement tractor is put on the books at $90,000 (after trade-in cost of $50,000 plus remaining tax basis of the old tractor of $40,000). John sells the tractor for $120,000 next year.

While the “cost” of the tractor is listed on the depreciation schedule at $90,000 and the sales price is $120,000, is the $30,000 excess a capital gain? No. The depreciation potential on the old tractor (the trade-in) carries over into the replacement tractor (Treas. Reg. §1.1245-2(c)(4)). In this example, John’s entire gain upon the sale of the replacement tractor is ordinary income due to I.R.C. §1245 depreciation recapture.

Trade-ins are complex enough as it is, and depreciation recapture potential adds to the complexity.

August 19, 2016 in Income Tax | Permalink | Comments (0)

Wednesday, August 17, 2016

FIFRA Pre-Emption of Pesticide Damage Claims

One of the 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 involves damages arising from the use of registered pesticides.  The Federal Insecticide, Fungicide and Rodenticide Act (FIFRA) authorizes the Environmental Protection Agency to regulate pesticide sale and use.  Under FIFRA, it is unlawful to use any registered pesticide in a manner inconsistent with its labeling.  While this “label use” provision gives the EPA authority to assess civil penalties against producers that use pesticides improperly or damage the environment, it also limits the ability of injured parties to sue pesticide manufacturers on either an inadequate labeling or wrongful death theory.  A significant question has been whether FIFRA preempts state law damage claims for pesticide-related agricultural crop injury and whether FIFRA pre-emption of damage claims is limited to the specific subjects that EPA reviews at the time it first approves a pesticide product’s labeling. 

Basically, FIFRA allows states to regulate the sale and use of federally registered pesticides to the extent the regulation does not permit any sales or uses prohibited by FIFRA, but a state cannot impose or continue in effect any requirements for labeling or packaging in addition to or different from what FIFRA requires.  So, a big issue is whether a significant legal question concerns the extent to which FIFRA preempts state common law tort claims on the basis that the claims impose labeling or packaging requirements in addition to or different from those imposed by FIFRA. A majority of courts have held that FIFRA preempts all common law tort claims that challenge the adequacy of pesticide labels.  However, while most courts have held that FIFRA preempts state law claims for failure to warn, actual defective label claims, and claims for breach of express and implied warranties, the courts have recognized that FIFRA does not necessarily preempt all state law claims.  Indeed, nothing in FIFRA precludes states from providing a remedy to farmers and state law claims can be asserted based on alleged FIFRA violations to the extent that the claims would not impose a requirement that is in addition to or different from FIFRA requirements.  However, a federal claim cannot be asserted.             

A couple of recent case illustrate when state pesticide label claims are not preempted by FIFRA.  In the first case, the plaintiff claimed that she developed cancer as a result of the use of the defendant’s pesticide glyphosate (commonly known as “Roundup”) for agricultural and non-agricultural purposes. She sued the defendant on the basis that the defendant failed to warn of the “carcinogenic nature of glyphosate” and was injured as a result. The plaintiff also sued under theories of strict liability, negligence and breach of implied and express warranties. The Environmental Protection Agency (EPA) had, before plaintiff’s use of pesticide, approved the product and the product label and had found that glyphosate is not carcinogenic to humans. The defendant claimed that the plaintiff’s claims were preempted by the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA). The defendant had registered the pesticide in accordance with FIFRA requirements by submitting a proposed label to the EPA along with supporting data and the EPA approved the label by deciding that the pesticide would perform its intended function without “unreasonable adverse effects” on human health or the environment. However, a registered pesticide can still be found to be misbranded and, as a result, be in violation of FIFRA. Misbranding means the label contains insufficient directions, warnings or cautionary statements to be “adequate to protect health.” The defendant claimed that because the EPA had determined that glyphosate was not carcinogenic, the defendant’s failure to include a warning label about the product’s carcinogenicity cannot constitute misbranding under FIFRA. The court rejected that claim because the documents the defendant relied on to support its position did not involve any final action of the EPA that had the force of law, or were regulations under the Food, Drug and Cosmetic Act and not FIFRA. Thus, the documents did not address the issue of misbranding under FIFRA. As such because FIFRA does not deem a registration of a pesticide to be conclusive as to whether a pesticide is misbranded (7 U.S.C. §136(a)(f)(2)), the defendant did not provide sufficient evidence to establish that glyphosate was not misbranded, and state requirements that a pesticide not be misbranded were not preempted. The court also rejected the defendant’s claim against the plaintiff’s design defect claim. Accordingly, the defendant’s motion to dismiss was denied.

The case is Mendoza v. Monsanto Company, No. 1:16-cv-00406-DAD-SMS, 2016 U.S. Dist. LEXIS 89003 (E.D. Cal. Jul. 8, 2016).

In the second case, the plaintiffs (a married couple) claimed that agricultural exposure to the defendant’s glyphosate pesticide (commonly referred to as “Roundup”) caused the wife to develop non-Hodgkin lymphoma in 2003. The defendant moved to dismiss the suit, claiming that the wife had a “suspicion of wrongdoing” in 2009 when she wrote an editorial discussing a possible link between glyphosate and her cancer which, according to the defendant, started the two-year statute of limitations running on her claim. The plaintiff asserted that she merely had a suspicion, that wasn’t confirmed until the World Health Organization designated glyphosate as a probably human cancer-causing agent in 2015. The court agreed with the plaintiff, and determined that the suit had been timely filed. The court also determined that the plaintiffs’ “warning-based” claims couched in negligence and strict liability failure to warn were not preempted by the Federal Insecticide, Fungicide and Rodenticide Act (FIFRA). The court noted that state-law labeling claims are not preempted if they don’t impose any requirement that is different or beyond what federal law requires. The court determined that the plaintiffs’ claims were consistent with FIFRA’s labeling requirements, because the plaintiffs’ claim is that the defendant’s existing label (the one used from 1995-2004) was misbranded in that it mispresented the safety of the pesticide and was an inadequate warning.

The case is Sheppard v. Monsanto Co., NO. 16-00043 JMS-RLP, 2016 U.S. Dist. LEXIS 84348 (D. Haw. Jun. 29, 2016).

August 17, 2016 in Civil Liabilities, Environmental Law | Permalink | Comments (0)

Monday, August 15, 2016

S.E. Tax on Passive Investment Income; Election Out of Subchapter K Doesn’t Change Entity’s Nature; and IRS Can Change Its Mind

A recent Tenth Circuit Court of Appeals opinion provides some good teaching points that tend to get forgotten or come as a surprise. The petitioner was a CEO of a computer company, and didn’t have any specialized knowledge or expertise in oil and gas ventures. In the 1970s, he acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. §761(a).

For the year at issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income. He also believed that he was not a partner because of the election under I.R.C. §761(a), so his distributive share was not subject to self-employment tax.

The IRS agreed with the petitioner’s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. §7701(a)(2). Importantly, the trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of sub-chapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar the IRS from changing its mind and prevailing on the issue for the year at issue.

On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. §1402(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year.

The outcome of the case is not surprising. In the oil and gas realm, operating agreements often create a joint venture between the owners of the working interests (who are otherwise passive) and the operator. That will make the income for the working interest owners self-employment taxable, and an election out of Subchapter K won’t change that result. That’s particularly the case if the court finds an agency relationship to be present, as it did in the present case. And, IRS gets a pass for inconsistency.

As a consolation prize, at least the investor’s income would not be subject to the Net Investment Income Tax imposed by the health care law (I.R.C. §1411).

The case is Methvin v. Comr., No. 15-9005, 2016 U.S. App. LEXIS 11659 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81.

August 15, 2016 in Income Tax | Permalink | Comments (0)

Thursday, August 11, 2016

IRS Does Double-Back Layout on Self-Employment Tax

Two self-employment tax issues affecting farmers and ranchers have been in the forefront in recent years – the self-employment tax treatment of Conservation Reserve Program (CRP) payments and the self-employment tax implications of purchased livestock that had their purchase price deducted under the de minimis safe harbor of the capitalization and repair regulations.  

On the CRP issue, in 2014 the U.S. Court of Appeals ruled that CRP payments in the hands of a non-farmer are not subject to self-employment tax.  The court, in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g, 140 T.C. 350 (2013), held the IRS to its historic position staked out in Rev. Rul. 60-32 that government payments attributable to idling farmland are not subject to self-employment tax when received by a person who is not a farmer.  The court refused to give deference to an IRS announcement of proposed rulemaking involving the creation of a new Rev. Rul. that would obsolete the 1960 revenue ruling.  The IRS never wrote the new rule, but continued to assert their new position on audit.  The court essentially told the IRS to follow appropriate procedure and write a new rule reflecting their change of mind.  In addition, the court determined that CRP payments are “rental payments” statutorily excluded from self-employment tax under I.R.C. §1402(a).  Instead of following the court’s invitation to write a new rule, the IRS issued a non-acquiescence with the Eighth Circuit’s opinion.  A.O.D. 2015-02, IRB 2015-41.  IRS said that it would continue audits asserting their judicially-rejected position, even inside the Eighth Circuit (AR, IA, MN, MO, NE, ND and SD). 

Recently, the IRS had the opportunity to show just how strong its opposition to the Morehouse decision is.  A Nebraska non-farmer investor in real estate received a CP2000 Notice from the IRS, indicating CRP income had been omitted from their 2014 return.  The CP2000 Notice assessed the income tax and SE Tax on the alleged omitted income.   The CRP rental income was in fact included on the return, but it was included on Schedule E along with cash rents, where it was not subject to self-employment tax.  The practitioner responded to the IRS Notice by explaining that the CRP rents were properly reported on Schedule E because the taxpayer was not a farmer.  This put the matter squarely before the IRS to reject the taxpayer’s position based on the non-acquiescence.  So what did IRS do?  Did it stand tall and firm on its claim that the Eighth Circuit got it wrong on the self-employment tax issue?  Not at all!  IRS replied to the taxpayer’s response with a letter informing the taxpayer that the IRS inquiry was being closed with no change from the taxpayer’s initial position that reported the CRP rents for the non-farmer on Schedule E.  Maybe IRS just doesn’t feel so strong in its position that the Eighth Circuit got it wrong after all.

From a more practical standpoint, how do you avoid getting the CP2000 matching Notice in situations for non-farm clients with CRP rental income?  Report the CRP rental income on either Schedule F or Form 4835 so that the IRS computer gets a match, and then show an offsetting deduction to move it over to Schedule E. 

On the capitalization and repair issue, taxpayers are permitted to make a de minimis safe harbor election that allows amounts otherwise required to be capitalized to be claimed as an I.R.C. §162 ordinary and necessary business expense.  Treas. Reg. §1.263(a)-1(f).  This de minimis expensing election has a limit of $5,000 for taxpayers with an Applicable Financial Statement (AFS) and $2,500 for those without an AFS.  Farmers will fall in the latter category. In both cases, the limit is applied either per the total on the invoice, or per item as substantiated by the invoice. One big issue for farmers and ranchers is how to report the income from the sale of purchased livestock that are held for productive use, such as breeding or dairy animals for which the de minimis safe harbor election was made allowing the full cost of the livestock to be deducted.  It had been believed that because the repair regulations (Treas. Reg. §1.263(a)-1(f)(3)(iii)) specify when the safe harbor is used, the sale amount is reported fully as ordinary income that is reported on Schedule F where it is subject to self-employment tax for a taxpayer who is sole proprietor farmer or a member of a farm partnership.  In that event, the use of the safe harbor election would produce a worse tax result that would claiming I.R.C. §179 on the livestock. 

An alternative interpretation of the repair regulations is that the self-employment tax treatment of the gain or loss on sale of assets for which the purchase price was deducted under the de minimis safe harbor is governed by Treas. Reg. §1.1402(a)-6(a).  That regulation states that the sale of property is not subject to self-employment tax unless at least one of two conditions are satisfied: (1) the property is stock in trade or other property of a kind which would properly be includible in inventory if on-hand at the close of the tax year; or (2) the property is held primarily for sale to customers in the ordinary course of a trade or business.  Because purchased livestock held for dairy or breeding purposes do not satisfy the first condition, the question comes down to whether condition two is satisfied – are the livestock held primarily for sale to customers in the ordinary course of a trade or business?  The answer to that question is highly fact-dependent.  If the livestock whose purchase costs have been deducted under the de minimis rule are not held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business, the effect of the regulation is to report the gain on sale on Part II of Form 4797. This follows Treas. Reg. §1.1402(a)-6(a) which bars Sec. 1231 treatment (which would result in the sale being reported on Part I of Form 4797).  In that event, the income received on sale would not be subject to self-employment tax.

Now, in an unofficial communication, the IRS appears to believe that the alternative interpretation is the correct approach.  However, the IRS is careful to point out that the alternative approach is based on the assumptions that the livestock were neither inventoriable nor held for sale, and that those assumptions are highly fact dependent on a case-by case basis.  The IRS is considering adding clarifying language to the Farmers’ Tax Guide (IRS Pub. 225) and/or the Schedule F Instructions. 

So, in the spirit of the summer Olympics, the IRS has done a double-back layout on the self-employment tax issue for farmers and ranchers and rural landowners.  Now, that’s some good news! 

Paul Neiffer (the author of the blog) and I will be talking about these developments and other farm income tax issues at upcoming seminars in Iowa on August 30-September 1 sponsored by the Iowa Society of CPAs.  If you can't join us in-person, the seminar on August 31 will be broadcast live over the web.  Hope to see you there.

August 11, 2016 in Income Tax | Permalink | Comments (0)

Tuesday, August 9, 2016

Treasury Attacks Estate and Entity Planning Techniques With Proposed Valuation Regulations

Over the past few decades, valuation discounting through the use of family-owned business entities has become a popular estate and gift tax planning technique. If structured properly, the courts have routinely validated discounts ranging from 10 to 45 percent. Valuation discounting has proven to be a very effective strategy for transferring wealth to subsequent generations. It is a particularly useful technique with respect to the transfer of small family businesses and farming/ranching operations. Similar, but lower, valuation discounts can also be achieved with respect to the transfer of fractional interests in real estate.

The basic concept behind discounting is grounded in the IRS standard for determining value of a transferred interest – the willing-buyer, willing-seller test. In other words, the fair market value of property is the price at which it would changes hands between a hypothetical willing-buyer and a willing-seller, with neither party being under any compulsion to buy or sell. Under this standard, it is immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller. Thus, there is no attribution of ownership between family members that would change a minority interest into a majority interest.

Now, IRS has issued new I.R.C. §2704 regulations that could seriously impact the ability to generate valuation discounts for the transfer of family-owned entities.  The proposed regulation was issued by itself, and not also as a temporary regulation, and does not have any provision stating that a taxpayer can rely on it before it is issued as a final regulation. The effective date of the proposed regulation reaches back to include valuations associated with any lapse of any right created on or after October 8, 1990 occurring on or after the date the proposed regulations is published in the Federal Register as a final regulation. This would make it nearly impossible to avoid the application of the final regulation by various estate planning techniques.

So, what is the IRS concerned about?  While the IRS has won a number of court cases involving discounting in the context of family limited partnerships (FLPs), it has lost some very significant ones.  The courts have validated discounts associated with FLPs where the FLP was formed for legitimate business purposes and state law formalities have been followed closely.   From my sources both inside and outside of the IRS, the IRS is apparently still encountering situations involving FLPs that are not established in accordance with state law, don’t adequately document the business reasons for forming the FLP and have inaccurate or incomplete asset appraisals.  They think that the revenue loss is large as a result of the technical non-compliance with I.R.C. §§2036 and 2704.   Consequently, the new proposed regulations eliminate the ability to value an interest in an entity (in the aggregate) at an amount less than the value of the value of the property had it not been contributed to the entity.  The IRS view is that the lower value of the property as contained in the entity is an inappropriate way to avoid transfer taxes. 

Clearly, the Treasury can write regulations that specify that certain restrictions on transfer can be disregarded when determining the value of an interest in an entity to a family member of the transferor.  However, without legislation allowing it, the IRS cannot simply ignore discounts for lack of marketability or lack of control (minority interest).  Long-standing interpretations of I.R.C. §2704 by the Tax Court and the Circuit Courts support valuation discounts when the transaction is done properly.  As a result, the Courts may have a different view than the IRS with respect to the proposed regulations based on the longstanding Congressional intent to allow discounts in a family context. Having discretion does not mean that Treasury has discretion to determine value as it pleases.

The new regulations will have to be analyzed and paid attention to. Comments on the proposed regulation are due by 90 days from August 4, 2016.  You can read the proposed regulations here:

August 9, 2016 in Business Planning, Estate Planning | Permalink | Comments (0)

Friday, August 5, 2016

Death of Livestock In Blizzard Was a Covered Loss by “Drowning”

Many farmers view insurance as a necessary “evil,” whether it be life insurance, disability insurance, crop insurance or insurance covering livestock losses, just to name a few.  With insurance, it is absolutely critical that the contract language be read and understood and that any lack of understanding of policy language be adequately explained, preferably in writing, by the insurer.  The rule of law with respect to ambiguous policy language is that, in the event of a dispute, the ambiguous language is construed against the drafter – the insurance company.  It is also important in some cases that if a lawsuit is brought against the insurance company, that the case be carefully briefed, filed and argued so as to not open up additional policy provisions that could defeat the insured’s position.  These points were on display in a recent case from South Dakota.

The plaintiffs (a married couple) operate a cattle and row-crop operation in South Dakota. A storm in the fall of 2013 began as rain and turned into a blizzard in which 93 of their cattle (yearling heifers) died. Their veterinarian necropsied some of the cattle and determined that their death was by drowning because the lungs of the cattle were saturated with water and their airways were obstructed with foam (air trapped in water), and there was clear liquid in all airways and running from the noses of the cattle. This was all the result of the cattle inhaling large amounts of rain and snow during the storm which triggered cardiac arrest and death. The plaintiffs insured the cattle against loss by “drowning.” The plaintiffs filed a claim for the death of the cattle by drowning, but the insurance company denied the claim due to none of the cattle being found submerged in water. The trial court agreed with the insurance company and granted them summary judgment.

On appeal, the state Supreme Court reversed. The Court noted that “drowning” was not defined in the policy and that because both parties offered reasonable interpretations of the term, the term was deemed ambiguous and the ambiguity was to be construed in the insured’s favor. The Court also held that exclusionary language contained in the policy excluding coverage for loss to livestock due to “smothering, suffocation or asphyxiation” or “freezing in blizzards or snowstorms,” didn’t apply because the plaintiffs only claimed coverage under drowning provision which didn’t contain similar exclusionary language.

The case is Papousek v. De Smet Farm Mutual Insurance Company of South Dakota, No. 27658-r-JMK, 2016 S.D. LEXIS 93 (S.D. Sup. Ct. Jul. 20, 2016).

August 5, 2016 in Civil Liabilities | Permalink | Comments (0)

Wednesday, August 3, 2016

Feedlot Has Superior Rights to Cattle Sale Proceeds

A common arrangement between cattlemen and feedlots generated a court case recently involving the rights to the proceeds of the sale of the cattle.  Under the facts of the case, a cattle feedlot financed the debtor’s purchase of cattle from a third party (cattle seller) through a lender. The debtor placed the cattle in the feedlot where the cattle would be feed and care for the cattle until selling them. The sale proceeds would then be first used to repay the feedlot for the amount financed, with the balance going to the debtor. After checking public records, the feedlot confirmed that the cattle were free and clear of liens and encumbrances and no records showed that the seller had any interest in the cattle. The feedlot loaned the debtor almost $600,000 for finance the purchase of the cattle. The promissory notes and security agreements that the parties executed were assigned to the lender, and the lender wired the funds directly to the debtor. Unfortunately, several of the debtor’s checks for the purchase of the cattle were not honored, resulting in the seller receiving only partial payment for the cattle. The debtor filed Chapter 11 bankruptcy, and the feedlot, cattle seller and lender battled over priority rights in the proceeds of the sale of the cattle. In a prior proceeding, the court found that the cattle seller had reclaimed the cattle for which he had not been paid via a replevin action that was unaffected by the debtor’s bankruptcy. The remaining cattle were eventually sold for a gross proceeds amount of $883,073.25. $215,119.87 of that amount was paid to the feedlot for its care and feeding of the cattle. The balance was placed in escrow pending the outcome of the litigation.

The feedlot claimed that it had superior rights to the proceeds of the cattle sale because the seller gave up possession to the feedlot and the feedlot was a purchaser in good faith in that title had been transferred to the buyer who then transferred it to the feedlot. The seller claimed it had prior rights because title to the cattle didn’t transfer to the feedlot, and because the feedlot’s interest in the cattle didn’t attach due to the feedlot not being a good faith purchaser because the feedlot should have first determined that it had a valid bill of sale showing that the debtor owned the cattle. The court agreed with the feedlot based on U.C.C. §2-401 which deals with title transfer and does not provide for a revesting of title in the seller when the buyer fails to pay for the goods. The court noted that the seller could have protected himself rather than simply relying on the buyer’s word. Accordingly, the feedlot was a good faith purchaser of the cattle that relied on the legal documents of ownership that were presented with the cattle. The court noted that cattlemen generally consider the bill of sale and brand inspection report (which the feedlot relied on) to be valid documentation of ownership.

So, industry custom played a key role in determining the priority rights to the sale proceeds of the cattle.  Also, unfortunately, simply relying on another party's word often isn't good enough to protect your rights.  

The case is In re Leonard, No. BK15-82016, 2016 Bankr. LEXIS 2681 (Bankr. D. Neb. Jul. 22, 2016).

August 3, 2016 in Secured Transactions | Permalink | Comments (0)

Monday, August 1, 2016

Farm Bankruptcy Case Highlights Debt Limitation in Chapter 12 Bankruptcy

A recent Chapter 12 (farm) bankruptcy case highlights an issue that farmers can run into when in financial distress.  In recent years, the expansion of the size of farm and ranch operations (due largely to increased crop prices and land values) caused some many farming operations to expand.  It also caused many of those same operations to take on more debt.  When crop prices collapsed and land values declined, that created financial distress in the farm sector.  Chapter 12 then became a major reality for these operations.  Chapter 12 reorganization has favorable provisions for farmers, including the ability to move any IRS (and state) tax claims to the general unsecured status that are related to the sale of farm assets that are used in the debtor's farming operation.  (11 U.S.C. Sec. 1222(A)(2)(a))  But, the debtor can't have more than $4,031,575 of aggregate debt (presently inflation-adjusted to $4,153,150).  That limit is too low for many of the farming operations that have expanded in recent years, and bars them from filing Chapter 12.  A legislative effort has been attempted over the past year to increase the debt limit, but hasn't been successful yet.  The aggregate debt limitation of Chapter 12 was illustrated in a recent case.  

In the case, the debtor filed a Chapter 12 petition along with schedules showing aggregate debt of almost $4.5 million. A creditor filed a motion to dismiss the debtor’s Chapter 12 petitioner because the debtor’s aggregate debt exceeded that allowed by Chapter 12 - $4,031,575. The debtor then filed a motion to convert the Chapter 12 case to a Chapter 11, which has no limit on a debtor’s aggregate debt. The debtor claimed that conversion to Chapter 11 was permissible because 11 U.S.C. §1208 doesn’t expressly bar conversion from Chapter 12 to Chapter 11, and because the Chapter 12 had been filed in good faith, conversion would not prejudice creditors, and conversion would be equitable. The creditor objected to conversion on the basis that there is no statutory authority for such conversion. The court noted that the issue had not been addressed by the First Circuit, but that other Circuits were split on the issue. The court examined the legislative history of Chapter 12 to note that early draft versions of Chapter 12 legislation contained limited authority to convert a Chapter 12 to Chapter 11 or 13, the final conference report did not contain any allowance for good faith conversion. Thus, based on a plain reading of the statute, the court denied conversion.

The case is In re Colon, No. 16-0060, 2016 Bankr. LEXIS 2344 (Bankr. D. P.R. Jun. 21, 2016).

August 1, 2016 in Bankruptcy | Permalink | Comments (0)