Friday, September 30, 2016
The title of today’s blog post might seem a bit odd. Indeed, in the normal course of events, when a farmer or rancher sells farm or ranch land the resulting gain would be treated as capital gain. That’s also the case for an investor in land that later sells it as an investment asset. In both instances, the land is a capital asset that was being used in the seller’s business of farming (or ranching) or it capital in nature as an investment asset. Seems rather straightforward. But, what if the facts are tweaked a bit? Let’s say that urban development was moving toward the farm or ranch and the seller, to take advantage of the upward price pressure on the land, started to parcel out the land and sell it in small tracts. What if the seller had the land platted? What if marketing steps were taken? What if the buyer believed the land had a strategic location at the time of purchase, farmed it for a period of time and then began steps to prepare it to be sold off in smaller residential tracts at substantial gain? Do those things change the character of the gain recognized on sale? Possibly.
Sales that are deemed to be in the ordinary course of the taxpayer’s business generate ordinary income. I.R.C. §1221(a)(1). However, the sale of a capital asset (such as land) generates capital gain. The different tax rates applicable to ordinary income and capital gain are often large for many taxpayers (at least a 15 percentage-point difference) with the capital gain rates being lower. So, a farmer, rancher or land investor will want to treat the gain from the sale of land as a capital gain taxed at the preferential lower rate. That will be the outcome, unless the land is determined to have been held by the seller for sale to others in the ordinary course of their business. The determination of the character of gain on sale is fact dependent and some recent cases shed light on the key factors.
In a California case, Allen v. United States, No. 13-cv-02501-WHO, 2014 U.S. Dist. LEXIS 73367 (N.D. Cal. May 28, 2014), a married couple sold 2.63 acres of undeveloped land that generated over $60,000. They reported the income as capital gain, but the IRS claimed that the income was "other income" taxable as ordinary income. The couple admitted that they bought the land for the purpose of development, and they did attempt to find a partner to develop the property. Ultimately, the property was sold to a developer and the couple received a payment each time a developed portion of the property was sold. The IRS denied capital gain treatment, asserting that the income was from property "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." The court noted that the determination of the nature of the income is a fact-based determination, and that the facts supported the IRS. The taxpayers intended to develop and sell the property at the time it was acquired, and the taxpayers were active in getting the property developed. The fact that the property was the only one purchased for development was not determinative. The court granted summary judgment to the IRS.
A U.S. Tax Court case, Fargo v. Comr., T.C. Memo. 2015-96, involved a partnership that acquired a leasehold interest in a tract of land with the intent to develop an apartment complex and retail space. The lease originally ran for 20 years, but was extended for another 34 years. The property generated only rental income and the taxpayer made no substantial effort to sell the property for 13 years. Ultimately, the property was sold for $14.5 million plus a share of the profits from the homes to be developed on the property. The partnership reported $628,222 of capital gain, but IRS took the position that the transaction triggered $7.5 million of ordinary income. The court agreed with the IRS. The court noted the following factors were important in making the gain characterization distinction: (1) the property was initially acquired for developmental purposes; (2) efforts to obtain financing and continue that development were made; (3) the sale was to an unrelated party with the plan for the petitioner to develop the property; and (4) efforts continued to develop the property up until the purchase date. While there were some factors that favored the taxpayer (only minor improvements were made; there were no prior sales; and no advertising or marketing had been performed), the court held that the factors weighed in the favor of the IRS and the sale was in the ordinary course of business under I.R.C. §1221(a)(1).
In yet another recent case, Long v. Comr., 772 F.3d 670 (11th Cir. 2014), the plaintiff, a real estate developer, entered into a contract with another party to buy land on which the plaintiff was planning on building a high-rise condominium building. The plaintiff hired architects, sought a zoning permit, printed promotional materials about the condominium, negotiated contracts with purchasers of condominium units and obtained deposits for units. However, the seller of the land unilaterally terminated the contract. The plaintiff sued for specific performance and the trial court ordered the seller to honor the contract. While the trial court's decision was on appeal, the plaintiff sold his position as the plaintiff in the contract litigation to a buyer for $5.75 million. The IRS characterized the $5.75 million as ordinary income rather than capital gain. The Tax Court agreed with the IRS on the basis that the plaintiff held the property (which the court said was the land subject to the contract) primarily for sale to customers in the ordinary course of business. On appeal, the court reversed on the basis that the taxpayer never actually owned the land and instead sold a right to buy the land - a contractual right. Accordingly, there was no intent to sell contract rights in the ordinary course of business. The plaintiff intended the contract to be fulfilled and develop the property, and the sale of the right to earn future undetermined income was a capital asset.
The Tax Court in a 2015 case, SI Boo, LLC v. Comr., T.C. Memo. 2015-19, held that ordinary income and self-employment tax was triggered on sale of properties acquired by tax deeds. The court noted that the taxpayers regularly did this. While they bought the tax liens primary to profit from redemptions of the liens, the court determined that the repeated sales of properties forfeited to them as lien holders constituted ordinary income as a dealer in real estate. They had also hired persons to act on their behalf to acquire the tax deeds, prepare the tracts for sale and maintain business records. The court also held that, under another rule, the income from the sales was not reportable on the installment method.
The most recent court decision involving the issue, Boree v. Comr., No. 14-15149, 2016 U.S. App. LEXIS 16682 (11th Cir. Sept. 2, 2016), aff’g., T.C. Memo. 2014-85, involved a taxpayer that was a self-described real estate professional who received income from land sales. The taxpayer reported the income as capital gain, but the Tax Court held that it was ordinary income because the taxpayer was found to have held the property primarily for sale to customers in the ordinary course of the petitioner's real estate business. The court noted that the issue of whether the taxpayer was a developer (ordinary income treatment) or an investor (capital gain treatment) was fact dependent, and that the facts supported developer status. That was the result because he held his business out to customers as a real estate business, and he engaged in development and frequent sales of numerous tracts over an extended period of time. Also, in prior years, he had reported the income from sales as ordinary income and had deducted the expenses associated with the tracts. On appeal, the appellate court affirmed.
The bottom line is that for most sales of farm or ranch land, the income from the sale will be characterized as capital gain. However, there are factors that can change the gain to ordinary.
Wednesday, September 28, 2016
In recent years, almost every state has enacted an Equine Activity Liability Act (ELA) designed to encourage the continued existence of equine-related activities, facilities and programs, and provide the equine industry limited protection against lawsuits. The laws generally require special language in written contracts and liability releases or waivers, require the posting of warning signs and attempt to educate the public about inherent risks in horse-related activities and immunities designed to limit liability. Under the typical statute, an “equine activity sponsor,” “equine professional,” or other person can only be sued in tort for damages related to the provision of faulty tack, failure to determine the plaintiff’s ability to safely manage a horse, or failure to post warning signs concerning dangerous latent conditions. Recovery for damages resulting from inherent risks associated with horses is barred, and some state statutes require the plaintiff to establish that the defendant’s conduct constituted “gross negligence,” “willful and wanton misconduct,” or “intentional wrongdoing.”
The various state statutes are all unique and fact issues abound. That means that cases involving a state’s ELA often end up before juries to decide those fact issues. One interpretation of the Iowa statute resulting in the term “person” in the Iowa Domesticated Animal Activities Act being construed to include an employer in an agricultural employment setting involving livestock. Baker v. Shields, 767 N.W.2d 404 (Iowa 2009). Another common issue involves determining what an inherent risk of horseback riding amounts to. In Wyoming, that is a fact issue because the statute doesn’t provide any precise definition as examples of inherent risks from riding horses. Under the Texas statute, the phrase “inherent risk of equine activity” refers to risks associated with the activity rather than simply those risks associated with innate animal behavior. Loftin v. Lee, No. 09-0313, 2011 Tex. LEXIS 326 (Tex. Sup. Ct. Apr. 29, 2011). The Ohio equine activities immunity statute has been held to bar recovery for an injury incurred while assisting an employer unload a horse from a trailer during a day off, because the person deliberately exposed themselves to an inherent risk associated with horses and viewed the activity as a spectator. Smith v. Landfair, No. 2011-1708, 2012 Ohio LEXIS 3095 (Ohio Sup. Ct. Dec. 6, 2012).
A recent case involved the construction of the Florida EALA. The plaintiff, a former jockey, visited a horse race course that the defendant managed. The decision was a spur-of-the-moment decision made along with the plaintiff’s roommate who was a current jockey and had a horse stabled there. As a former jockey, the plaintiff was required to get a guest pass to enter the stables. While walking through the barn to see the roommate’s horse, another horse jumped out of its stall and bit the plaintiff’s chest. The plaintiff sued the defendant for negligence. The defendant asserted immunity based on the state (FL) Equine Activities Liability Act (EALA) on the basis that the plaintiff was a “participant engaged in an equine activity” that was precluded from recovering damages. The EALA immunizes an equine activity sponsor, an equine professional, or any other person or entity from liability to a “participant” from the inherent risks of equine activities. A “participant” need not pay a fee, and engaging in an equine activity includes “visiting or touring…an equine facility as part of an organized event or activity.” The plaintiff claimed that the decision to visit the stables was simply a spur-of-the-moment decision that did not constitute an organized event or activity, the court disagreed. The court focused on the requirement that the plaintiff obtain a guest pass before entering the horse barn. That was sufficient enough of a protocol to amount to “organization” which made the plaintiff’s visit to the stables “an organized activity” under the EALA.
If you have horses, engage is horse-related activities, or attend horse events for pleasure, you might want to become familiar with the governing state EALA.
The Florida case is Germer v. Churchill Downs Management, No. 3D14-2695, 2016 Fla. App. LEXIS 13398 (Fla. Ct. App. Sept. 7, 2016).
Monday, September 26, 2016
The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§201, et seq.) as originally enacted, was intended to alleviate some of the more harmful effects of the Great Depression. In particular, the Act was intended to raise the wages and shorten the working hours of the nation's workers. Since 1938, the FLSA has been amended frequently and extensively. It is very complex and not all of it pertains to agriculture. In today’s blogpost, we examine the FLSA exemption from the requirement to pay the minimum wage, whether non-workday activities must be compensated, and the exemption to pay overtime wages to employees that are engaged in “agriculture” activities.
Under the FLSA, an agricultural employer who uses 500 man-days or more of agricultural labor in any calendar quarter of a particular year must pay the agricultural minimum wage to certain agricultural employees in the following calendar year. A “man-day” is a day during which an employee performs any agricultural labor for more than an hour, and all ag employees count in the 500 man-days test. 29 U.S.C. §203(e)(3)). The minimum wage must be paid to all agricultural employees except: (1) members of the employer's immediate family, unless the farm is incorporated; (2) local hand-harvest, piece-rate workers who come to the farm from their permanent residences each day, but only if such workers were employed less than 13 weeks in agriculture in the preceding year; (3) children, age 16 and under, whose parents are migrant workers, and who are employed as hand-harvest piece-rate workers on the same farm as their parents, provided that they receive the same piece-rate as other workers; and (4) employees engaged in range production of livestock. Where the agricultural minimum wage must be paid to piece-rate employees, the rate of pay for piece-rate work must be sufficient to allow a worker reasonably to generate that rate of hourly income.
The FLSA also requires covered employers to compensate employees for activities performed during the workday. But, the FLSA does not require that compensation be paid to employees for activities performed outside the workday such as walking, riding or traveling to and from the actual place of performance of the employee’s principal activity, and for activities which occur before and after the employee’s principal activity. On the question of whether an employee is entitled to compensation for time spent waiting at stations where required safety and health equipment is distributed, donned and doffed, and traveling to and from these stations to work sites at the beginning and end of each workday, the U.S. Supreme Court has ruled that such activities are indispensable to an employee’s principal activity and are, therefore, a principal activity itself. IBP, Inc. v. Alvarez, et al., 546 U.S. 21 (2005). However, the Court ruled that unless an employee is required to report at a specific time and wait to don required gear, the time spent waiting to don gear is preliminary to the first principal activity of the workday and is not compensable unless compensation is required by the employment agreement or industry custom and practice.
On the overtime issue, as noted above, the FLSA requires payment of an enhanced rate of at least one and one-half times an employee’s regular rate for work over 40 hours in a week. However, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. §213(b)(12). The 500 man-days test is irrelevant in this context. In addition, there are specific FLSA hour exemptions for certain employment that is not within the FLSA definition of agriculture.
But, just what exactly is “agriculture” for purposes of the exemption from paying overtime wages? The agricultural exemption is broad, defining “agriculture” to include “farming in all its branches and the production, cultivation, growing, and harvesting of...horticultural commodities and any practices performed by a farmer or on a farm as an incident to or in conjunction with farming operations.” There are numerous cases on the issue, including a recent one from Connecticut.
In the Connecticut case, the plaintiff worked at a small farm, originally commuting to the farm from his home, where he assisted the resident caretaker. When the resident caretaker died, the plaintiff moved to the farm and assumed full responsibility for caring for the animals and grounds. At the farm were several retired racehorses, a mule, a donkey, two llamas, two cows, about 20 chickens, ten ducks, twenty pigeons and a dog. Also, on the farm was the deceased caretaker’s 1,000-pound pig. The plaintiff fed the animals twice daily, took them from the stable to pasture, sprayed the horses with fly spray and groomed them, and also check on the horses at night. The plaintiff also drove the farm truck to buy food and supplies for the all of the livestock. The plaintiff was also responsible for the animals’ medical care by lining up veterinarians. On a daily basis, the plaintiff called the owner to report on the animals. The plaintiff also maintained the farm grounds by shoveling snow, mowing grass, trimming trees, and controlling weeds. The plaintiff had some assistance in these tasks, but remained on the farm on a constant basis to care for the animals. After the owner died, the plaintiff filed a claim against the owner’s estate for overtime pay under the FLSA. As noted above, the FLSA requires overtime pay for works hours exceeding 40 hours per week, but a worker who works in “agriculture” for a small agricultural operation is exempt from the overtime requirements. The court examined the FLSA definition of “agriculture” and noted that it includes “farming in all its branches and among other things includes…the raising of livestock, bees, fur-bearing animals, or poultry, and any practice…performed on a farm as an incident to or in conjunction with such farming operation.” Based on that definition, the court held that the plaintiff was engaged in the primary agricultural practice of raising livestock, which the FLSA defines as “cattle, sheep, swine, horses, mules, donkeys, and goats.” The court also noted that the FLSA regulations define “raising” of livestock as “the breeding, fattening, feeding, and general care of livestock.” The court also held that the balance of the plaintiff’s work on the farm that did not involve feeding and general care of the animals also qualified for the agriculture exemption because they were performed on the farm and were incidental to the farming activities.
Thursday, September 22, 2016
An aspect of estate and business planning for farmers and ranchers (and other small businesses) that has popped-up since the enactment of the health care law in 2010, includes planning to minimize the impact of the Net Investment Income Tax (NIIT). Often, clients have a desire to simultaneously minimize self-employment tax. The strategy to minimize both taxes involves the use of the limited liability company (LLC) – a particular type of LLC. That’s the topic of today’s blog post
If we look at the applicable proposed regulations, an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). However, the LLC could be structured as a manager-managed LLC with two membership classes as a means of minimizing self-employment tax. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-managers that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income from their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments.
This all means that it is possible to utilize a manager-managed LLC with the taxpayer holding both manager and non-manager interests that can be bifurcated. The result is that an individual holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Let’s look at an example on this issue prepared by Paul Neiffer, the author of the farmcpatoday.com blog:
Example: Bob and Mary, a married couple, operate their farming business in an LLC. Mary works full-time as a nurse and is not involved in the farming operation. She does, however, have a 49 percent non-manager ownership interest in the LLC. Bob, works on the farm and has a 49 percent non-manager interest along with a 2 percent manager interest. Bob receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax.
Now here’s the application to the NIIT. While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.
If we return to the example again, the end result would be that self-employment tax is significantly reduced (15.3 percent of Bob’s reasonable compensation (in the form of a guaranteed payment)) and the NII surtax is avoided on Mary’s income.
Bottom line: The manager-managed LLC can provide a better overall tax result than the use of an S corporation with land rental income because of the ability to not only reduce self-employment tax, but also the ability to eliminate the NIIT. It also produces a better result than a partnership.
Of course, the NIIT and S.E. tax are only two pieces of the puzzle to an overall business plan. Other non-tax considerations may carry more weight in a particular situation. But for some, this strategy can be quite beneficial.
Tuesday, September 20, 2016
I often field questions that concern farm real estate legal and tax issues. It seems as if some of the more frequent real estate-related questions that have come up recently concern steps that can be taken to ensure that a farm land purchase goes through and that nothing unexpected occurs to disrupt the deal.
So, what can be done to ensure a successful transition? A lot of it boils down to making sure that the buyer has full information about the property they are interested in buying. This is especially important with respect to farmland. One of the reasons is because there is a significant federal environmental rule that can come into play. The Comprehensive Environmental Response Compensation & Liability Act (CERCLA) focuses on hazardous waste sites, but it can have significant ramifications for agricultural operations because the term “hazardous waste” has been defined to include most pesticides, fertilizers, and other chemicals commonly used on farms and ranches and its presence can lead to huge liability. But, there are defenses to liability.
Perhaps the most important CERCLA defense for farmland buyers is the “innocent purchaser” defense. This defense can apply if the defendant purchased land not known at the time of purchase to contain hazardous substances, but which is later determined to have some environmental contamination at the time of the purchase or is contiguous to land not known at the time of the purchase to be contaminated. A buyer attempting to utilize this defense must establish that the real estate was purchased after the disposal or placement of the hazardous substance, and that they didn’t know and had no reason to know at the time of purchase that a hazardous substance existed on the property. To utilize the defense, the buyer, as of the purchase date, must have undertaken “all appropriate inquiry” into the previous ownership and uses of the property in an effort to minimize liability. The phrase “all appropriate inquiry” generally depends upon the existence or nonexistence of five factors: (1) the buyer’s knowledge or experience about the property; (2) the relationship of the purchase price to the value of the property if it was uncontaminated; (3) commonly known or reasonably ascertainable information about the property; (4) the obviousness of the presence or likely presence of contamination of the property; and (5) the ability to detect such contamination by appropriate inspection.
A buyer of farm land can take several common-sense steps to help satisfy the “appropriate inquiry obligation”. Certainly, a title search should be made of the property. Any indication of previous owners that may have conducted operations that might lead to contamination should be investigated. Aerial photographs of the property should be viewed and historical records examined. Likewise, investigation should be made of any government regulatory files concerning the property. A visual observation of the premises should be made, soil and well tests conducted, and neighbors questioned. However, the execution of an environmental audit may be the best method to satisfy the “all appropriate inquiry” requirement. Some states have enacted legislation requiring the completion of an environmental audit upon the sale of agricultural real estate. Today, many real estate brokers, banks and other lenders utilize environmental audits to protect against cleanup liability and lawsuits filed under CERCLA.
There’s more than just CERCLA to be concerned about when buying a farm. As previously noted, a lot of information about a tract of farmland can be obtained publicly. In the Midwest, checking drainage records with in the local Auditor’s office (at least in some states) is a good place to discover drainage information. Those records may not be in the Recorder’s records and probably won’t show up in an abstract. Also, there may be private drainage agreements and/or easements that exist. Those agreements will likely be recorded and appear in the Recorder’s office records for the property. Also, USDA records about the land should be examined. This includes FSA and NRCS records. Many sellers will choose to make all of the records open concerning a particular farm. So, that can be a good way to get your hands on USDA maps and documents. This will also allow the buyer to determine if there are any government contracts or easements on the property (think CRP and WRP here). Also, the USDA information will allow the buyer to determine if any of the land is highly erodible or has wetland status. That can impact value substantially.
Another little fact that a buyer of farmland definitely wants to know is whether the land is leased to a tenant. In some states, long-term farm leases must be recorded. In that situation, check the publicly filed records. But, most farm leases are short-term leases. Relatedly, for farmland purchases from an individual (or entity) seller or an estate, it is important to understand whether the lease will continue (and, if so, for how long) or whether it has been properly terminated in accordance with state law. The mere sale of the land, absent some written agreement, will not terminate any existing lease.
Other things to consider include getting all appropriate signatures (that means a spouse, when applicable), and determining whether the sale is part of a family settlement agreement. Also, it is important to make sure that the legal description matches what is being purchased. On this point, take great care when using the abstract and bring it up to date before the purchase and have it carefully examined for accuracy and for defects in title. Remember the old Bugs-Bunny cartoon involving Christopher Columbus and the debate he was having: “The world, she’s a flat. No, the world, she’s a round.” The point here is that the world is round, but maps are square. What this means is that sometimes a tract of land won’t have precisely the acres that the buyer thinks it has – a half-section, for example, may not contain 320 acres, for example. That’s especially likely if the tract lies on the edge of a township, county or a state border.
From a practical standpoint, put your boots on and physically walk the tract. Look at the fences. Are they on the actual, intended location or boundary? If not, had the adjoining landowners mutually recognized the existing fence location for a long-enough period of time (determined by state law) so that it is the actual dividing line irrespective of what a survey shows? Is there a written fence agreement that has been recorded? Probably not, but always check. Look for paths that might be easements. Relatedly, are existing paths wide enough to allow equipment into fields and locations where planting is desired? How much of the land is consumed by ditches and roads? The seller will try to sell in accordance with deeded acres, but a buyer that plans on farming the property is interested in paying only for tillable ground. Not much, if any, value is assigned to non-tillable ground other than pasture.
There are lots of things to think about and get clarified when buying farmland. While some information is publicly available, that disclosure document is critical. Failure to disclose key information can serve as the basis for cancelling a farm sale before it takes place if the failure pertains to information that serves as the basis of the bargain.
As you can see, there is a lot involved in a farm land sale transaction. Be careful out there!
Friday, September 16, 2016
Receipt of an Inheritance While in Reorganization Bankruptcy – Implications for Debtors and Creditors
A bankruptcy reorganization plan may be modified, at the request of the debtor, the trustee or the holder of an unsecured claim, at any time after confirmation of the plan and before completion of payments. 11 U.S.C. §1229(a). A modification enables the debtor to make adjustments to financial obligations when the family farm debtor's financial situation has changed. But, a modified plan must meet all of the requirements for plan confirmation.
A change in finances can occur, for example, when the debtor wins the lottery or receives an inheritance. Under 11 U.S.C. §541, a debtor’s bankruptcy estate includes all assets that the debtor inherits within 180 days of the bankruptcy petition. That is true in a Chapter 7, but it can also be the result in a Chapter 11, 12 or 13 bankruptcy. Whenever an accession to the debtor’s wealth occurs, a significant question is whether that accession is particular to the debtor or, in the case of a joint bankruptcy petition, whether that accession to wealth also belongs to the debtor’s spouse. That can be a big deal when there are creditors of one spouse that aren’t creditors of the other spouse. In that event, can a modified bankruptcy plan specify that only the creditors of one spouse be paid from the increase in the debtor’s wealth, or are the creditors of both spouses entitled to be paid? A recent case sheds some light on the issue.
In the recent case, the debtors, a married couple, filed Chapter 13 bankruptcy. The husband received a $221,510.53 inheritance 34 months into the Chapter 13 reorganization plan. They proposed to use a portion of the funds to pay off all of the husband’s debts (including the mortgage on the couple’s home) and keep the rest of the funds without paying on any of the debts of the wife. The result would be to leave about $12,000 of the wife’s debts unpaid. The bankruptcy trustee objected on the basis that all claims should be paid from the inheritance.
The court noted that there was no controlling authority in the jurisdiction (MO) on the issue of whether a post-petition inheritance was property of the bankruptcy estate, but also determined that state law governs the nature of a property interest. On that point the court noted that MO. Rev. Stat. §451.250.1 specifies that an inheritance is the separate property of a spouse that receives it and cannot be taken by process of law to pay the debts of the other spouse. Thus, the question was whether a joint bankruptcy filing of the spouses alters the outcome of the state law provision. The court noted that in In re True, 285 B.R. 405 (Bankr. W.D. Mo. 2002), a farm was not available to pay the debtor-spouse’s separate debts under §451.250.1 where the farm was titled exclusively in the non-debtor spouse’s name. The court in the present case believed that In re True was directly on point, and that, as a result, the husband’s inheritance was his separate property and was included in the bankruptcy estate for payment of debts for which he alone was responsible.
The court also held that the inheritance constituted a substantial change in circumstances that required an amended plan be filed. Under 11 U.S.C. §1322(a)(1), the plan must provide for the submission of all or such portion of future earnings or other future income of the debtor to the trustee’s supervision and control. The court held that the proposal to commit the inheritance to pay the husband’s creditors in full complied with that requirement, given that the inheritance is the husband’s separate property. The proposal was also not in bad faith, because the wife’s creditors would not be entitled to be paid from the husband’s inheritance if the couple were not in bankruptcy. Given the similarity of Chapters 12 and 13, the same situation could occur in a Chapter 12 bankruptcy.
It's an interesting case, with important implications for debtors and creditors in a reorganizational bankruptcy. But, from a planning standpoint, is there anything that can be done to address this potential situation? One suggestion is to have the will or trust of any person that is likely to leave a potential debtor property contain clause language that conditions the bequest. Under the clause, if the property would become property of a bankruptcy estate, the bequest lapses and passes to a spend-thrift trust for the benefit of the intended beneficiary. At least, that is the approach of one rather prominent bankruptcy attorney that I know.
The case is In re Portell, No. 12-44058-13, 2016 Bankr. LEXIS 3301 (Bankr. W.D. Mo. Sept. 9, 2016).
Wednesday, September 14, 2016
After 25 years of working with agricultural producers, there are some common mistakes or misunderstandings that I have noticed that farmers and ranchers (and others) have when it comes to estate planning. I have also noticed some common errors in estate plan that may or may not be related to the common mistakes/misunderstandings.
With that much said, what are those common problem areas? Here’s how I see ten frequently encountered ones (in no particular order):
- Simply not doing anything. I remember when I first started practicing in Nebraska that I was assigned to work on an estate plan for an older farm client of the firm. The present will for the couple dated to the late 1960s. That will was seriously outdated, and no longer comported with the couple’s situation or the complexity of their estates. So, when should an estate plan (will or trust) be updated? Anytime there is a birth (or death) of a child, the marriage, divorce or separation of anyone named in the will/trust, major changes in the law (think tax here), significant changes in income or wealth, or a change in objectives.
- Title ownership of property that doesn’t comply with the overall estate planning goals and objectives. This includes the improper use of jointly held property, as well as IRAs and other documents that have beneficiary designations. Sometimes, even lawyers make mistakes on this one. A recent Colorado Supreme Court decision involved an action by kids against the lawyers that did the parents’ estate plan. Everything was to go equally to the kids, but somewhere along the line title ownership to the surviving parent’s residence did not get changed from joint tenancy. That blew the entire estate plan distribution that the parents desired. The kids that got shorted sued the lawyers, but the Court said the lawyers didn’t owe them any duty because they weren’t the clients. Not every state court would come out the same on that issue.
- Leaving everything outright to the surviving spouse when the family wealth is “large.” In these types of estates, that strategy fails to optimize the marital deduction. Also, even though “portability” of the unused exclusion at the time of the first spouse’s death is available, states that tax wealth at death don’t have the same rule.
- Simply thinking that there is insufficient wealth to need to do any estate planning. I can’t tell you how many times farm/ranch families have underestimated their wealth once they are forced to start itemizing their assets. Don’t forget about insurance proceeds, and remember that asset values could appreciate.
- Not accounting for the lack of liquidity of farm and ranch estates. The biggest asset in the estate for a farmer or rancher is land. Land is inherently illiquid. That means that liquidity planning is typically necessary in a farm/ranch estate – both pre-death and post-death.
- Not owning life insurance in the proper manner. This issue ties into No. 5. Insurance is often used as a liquidity planning tool. It is also an effective strategy for funding a buy-sell agreement. While the death benefit is income tax free, it is potentially subject to estate tax if the policy is owned by the insured at the time of death. For many client, some form of irrevocable life insurance trust will likely need to be utilized. That way the death benefit avoids estate tax.
- Not understanding the difference between “equal” and “fair”. In situations where there are both “on-farm” and “off-farm” heirs, the control of the farming/ranching operation should pass to the “on-farm” heirs and the “off-farms” heirs should get an income interest that is roughly balanced to the “on-farm” heirs’ interests. At least, that’s what many clients will desire. But, they at least have to recognize that “equal” does not mean simply dividing assets up equally.
- Improper use of life estate/remainder arrangements. While these are popular in agriculture, if not used properly, it can result in a non-optimal tax situation at death. It’s worth at least making sure it is structured properly.
- For larger estates where the goal is to continue the farming/ranching operation into a subsequent generation(s), not preserving eligibility for special use valuation.
- Not doing the basics in preserving records and key documents. It is immensely helpful to store key documents in a secure place where the people that will need to find them know where they are. This includes, the will/trust, deeds, tax returns, etc. It’s amazing how often this basic step isn’t done.
Well, I could go on. There are numerous others that could be mentioned. These seem to be the big ones, though.
Monday, September 12, 2016
Historically, the I.R.C. §179 election was required to be made as part of a timely filed return. No revocations of the election, once it was made, were allowed without IRS consent. However, in 2003, the Congress enacted I.R.C. §179(c)(2) to permit taxpayers to revoke the I.R.C. §179 election on an amended return. Subsequent extender legislation continually renewed the revocation ability so that it applied to tax years beginning before 2015. Then, the PATH Act enacted in December of 2015 retroactively extended the provision for tax years beginning before 2016 and then permanently extended the provision for later years.
Here’s an example of revoking the I.R.C. §179 deduction on an amended return:
Joe, a farm proprietor, is a 50% shareholder in an S corporation that conducts a
hog breeding activity. The other 50% shareholder is Joe’s brother. When Joe
receives the Form 1120S Schedule K-1 for 2015, he recognizes that the S corporation
has made a 179 election with respect to $500,000 of farm equipment (Joe is
allocated a $250,000 Sec. 179 deduction as a 50% shareholder). However, during
2015, Joe made well and drainage facility improvements of approximately $400,000.
Recognizing that these improvements in his proprietorship are 15-year recovery
assets, Joe suggests to his brother that the S corporation amend its return to reduce
the I.R.C. §179 election on the farm equipment to $200,000, so that his 50% is no
more than $100,000.
Treasury Regulation §1.179-5(c) allows a late I.R.C. §179 election on an amended return at any time within the statute of limitations for years beginning after 2002 and before 2008. The IRS later announced in Rev. Proc. 2008-54, Sec. 7 that I.R.C. §179 elections may be made by amended return for any taxable year in which Sec. 179(c)(2) allows a revocation of the election. Thus, given the PATH Act provision that permanently extended I.R.C. §179 and, hence, I.R.C. §179(c)(2), this amended return opportunity is available for property placed in service in tax years beginning after 2002. In addition, Treas. Reg. §1.179-5(a) specifies that any amended election must specify the items of I.R.C. §179 property and the portion of the cost of each item to be taken into account, and must also make other appropriate adjustments to the depreciation computations for the current and any succeeding tax years.
Consider the following example of making the I.R.C. §179 election on an amended return:
Tom, a farm proprietor, purchased and placed in service one item of Sec. 179
property during 2014, a tractor costing $135,000. On Tom’s 2014 tax return,
he elected to expense under Sec. 179 only $20,000 of the cost of this
asset, as that deduction reduced his joint taxable income to the top of the 15%
federal tax bracket. Subsequently, in the course of preparation of Tom’s 2015
return it becomes apparent that a Schedule J farm income averaging election
would be beneficial, and Tom would be better served if the 2014 base year had lower
taxable income. Accordingly, an amended return is prepared for 2014, increasing the
Sec. 179 deduction on the tractor by $30,000, to better position the Schedule J
income averaging calculation as part of Tom’s 2015 tax return. As an added benefit,
Tom’s SE tax was also reduced for 2014.
So, when would an amended I.R.C. §179 election be useful? Here are some possibilities:
- Whenever there is late-appearing income. An example would be a corrected Schedule K-1 requiring an amended return which could be offset by an amended I.R.C. §179 election (if, of course, the taxpayer did not originally maximize the I.R.C. §179 limit).
- If, upon IRS examination, an expenditure originally deducted as a repair is capitalized, the taxpayer could make a late I.R.C. §179 election if the maximum amount had not earlier been utilized.
- As noted in the second example above, an amended election could be used to better position the based period income for a current Schedule J farm income averaging election.
- In situations where the taxpayer did not originally properly designate or specify assets that were the subject of an I.R.C. §179 election, the IRS cannot disallow the election because of lack of disclosure. That’s because the taxpayer can make a late or corrected election on an amended return.
- If an asset that has been recently acquired is sold, the I.R.C. §179 election in the earlier year could be switched to other qualifying assets that were purchased in that year. Doing so will restore basis on the asset that is currently sold (and minimize gain on sale). The following example illustrates this.
Tim, an ag producer, purchased and placed in service two items of Sec. 179
property in 2014 a tractor costing $120,000 and a combine costing $230,000.
In his 2014 Form 1040, Tim elected to expense all of the $120,000 tractor.
In November 2015, Tim decided he no longer needed the tractor and sells
that asset for $110,000. Under the regulations, Tim is allowed to file an amended
return for 2014, revoking the Sec. 179 election for the tractor, claiming
normal depreciation for 2014 on that asset, and making an election under I.R.C.
179 to claim the $120,000 amount on the combine. The amended return must
also include an adjustment to the depreciation previously claimed on the
combine. As a result of the amended I.R.C. §179 election, Tim has eliminated
over $100,000 of gain that would have occurred from the sale of the tractor.
Rev. Proc. 2008-54, Sec. 7, was released in response to a commentator claiming that an I.R.C. §179 election could not be made on an amended return. In the revenue procedure, IRS stated that the Treasury intended to amend Treas. Reg. §1.179-5(c) to incorporate the guidance set forth in Sec. 7. The IRS also stated that until that time, taxpayers could rely on the guidance of Sec. 7 of Rev. Proc. 2008-54. Even assuming that the IRS has no authority to issue a revenue procedure that changes the effect of a Treasury Regulation before the Regulation is amended, that point is irrelevant. The IRS view is that a taxpayer can make and/or revoke an I.R.C. §179 election on an amended return for an open tax year. Substantial IRS resources are required to change a regulation. Issuing a revenue procedure provided a fix while the law was in flux. Taxpayers may continue to rely on the official release from the National Office of the IRS to originally elect and/or amend a previous election, regardless of the regulation’s higher authority.
Ignore any commentary that would indicate otherwise, unless it comes from the IRS.
Thursday, September 8, 2016
I field a lot of questions involving farm income tax issues. Sometimes those questions involve the proper treatment of income received from various farm-related activities. Today I take a look at a few of those common questions involving breeding fees, mineral and soil sales, crop share rents, livestock sales, and the sale of farm business assets.
Amounts that a farmer or rancher receives as breeding fees are includible in gross income. If part or all of the fee is later refunded because the animal did not produce live offspring, you still report the breeding fees as income in the year received, but then you take a deduction when the refund is made.
If you sell soil, sod and other minerals on a regular basis, that supports the characterization as sales of assets held primarily for sale to customers. So, that would be reported as ordinary income. The U.S. Tax Court, in 1976, held that the proceeds from the sale of sod are subject to an allowance for depletion. Myers v. Comm’r, 66 T.C. 235 (1976), acq., 1977-2 C.B. 1.
For mineral deposits, the disposition could be held to be a sale that would be reported as capital gains. But, that probably is not going to be the case in most situations. It’s more likely that a lease is involved which produces ordinary gains. Whether a sale or lease takes place depends upon whether an economic interest was retained in the deposits in question. The answer to that question will depend on the facts of each situation.
Crop share rents received by a farm landlord under a crop share or livestock share lease are included in income in the year the crop or livestock is reduced to money (or its equivalent), fed to livestock or donated to charity, whether the taxpayer is on the cash or accrual method of accounting. If crop share rents are received in one taxable year and fed to livestock in a later taxable year, the landlord includes in income an amount equal to the fair market value of the share rents at the time the crop share amounts are fed to livestock. An offsetting deduction is available at the same time.
For livestock, the amount of cash and the value of other merchandise or other property received during the tax year from the sale of livestock (and other produce) is included in gross income. Raised livestock (and crops) typically have a zero basis, which will result in the entire amount of the cash and the value of other merchandise or other property received being reported in gross income.
In general, for gains and losses arising from the sale of certain capital assets - farmland, depreciable assets used in the farm business, livestock (held for draft, breeding, dairy and or sporting purposes), unharvested crops sold with the land, and some other transactions - a special form of tax treatment applies. The depreciation previously taken on assets which are not real property is treated as ordinary income when the asset is sold, up to the amount of the gain from the sale. If the aggregation of these transactions produces a net gain (after determining the depreciation recapture), it is treated as long-term capital gain provided the assets were held for the requisite time period unless, in the prior five years, there were net losses from such aggregation. If there were net losses, then the net gain for the year is treated as ordinary income to the extent of the prior losses. For this purpose, a net loss of a prior year is disregarded after it has once been used to convert a capital gain to ordinary income in a prior year. If aggregation of these transactions for the year produces a loss, the loss is deducted as an ordinary loss. For capital assets not used in the business, gains are capital gains and losses are capital losses. For individuals, capital losses offset capital gains and up to $3,000 of ordinary income each year. Corporations are not eligible for the $3,000 deduction against ordinary income.
For long-term capital gain treatment in general, assets must be held for more than one year. However, cattle and horses must be held for 24 months or more. For other livestock, they must be held for 12 months or more.
These are just a few of the common questions that seem to predominate concerning the sale of farm assets. Remember, this is just a general overview. There are additional technical rules that might also be involved in some situations.
Tuesday, September 6, 2016
The turn of the calendar to September lets us know that fall is just around the corner. For some rural landowners, that means that various activities will occur where members of the public will be invited to the premises to engage in various activities such as hayrides, corn mazes, and similar activities, often for compensation. When others come onto the farm or ranch, that raises the prospect of injury and potential liability.
In recent years, numerous states have enacted agritourism legislation designed to limit landowner liability to those persons engaging in an “agritourism activity.” Typically, such legislation protects the landowner (commonly defined as a “person who is engaged in the business of farming or ranching and [who] provides one or more agritourism activities, whether or not for compensation”) from liability for injuries to participants or spectators associated with the inherent risks of a covered activity. The statutes tend to be written very broadly and can apply to such things as mentioned above - corn mazes, hay rides and even hunting and fishing activities. Under some provisions, the landowner must post warning signs to receive the protection of the statute, and in some states the landowner must register their property with the state.
Generally, the state laws related to agritourism relate to financial incentives via tax credits or cost-sharing, promotion, protecting the ag real property tax classification of the property involved, or liability protection. On the tax classification issue, the Ohio Supreme Court, in Columbia Township Board of Zoning v. Otis, 663 N.E.2d 377, 104 Ohio App. 3d 756 (Ohio 1995), held that haunted hay rides on farm property did not constitute the use of land for agricultural purposes because the addition of a Halloween theme with shrieks and flashing lights was completely inconsistent with traditional agricultural activity. Similarly, in Shore v. Maple Lane Farms, LLC, 411 S.W.3d 405 (Tenn. Sup. Ct. 2013), the Tennessee Supreme Court reversed a determination by the court of appeals that music concerts on a farm were within the definition of farm activities within the scope of the agritourism statute and were exempt from a county zoning provision. The Tennessee Supreme Court said the activity was not “agriculture” as defined by the statute. Likewise, in Forster v. Town of Henniker, 167 N.H. 745 (2015), the court held that the use of a Christmas tree farm for weddings did not meet the definition of agritourism and, as a result, was not “agriculture” for zoning purposes.
On the liability issue, some state laws (such as the Illinois, Kansas, Maine and Oklahoma provisions) limit liability to situations where the landowner acted wantonly or with willful negligence, and exclude liability for injury arising from the inherent risks associated with an active farming operation. In many of the states that have agritourism statutes, the posting of specific signage is required to get the liability protection and, of course, the person claiming the protection of the statute must meet the definition of a covered person and the activity that gave rise to the liability claim must be a statutorily covered activity. Further, in some states (such as Iowa), liability release forms, at least with respect to minors, may be deemed to violate “public policy” (as decided by judges rather than the public).
In any event, it is important for landowners to become familiar with the particulars of state law.
Friday, September 2, 2016
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 – farmers and ranchers can deduct up to 100 percent of their income. For others, the limit is 50 percent of annual income.
The transaction 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. The governing Code provision is I.R.C. §170(h).
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. Two recent cases illustrate the technical nature of the of just a couple of the myriad of rules that can apply.
In the first case, the petitioner made a charitable contribution a permanent conservation easement on two private golf courses in the Kansas City area in 2003 valued at $16.4 million. The IRS challenged the charitable contribution deduction on numerous grounds, and in an earlier action, the petitioner conceded that the donation did not satisfy the open space conservation test, granting the IRS summary judgment on that issue, with other issues remaining in dispute. At the time of the donation, two banks held senior deeds of trust on the land at issue. Subordination agreements were not recorded until approximately three months after the donation stating that they were effective at the time of the donation. In addition, the petitioner had no power or authority to enforce the easement with respect to a portion of the property due to its lack of ownership of the property. The Tax Court cited Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015) and Minnick v. Comr., 796 F.3d 1156 (9th Cir. 2015) as precedent on the issue that the donor must obtain a subordination agreement from the lender at the time the donation is made. Here, the court held that the evidence failed to establish that the petitioner and the lenders entered into any agreements to subordinate their interests that would be binding under state (MO) law on or before the date of the transfer to the qualified charity. As a result, the donated easement was not protected into perpetuity and failed to qualify as a qualified conservation contribution.
The case is RP Golf, LLC v. Comr., T.C. Memo. 2016-80.
In the second case, the petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the donees were entitled to a proportionate share of extinguishment proceeds. If extinguishment occurred, the donees were entitled to receive at least the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008. Under Treas. Reg. §1.170A(g)(6)(i), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds is the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
The case is Carroll, et al. v. Comr., 146 T.C. No. 13 (2016).
So, the key point with the donation of conservation easements is that they are perpetual. That means forever. If you are giving up rights associated with the property, you can't get those rights back. You also can't retain any right to modify boundaries or move the conservation easement to another property. That was the outcome of another case in 2015 - Balsam Mountain Investments, LLC v. Comr., T.C. Memo. 2015-43.