Friday, October 28, 2016
This week I began the fall tour of various parts of farm country with tax seminars for practitioners. It’s always an enjoyable time to visit with the tax pros and listen to them talk about the tax issues they are dealing with for their clients. This week was the western Kansas swing. These practitioners are the salt-of-the-earth professionals that put in a great deal of effort for their clients, many of which are involved in agricultural production. They also perform a great service to their local communities.
One of the issues that seemed to recur this week involved farm casualty and theft losses. So, that’s the focus of today’s blog post.
Casualty and theft losses are important because of the exposure of farm property to the elements as well as exposure to those who might steal. The basic first principle is that casualty and theft losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.
A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. So, for example, you can’t take a casualty loss deduction for “buyer resistance” to your farm because your neighbor had wind towers put up, or the feds determined that your property has jurisdictional wetlands on it, or it happens to be located near a murder suspect (all actual cases). The issue in a particular case comes down to drawing a line. The line is between what is a casualty and what is ordinary wear and tear. If, for example, a farmer or rancher fails to screw the drain plug into a crankcase and loses all of the oil, or failed to put any oil in the crankcase after draining it and starts down the road, is that a casualty loss or is that ordinary wear and tear when the engine is ruined? In this situation, it really comes down to whether there was willful negligence. If not, then the loss is probably a casualty loss.
In the farm and ranch setting, there are a number of cases involving the improper use of herbicides, flood, frost and freezing, insect damage, drought, fire and wind, all of which are examples of casualty where damage was caused. If the taxpayer can successfully demonstrate that such losses were sudden, unexpected and unusual, the losses will be deductible if the loss was not caused as the result of willful negligence. Losses because of disease or termite damage, for example, are generally not eligible for casualty loss treatment because the loss is progressive rather than sudden. For example, Dutch Elm disease has been repeatedly rejected as a cause of a casualty loss along with most other tree diseases as well.
Theft, on the other hand, is the criminal misappropriation of property. Theft includes larceny, robbery and embezzlement. In one case, an individual purchased a farm, under a sale contract which specified that the well on the premises was a “good producing water well.” Shortly after the buyer obtained possession of the premises, the well went dry. The buyer argued in court that he had suffered a theft loss because the seller misrepresented the well. The court rejected the buyer's argument, ruling that no theft had occurred. The court ruled that there may have been fraud or misrepresentation but not theft giving rise to a deduction. It is usually quite difficult for an event to be considered a theft unless there has been a criminal taking of property as determined by state law. However, courts will allow a theft loss deduction for investors who were defrauded in a real estate investment scheme.
Theft losses are only deductible in the year of discovery rather than the year that the theft occurred. This fact has proved to be one of the major stumbling blocks in the ability to deduct for losses attributable to theft. Many times, people wait around thinking they will find the item that has come up missing, or that it will be returned, only to discover too late that the property was stolen and is not now deductible. Casualty losses, alternatively, are deductible only in the year the damage occurred.
The amount of the deduction for both casualty and theft losses is the lesser of (1) the difference between the fair market value before the casualty or theft and the fair market value afterwards and (2) the amount of the adjusted income tax basis for purposes of determining loss. Obviously, with theft, the item is gone, so the fair market value afterward is zero. Thus, the deductible theft loss is equivalent to the fair market value of the item immediately preceding the time of the theft. However, the deduction can never exceed the basis in the item. Hence, the loss attributable to theft or casualty is the lesser of the difference of the fair market value before and after or the basis in the item. In effect, the measure of the loss is the economic loss suffered limited by the basis.
A similar principle applies for crops lost immediately before harvest due to a catastrophic event. If the taxpayer deducted the cost of raising the crop, the income tax basis in the crop is zero and the deductible loss is zero. The part that has been through the tax mill once cannot be run through a second time.
For property held for non-business use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of adjusted gross income (unless the loss was a result of certain hurricanes). Since 1983, non-business losses have been deductible only to the extent total non-business casualty and theft losses exceed 10 percent of the taxpayer's adjusted gross income. However, each casualty or theft loss of non-business property continues to be deductible only to the extent the loss exceeds $100.
Personal casualty gains and losses (from non-business property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent adjusted gross income floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.
Unfortunately, casualty and theft losses are not that uncommon for farmers and ranchers. But, for those that sustain them, the tax rules do allow a recovery through the tax code of some of the value that has been lost.
Wednesday, October 26, 2016
The economic circumstances in agriculture presently are disturbing. The financial situation in the agricultural economy has changed considerably over the past 18 months to two years. For instance, in Kansas, 2015 average net farm income was the lowest since 1985. Crop prices are down and the cost of production has gone up. This has had a significant impact on many farmers’ ability to repay debt. Repayment capacity is an important issue, and an erosion of a farmer’s working capital negatively impacts financing. This all means that some farmers (and their lenders) either have already made or will soon be making some very difficult decisions before the spring of 2017.
One possible decision is to restructure debt via the filing of a Chapter 12 bankruptcy petition. That’s the bankruptcy reorganization provision that was enacted during the throes of the last significant debt crisis in agriculture 30 years ago. But, what does it take to be eligible for Chapter 12 bankruptcy? Do you really have to be a farmer? It seems like an obvious question. But, is the answer simple? That’s the subject of today’s topic.
What is a “Family Farmer”?
To be eligible for Chapter 12 bankruptcy, a debtor must be a “family farmer” or a “family fisherman” with “regular annual income.” The term “farming operation” includes farming, tillage of the soil, dairy farming, ranching, production or raising of crops, poultry, or livestock, and production of poultry or livestock products in an unmanufactured state. 11 U.S.C. §101(21). A “family farmer” is defined as an individual or individual and spouse who earned more than 50 percent of their gross income from farming either for the taxable year preceding the year of filing or during the second and third tax years preceding filing (a different rule applies to a “family fisherman) and whose aggregate debts do not exceed $4,153,150 (a lower threshold applies for a “family fisherman”). In addition, more than 80 percent of the debt must be debt from a farming operation that the debtor owns or operates.
To be eligible, more than 50 percent of an individual debtor’s gross income must come from farming in either the year before filing or in both the second and third tax years preceding filing (a different rule applies to a “family fisherman”). This provision seeks to disqualify tax shelter and recreational farms from Chapter 12 protection.
The Need For Farm Income
The farm income test is to be applied at the time of bankruptcy filing. That means that the determination of whether a debtor is a farmer that is engaged in farming is made at the time the bankruptcy petition is filed. Likewise, the determination of whether the debtor has the intent to continue farming is made at the time of filing also. See, e.g., In re Nelson, 291 B.R. 861 (Bankr. D. Idaho. 2003). Indeed, 11 U.S.C. §101(18), says that a “family farmer” is an individual and spouse “engaged in in a farming operation…”. Or, at least that was the thinking…
In a recent case, In re Williams, No. 15-11023(1)(12), 2016 Bankr. LEXIS 1804 (Bankr. W.D. Ky. Apr. 22, 2016), the court reached the conclusion that a debtor that was not currently actively engaged in farming and did not intend to return to farming was eligible to file Chapter 12. Shortly after the petition was filed, the debtors (a married couple) had last farmed two years earlier and notified the creditors that they had no intent of farming again. Instead, their son planted and harvested the crops. Based on those facts, the bankruptcy trustee claimed the debtors were ineligible for Chapter 12. But, the debtors claimed that they had just made a reasonable choice to end a farming business that was no longer profitable.
But, you say, “I thought the purpose of Chapter 12 is to keep farmers on the farm by allowing them to scale their operation down, write off some debt and pay off the balance over time while continuing farming?” You are correct. That is the legislative intent behind Chapter 12. Take a look at 132 Cong. Rec. at S15076 (Oct. 3, 1986). However, the Williams court took note that there was no specific requirement in the Bankruptcy Code that the regular income to fund the Chapter 12 reorganization plan need come specifically from farming. It just had to be stable and regular. The court noted that 11 U.S.C. §101(19) requires a debtor to have regular income sufficient enough to enable the debtor to make plan payments, and that its definition of “family farmer with regular income” meant that the income only be sufficiently stable and regular to enable the debtor to make plan payments. It didn’t require the income to be generated from farming activities. So, the debtors didn’t have to be engaged in farming at the time they filed Chapter 12 and, apparently, they also didn’t have to have any intent to return to farming.
What about funding the reorganization plan? Do the funds required to fund the plan have to derive from farming? Williams would indicate that the answer to that question is “no” and there is some support for that. For example, one court has held that the bankruptcy code does not require that a farmer who meets the pre-petition farm income test must have sufficient farm income to fund the Chapter 12 plan. In In re Sorrell,386 B.R. 798 (Bankr. D. Utah 2002), the debtors, husband and wife, owned two farms which were used for crops and raising livestock. Their Chapter 12 plan provided for modified payment of secured claims and about 10 percent of the unsecured claims. The plan was funded with the wife’s income as a loan officer, the husband’s income from off-farm employment, disability payments, farm subsidies and some cash from asset liquidation. A secured creditor objected to the plan, arguing that the debtors were not eligible for Chapter 12 because the plan was not funded from farm operations. The farm had a profit of only $19 per month. The court held that the definition of family farmer required only that the debtor have regular income, not that the income be necessarily derived from the farm. Another court has held that a Chapter 12 debtor whose reorganization plan proposed the debtor’s discontinuing farming and enrollment of all of the debtor’s farmland in the Conservation Reserve Program was not ineligible for Chapter 12 relief. In re Clark, 288 B.R. 237 (Bankr. D. Kan. 2003).
These seem to be odd results based on the legislative intent behind Chapter 12. However, for farmers that are experiencing severe financial difficulties that are not likely to actually continue in farming, reorganization of debts under Chapter 12 might still be a possibility. That could be a more favorable option than utilizing a different reorganization provision of the bankruptcy code or filing a liquidation bankruptcy.
Just something to think about for those that might have to make a difficult decision come spring.
Monday, October 24, 2016
It is not uncommon for farmers to encounter the need to have their farm assets valued. Lenders, for instance, have a keen interest in understanding the value of assets utilized in the farming operation. Also, valuation is an issue when estate, business and succession planning is engaged in. What are the valuation issues that are associated with estate and business planning for farmers and ranchers? I have had this discussion recently with an Iowa practitioner that has dealt with farm clients for many years. Today’s blog post is a summary of his thoughts on the matter and my additional insights.
Real Estate Valuation
Farmland is typically the asset of largest value in a farmer’s estate. That makes it important to arrive at an accurate measure of market value. The starting point is to correctly denote the number acres. What are the total acres? What are the taxable acres? What are the tillable acres? Often “total acres” defines the total area within a legal description and makes no reference to quality or any restrictions on title, such as easements. “Taxable acres” is tied to assessed acres, and “tillable acres” are those that are used in crop production. Recent developments in technology have made it easier to more accurately determine tillable acres, and certifications to the USDA can also determine tillable acres. But, “tillable acres” does not include areas that can’t be farmed – waterways, fence rows, timber land, creeks etc. Make sure that the valuation is accurately measuring the type of land at issue and breaks it out properly.
Make sure that legal descriptions are accurate. Local government offices such as the County Recorder and County Auditor can be helpful on this. They can review a legal description and should be able to determine if any part of the legal description has been transferred. They can also help to determine how the land at issue is owned – individually, in some form of entity, in fee simple, in life estate, etc.
For farmland, zoning issues are usually not a big deal. But, if an airport is nearby there could be issues that come into play that would restrict the height of structures on the property. That could impact the ability to erect a cell tower, aerogenerator, or even impact the use of drones on the property.
Getting some type of formal valuation of farmland is critical to gaining a proper understanding of the land’s worth for planning purposes. One approach is to use a certified appraisal, while another approach is to use an estimate of selling price based on comparable sales. In any event, some attempt needs to be made to get an accurate view of the land’s fair market value. Land markets are tricky and appraisals have their drawbacks and may need to be supplemented with additional data that might not be incorporated into the appraisal, such as local buyer strength, distance to local markets and similar features. I remember, a situation a couple of decades ago when farmland values in a rather larger part of a particular area of the Nebraska Sandhills were blown way out of proportion by an individual from out of state that was buying up farm and ranchland and paying prices that no local farmer would even consider paying. So, watch out for those unique characteristics.
Valuing livestock is usually not as difficult as valuing land. Daily market prices exist for just about all types of livestock. The key is to make sure to understand and properly note differences in livestock with respect to gender, and whether the livestock are to be used for breeding, dairy or meat production purposes. So, if you know your categories and weight ranges in those categories you will get an accurate picture of value. Also, livestock can be affected by health issues and catastrophes that can wipe out value very quickly. Think “Bird Flu” here.
It is easy to come up with an accurate value for most agricultural crops. They are valued in a similar fashion to the valuation of livestock. There is a daily market price that is readily accessible. But, factors that can influence the daily market price would be quality and the cost to deliver the commodity to market. Valuing fruits and vegetable can be a bit trickier. Most of those types of agricultural crops do not have any reliable daily market price, and there may not be any type of reasonable guarantee that the fruit or vegetable can be sold at its highest valued use. Many of these crops are sold via production contract, so that can determine value, but there are risks associated with production contracts that can affect value, such as the contracting processor terminating the contract. Also, valuation issues can arise when growing crops need to be valued, perhaps because of the death of the farmer. Some states, such as Iowa, have specific regulations that apply to establish the value of growing crops. The IRS also has regulations that provide guidance in this area. Relatedly, predicting harvest yields is highly speculative. But, it might be possible to use the amount of the potential harvest that is insured as a basis for determining a yield when valuing a growing crop.
I have blogged previously about the recent Treasury Department regulations that have been proposed that would deny minority discounts in family-controlled entities. In recent decades, discounts for minority interest and lack of marketability have been recognized by the courts as a necessary element in arriving at the true fair market value of a gifted or inherited interest in a family business. But, the proposed regulations would foreclose many, if not all, of those planning opportunities. It’s the Treasury’s attempt to redefine value in just about any manner that it wants, and is a movement away from the time-tested (and judicially validated) willing-buyer/willing-seller test. If the Treasury insist on finalizing the rules in their present form, you can expect court challenges that will take years to arrive at a final determination on their validity.
Valuation issues arise often in agriculture. Land is the big item to determine value accurately to the best of one’s ability. Crops and livestock are usually fairly easy to get an accurate valuation, at least for Midwest type agricultural crops. But, as always, good valuation numbers will help for financial, tax, and estate, business and succession planning purposes.
Thursday, October 20, 2016
Before 2013, the estate planning technique for persons with modest to high wealth was to engage in planning techniques that would ensure the sufficient amounts of property would not be included in the gross estate at death. That’s because the estate tax exemption was less than it is now and the federal estate tax rate was higher. However, with a law change that took effect at the beginning of 2013, the federal estate tax exemption was increased to five million dollars per decedent, became coupled with the gift tax exclusion and was also indexed for inflation. In addition, the estate tax exemption was made portable between spouses by election. The inflation-adjusted exemption presently is $5.45 million per decedent. For most people, that means that the federal estate tax is largely a non-issue. Some states do impose taxes at death, however, and those that do typically have lower exemptions than the federal exemption. That’s a concern for those either living or having property in those states at the time of death.
Planning for a Basis Increase
So, while federal estate tax may not be an issue, income tax basis is a big issue. Because of the relatively high level of the exemption, a planning strategy for many might be to deliberately cause inclusion of property in the estate at death so that the heirs can get an income tax basis in the property equal to its fair market value at the time of the decedent’s death. A couple of common techniques for getting a basis step-up involve life estates and powers of appointment.
If an individual makes a gift of property, but keeps some powers over the property, those retained powers will pull the property back into the donor’s estate. The retained power to revoke, alter, amend or terminate the transfer causes inclusion of the property subject to the power in the transferor’s estate. For example, a parent may gift a farm or ranch to the children during life, but retain the right to income for life. This retained right to the income pulls the property back into the parent’s gross estate with the result that the heirs will get a stepped-up basis in the property equal to its fair market value at the time of the parent’s death. While the property would potentially be subject to federal estate tax in the parent’s estate, the $5.45 million exemption will likely eliminate any federal estate tax.
For those that have larger estates where federal estate tax might be a concern, rather than gifting property and retaining a life estate, the strategy might be for the parents to sell the remainder interest in the farm or ranch to the children, but retain a life estate interest in the transferred property. If the sale of the remainder interest is bona fide and is for full and adequate consideration, the value of the retained life estate should not be included in the seller’s gross estate upon death. The IRS prescribes tables that can be used to value the remainder interest, with the value depending upon the seller’s life expectancy. The IRS historically took the position that the sale of a remainder interest at its actuarial value requires the retained life estate to be valued in the seller’s estate at its date of death fair market value less the value of the remainder interest that was sold. However, the U.S. Courts of Appeal for the Third, Fifth and Ninth Circuits have rejected that position and have held that the bona fide sale of a remainder interest for its actuarial fair market value did not cause the value of the retained life estate to be included in the decedent’s gross estate.
Power of Appointment
The gross estate also includes property over which the decedent possessed a general power of appointment. That’s the power to direct the distribution of another person’s property. There are two different types of powers of appointment. One is called a “general power.” With a general power of appointment, the holder gets the power to designate who gets the property subject to the power, including the holder. The power is exercisable in favor of the holder of the power, the holder’s estate, the holder’s creditors, or creditors of the holder’s estate. A general power is fully taxable because it pulls all of the property subject to the power into the power holder’s estate. On the other hand, a form of a special power is one that is limited by an ascertainable standard (health, education, welfare or maintenance). The property subject to such a power is not taxed in the power holder’s estate. The drafting language that is used with the intent to create an ascertainable standard is critical. In general, a special power of appointment is a power exercisable in favor of anyone except the holder of the power, that person’s estate, that person’s creditors or the creditors of that person’s estate or a power limited by an ascertainable standard, such as health, education, support or maintenance. Again, the property subject to a special power of appointment is not taxable to the holder of the power.
Gifts Within Three Years of Death
It is also possible to cause property to be included in a decedent’s estate by gifting an asset too close in time to death. For gifts made before January 1, 1977, all transfers made within three years of death that were “in contemplation of death” were included in the gross estate. All gifts made within three years of death for persons dying after 1976 and before 1982 were included in the gross estate unless a federal gift tax return was not required to be filed. For deaths after 1981, the three- year rule applies only in specified instances. These instances include situations where (1) the decedent retained a life estate in the property, (2) the transfer is to take effect at death, (3) the transfer is revocable, or (4) the transfer involves a transfer of ownership in a life insurance policy on the decedent’s life. For some people, this rule comes into play with respect to life insurance. If life insurance ownership is transferred by gift from the insured within three years of the insured’s death, the full amount of the face value of the policy is included in the insured’s gross estate. For example, if a husband buys a policy that insures his life and then gifts the policy to his wife and dies two years after making the gift, the entire value of the policy will be included in his estate. Similarly, if the husband makes a cash gift to his wife and the wife uses the cash to buy a life insurance policy on her husband’s life and the husband dies six months later, the policy proceeds are included in his estate if the transfer is one “with respect to an insurance policy.” So, if the idea is to not cause inclusion in the estate, then the cash gift should not equate to what is needed for the insurance premium payment, and the cash should not be gifted immediately before the premium due date. Alternatively, if the wife buys a policy on her husband’s life, but the husband pays the premium each year and dies within three years of the wife’s purchase, the proceeds are not included in the husband’s estate.
There are other techniques that can be used to cause inclusion of property in the decedent’s estate, including disclaimer wills and joint exempt step-up trusts. Inclusion of property in the estate has become a big deal after 2012. The federal estate tax is a big deal when it applies, but it applies in relatively few instances. However, everyone is concerned with income tax basis.
Just some things to think about when you next update your estate plan.
Tuesday, October 18, 2016
In early 2011, the Food Safety Modernization Act (FSMA) was signed into law. The FSMA give the Food and Drug Administration (FDA) expansive power to regulate the food supply, including the ability to establish standards for the harvesting of produce and preventative control for food production businesses. It’s the largest expansion of the U.S. food safety law since the 1930s. The FSMA also gives the FDA greater authority to restrict imports and conduct inspections of domestic and foreign food facilities. To implement the requirements of the FSMA, the FDA prepared in excess of 50 rules, guidance documents, reports and studies in short order. Indeed, the timeframe was so short FDA complained that they didn’t have enough time to do the job appropriately. That led to lawsuits being filed by to compel the FDA to issue several rules that were past-due. A federal court agreed in the Spring of 2013, and FDA issued four proposed rules with comment periods ending in November of 2013. One of the most contentious issues involved the rule FDA was to develop on intentional adulteration. FDA claimed it needed two more years to develop an appropriate rule, but the Court ordered them to develop it immediately.
When the 2014 Farm Bill came along it failed to repeal the FSMA. Instead the Farm Bill simply directed the Secretary of the Department of Health and Human Services to conduct an economic analysis of the FSMA when publishing a final rule on “Standards for the Growing, Harvesting, Packing, and Holding of Produce for Human Consumption.” Consequently, the FDA issued seven major rules beginning in late 2015 and ending this past May. It appears that the intent of the rules is to focus on the prevention of food safety risks instead of dealing with problems after they occur. The rules also present various practical issues in their application, enforcement, and how they relate to the food supply chain.
Summary of New Regulations
In a nutshell, the new rules, establish a system of preventative controls for facilities that deal with food products (and taxes them to pay for the increased regulatory cost) as well as mandatory safety standards for farming activities involving certain types of farm products – primarily fruit and vegetables (as well as dog food). The rules govern soil and water, hygiene, packing, temperatures and also dictate certain grazing practices of livestock.
While space here doesn’t allow a detailed look at the new regulations, here’s a breakdown of the major provisions:
- The rules establish national standards for on-farm growing, harvesting, packing and storage of domestic and imported produce.
- Covered parties must verify and either provide or receive documentation with respect to food safety risks if they are involved in the food supply/distribution chain and sometimes verification has to be obtained from parties several steps back in the supply chain.
- A covered facility must develop a written food safety plan that identifies hazards that are in need of preventative controls (in addition to any existing Hazard Analysis and Critical Control Plan (HACCP)) to minimize or prevent hazards for food that is manufactured, processed packed or stored at the facility.
- Raw materials or ingredients can only be obtained from an approved supplier, and the burden is on a manufacturer or processor to make sure that the suppliers that they get food products from are following acceptable protocols to make sure that food safety hazards are controlled.
- The preventative controls require food processors to develop and implement written plans that identify hazards that are likely to cause illness or injury based on the severity of any illness that might result and the likelihood that it would occur if the controls weren’t in place; guidance is needed on the severity and probability thresholds. Exempt are seafood or juice processors and some farms.
- Manufacturers and processors must document that they searched the FDA’s public database to make sure that a supplier is in good standing with FDA protocols, and must have procedures in place for receiving raw materials and other ingredients from approved suppliers.
- A written food safety plan must be produced within 24 hours of demand.
- A “produce safety rule” applies to farms that grow or harvest crops or raise animals in one general area, and the rule is expansive enough that it covers cooperatives, on-farm packinghouses, food aggregation and minimal “manufacturing” or “processing” activities, and off-farm packing at “secondary” activities.
- Under the “produce safety rule” a covered farm must inspect and maintain the integrity of its water sources, and take corrective action when necessary, and identify and not harvest produce that is reasonably likely to be contaminated.
- Exemptions exist for “small” farms – defined as those with average annual revenue of less than $25,000 during the previous three-year period, as well as those with average food sales of less than $500,000 annually during the prior three years that sell “predominantly” to “qualified end-users” (restaurants or retail food establishments in the same state or within a 275-mile radius have less stringent requirements imposed).
- Another regulation requires the FDA to implement a program to ensure that imported food is produced in compliance with processes that provide the same level of safety protection that is required of U.S. facilities, and FDA must perform audits to ensure the safety of imported food products.
- Another regulation establishes sanitary rules that apply during transport of food products, and the rules apply to “freight brokers” and “loaders” as covered parties. Basically, shippers will have to communicate their food safety requirements (including operating temperature) to carriers with respect to equipment, operations and training. Written policies will have to be put in place, and carriers will have to document that they are in compliance with the new rules. Failure to do so could result in fines and, perhaps, criminal sanctions. But, the rules don’t apply to transportation activities of entities with less than $500,000 in average annual revenue, and also don’t apply to foods that are entirely enclosed by a container or to certain types of animal foods. USDA facilities are also exempt, and other exemptions apply to relatively smaller businesses.
- There is a “food defense rule” that requires large food companies to come up with plans to assess and manage the risk of intentional adulteration that is intended to cause wide-scale public harm.
- An animal food rule establishes preventative control programs for animal food processors. Again, certain farms are exempt.
The new regulations are generally located at 80 Fed. Reg. 56169 and are contained in 21 C.F.R. Part 117 and various subparts thereof. The sanitary transport rule is contained at 81 Fed Reg. 20091, and mitigation strategies (the Food Defense Rule) are contained at 80 Fed. Reg. 34165. They are generally effective on April 6, 2017, but there are phase-in dates based on business size and other factors that can make the effective date later in certain situations.
While there have been some significant and highly publicized foodborne illness events in recent years, there is no doubt that the U.S. food supply is safe. Indeed, the Centers for Disease Control and Prevention says that the U.S. Food Supply is one of the safest in the world. However, the Administration directed the FDA to significantly expand regulations on farmers, shippers, packers, manufacturers and others in the food supply chain. I can’t find where any cost-benefit analysis was engaged in to determine whether the additional cost that will ultimately be imposed disproportionately on consumers, small farms and local food producers is justified economically. I also can’t find that the government had any evidence that the rules would actually address a major problem with food safety and reduce illnesses caused by food. Only time will tell whether the increased regulation of food production activities actually accomplishes anything other than subjecting the food production chain to further regulations.
Friday, October 14, 2016
One of the big desires of older farm couples or surviving spouses is to stay in the farm home as long as possible. I had a call not long ago from a farmer’s son who was asking about legal and tax issues associated with in-home care for his father. The son, who was farming the family operation, was 75 and his father was 98. The father didn’t want to leave the homestead and go to a nursing home. He wanted to stay involved in providing input in farming decisions. However, the son knew that his father’s care was getting to be just about too much to handle for he and his wife (who were both in their mid-70s). He clearly understood his father’s desire to physically stay in the farm home, but was struggling with the realities of the level of care that his father needed. He was also concerned about the cost of nursing home care (which can often exceed $70,000 annually). So, he was checking into in-home care. It became apparent after talking with him for a while that he wasn’t talking about hiring someone to come in for an hour or so on a daily basis. His father was in need of care all day long, as well as through the night. He said that he had a sister that was licensed as a nurse and was willing to leave her current nursing job to take care of their father if they could work out an arrangement.
In today’s blog post, I examine a few of the things I mentioned over the phone that day, and throw in a few additional items I didn’t address in that phone conversation.
The sister’s willingness to take care of their father is certainly noble. But, what are the issues surrounding her hiring as the caregiver? Perhaps the starting point when employing a senior caregiver are the rules governing a household employer. It’s a different ballgame in many respects from being an employer in a commercial business setting. What you get into are the rules surrounding household employer obligations, worker classification, gross/net pay, and overtime. In addition, the IRS and the applicable state tax folks also get involved.
So what do you need to do when you hire a caregiver as an employee? For starters, you will have to register for federal and state taxpayer identification numbers. Once you have the federal number, then you can apply for the state number that you will need to properly deal with state unemployment insurance taxes and (in most states) state income tax. There probably is also a report that has to be filed with the state concerning the new hire. The state will use that report in tracking employment numbers. You will also have to set up a payroll so that FICA tax can be properly withheld and, perhaps, income tax. In some states, you have to provide details with respect to each payment concerning the number of hours worked and whether there was any overtime. Also, since you are now an employer, you will have to make sure that state tax returns are filed and that you remit the employer and employee taxes. The same goes for federal tax returns although the federal employment taxes are paid a bit differently. In addition, year-end tax documents will have to be prepared. Keep in mind, calculating payroll tax can get confusing when the caregiver stays around-the-clock. In that case, federal law says that up to eight hours can be treated as sleeping time (non-compensable). But, to get that treatment, the caregiver has to agree to the arrangement in writing and a place to sleep must be provided and the caregiver must get at least 5 straight hours of sleep without interruption.
Schedule H (Form 1040) must be filed if you pay any one household employee cash wages of $1,900 or more (in 2015), or withheld federal income tax for the year for any household employee, or paid total cash wages of $1,000 or more in any calendar quarter to all household employees.
As for overtime, a household employee has to be paid overtime if they work over 40 hours in a 7-day week. “Companion care” hours don’t count, just those hours devoted to household or medical work. So, time spent playing a mean game of Chinese checkers with the person being cared for doesn’t count toward overtime hours. On this point, starting in 2015, a caregiver that works for a third-party company does get overtime. But, in the situation I was presented with by the caller, his sister wouldn’t get overtime pay for the “companion care” hours.
A good IRS publication to review is Pub. 503 (Child and Dependent Care Expenses). In Pub. 503, you can read about the adult child (as the employer) being able to take a deduction for dependent care expenses (assuming that the parent is a “qualified person”). Also, in Pub. 502, there is an explanation of the medical care tax deduction. There also might be the chance to pay for medical care with pre-tax dollars via a flex-spending account. But, to be able to do that, numerous hurdles must be cleared.
As you can see, this can get complex quickly. But, with appropriate planning and the use of tax and legal professionals, it just might be possible to allow a senior member of the farm family to stay in the farm home longer. For some, it might just be worth the additional hassle. That’s especially true, if long-term care planning has not been engaged in advance of the need to enter a nursing home. Also, it’s been suggested to me that in the farm context, some people treat in-home care providers as farm employees. That might be reasonable if the farm is incorporated and the farm owns the house. On this note, it might be plausible to argue that it is necessary for the elderly parent to remain in the home to provide a presence on the farm around-the-clock to deter vandals and thieves, and to keep an eye on the animals and call for help if they get out of their enclosures.
I also suspect that tax reporting in the caregiver arena is not done appropriately in a good proportion of instances. I don’t know for sure. That’s just my suspicion.
In any event, incorporating long-term care planning into an overall estate plan is an excellent idea. Related to that, acquiring long-term care insurance might be an appropriate step for some. The problem with long-term care insurance, however, is that those that can afford it don’t need it and those that need it can’t afford it!
I am not sure what the caller did after we hung-up that day. I haven’t heard back. Hopefully, I was able to provide some food for thought and not simply confuse the issue and scare him away from investigating further. Also, I hope that his father is still on the farm and enjoying the sights and sounds of another fall harvest.
Wednesday, October 12, 2016
Interestingly (at least to me), at many of my tax seminars this year, practitioners have expressed interest in the new tax provision governing the donation of food items to charity. On the articles page of my website (www.washburnlaw.edu/waltr), I posted an article on this issue on July 6, 2016, authored by Chris Hesse. Chris is a Principal in the National Tax Office of CliftonLarsonAllen, LLP in Minneapolis. Today’s post is a quick summary of that article and also involves some of the questions about the provision that have come up at tax seminars over the summer and fall.
Normally, a farmer wouldn’t be able to claim a deduction for food products that are donated to charity. That’s because the farmer doesn’t have any tax basis in the food items. The costs of raising the products have already been deducted, leaving no basis. But, there is a provision that is in the Code now that provides for a tax basis in food items resulting in a charitable deduction possibility. Under this provision (it’s contained in I.R.C. §170), it doesn’t matter what business form the farmer conducts the farming business in, and the food must be “wholesome.” Its value is tied to the price at which the items would sell for.
Under the new rule, for farmers on the cash method, the charitable deduction is one-half of the fair market value of the contributed food item. That’s the starting point. Under the late-2015 legislation, the deemed tax basis is 25 percent of the food’s fair market value. This is the rule starting in 2016. Before 2016, a farmer with zero basis inventory couldn’t get any charitable deduction for a contribution of those items.
The food items must be donated to a certain type of charity for the donor to be able to claim a charitable deduction. This point has generated numerous questions and practitioner interest at the seminars. The charity must be one that uses the food to further its charitable purpose or function in caring for the ill, needy or infants. So, what kind of charity is that? Certainly a food bank would qualify. But what other types of charities would qualify? How about a soup kitchen? Would a homeless shelter be a qualified charity? The answer basically comes down to whether the use of the food by the charity is essential to the charity’s exempt purpose.
Among other requirements, the donor can’t receive any goods or services in exchange for the donation. Also, the typical charitable contribution rules must be followed. Thus, because in-kind property is being donated to charity rather than cash, the charitable organization must provide a written statement that shows that the use and disposition of the donated items will be in accordance with the charity’s exempt purpose, and denotes that the other requirements are also satisfied.
So how big of a deduction can be claimed by a donating farmer? The limit is 15 percent of the taxpayer’s aggregate net income for the year from the trade or business from which the contributions were made. When computing that amount, don’t take into account the charitable deduction itself. So, for a farmer, that donates food from the farm business, the 15 percent limit would be applied to the farmer’s Schedule F income by itself. It wouldn’t include non-farm business income that is reported on other Schedules. One issue where clarification is needed is whether a farmer’s sale of a Schedule F depreciable asset that is reported on Form 4797 triggers gain (or loss) that is part of the Schedule F business income for purposes of the 15 percent limitation. For C corporate donors, the limit is 15 percent of taxable income determined without regard to charitable contributions. Different rules apply to other types of corporate charitable contributions.
While not explicitly clear in the statute, it does appear that the deduction provision applies to any type of taxpayer. So, if that’s right, there are numerous types of taxpayers that could potentially qualify for the deduction upon the donation of wholesome food products to the right type of charity. For instance, a taxpayer that owns fresh food that is packed for shipping could get the deduction. The same is true for a grower of fresh produce that sells the produce at a farmers’ market, but has food items left over. Also, many taxpayers involved in the production process of fresh fruit or vegetables can potentially use the provision. For a grocery store that has leftover food products (that meet the “wholesome” requirement), they are likely to be on the accrual method and will have to determine the reduction from fair market value to derive the amount of the charitable deduction that they can claim.
Take a look at this new provision. You may have some clients that can benefit from it that couldn’t have in the past.
Monday, October 10, 2016
One of the areas of “low-hanging fruit” for IRS auditors in recent years involves the issue of reasonable compensation in the S corporation context. Salary that is too low in relation to the services rendered results in the avoidance of payroll taxes. So, when shareholder-employees take flow-through distributions from the corporation instead of a salary, the distributions are not subject to payroll taxes (i.e., the employer and employee portions of Federal Insurance Contributions Act (FICA) taxes and the employer Federal Unemployment Tax Act (FUTA) tax. In accordance with Rev. Rul. 59-221, S corporation flow-through income is taxed at the individual level and is (normally) not subject to self-employment tax. Also, in addition to avoiding FICA and FUTA tax via S corporation distributions, the 0.9% Medicare tax imposed by I.R.C. §3101(b)(2) for high-wage earners (but not on employers) is also avoided by taking income from an S corporation in the form of distributions. These are the tax incentives for S corporation shareholder-employees to take less salary relative to distributions from the corporation. With the Social Security wage base set at $118,500 for 2016, setting a shareholder-employee’s compensation beneath that amount with the balance of compensation consisting of dividends can produce significant tax savings. The savings will likely increase in 2017. It is currently projected that the Social Security wage base will be $126,000 in 2017.
Who’s an “Employee”?
Most S corporations, particularly those that involve agricultural businesses, have shareholders that perform substantial services for the corporation as officers and otherwise. In fact, the services don’t have to be substantial. Indeed, under a Treasury Regulation, the provision of more than minor services for remuneration makes the shareholder an “employee.” Once, “employee” status is achieved, the IRS views either a low or non-existent salary to a shareholder who is also an officer/employee as an attempt to evade payroll taxes. If a court determines that the IRS is correct, the late payment penalty is 10 percent. The penalty on the person responsible for withholding and paying the tax is 100 percent of the taxes owed if the employer fails to pay the tax. Of course, the burden is on the corporation to establish that the salary amount under question is reasonable.
Before 2005, the court cases involved S corporation owners who received all of their compensation in form of dividends. Most of the pre-2005 cases involved reclassifications on an all-or-nothing basis. In 2005, the IRS issued a study entitled, “S Corporation Reporting Compliance.” Now the courts’ focus is on the reasonableness of the compensation in relation to the services provided to the S corporation. That means each situation is fact-dependent and is based on the type of business the S corporation is engaged in and the amount and value of the services rendered.
So what are the factors that the IRS examines to determine if reasonable compensation has been paid? Here’s a list of some of the primary ones:
- The employee’s qualifications;
- the nature, extent, and scope of the employee’s work;
- the size and complexities of the business;
- a comparison of salaries paid;
- the prevailing general economic conditions;
- comparison of salaries with distributions to shareholders;
- the prevailing rates of compensation paid in similar businesses;
- the taxpayer’s salary policy for all employees; and
- in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.
According to the IRS, the key to establishing reasonable compensation is determining what the shareholder/employee did for the S corporation. That means that the IRS looks to the source of the S corporation’s gross receipts. If they came from services of non-shareholder employees, or capital and equipment, then they should not be associated with the shareholder/employee’s personal services, and it is reasonable that the shareholder would receive distributions as well as compensation. Alternatively, if most of the gross receipts and profits are associated with the shareholder’s personal services, then most of the profit distribution should be allocated as compensation. In addition to the shareholder/employee’s direct generation of gross receipts, the shareholder/employee should also be compensated for administrative work performed for the other income-producing employees or assets. As applied in the ag context, for example, this means that reasonable compensation for a shareholder/employee in a crop farming operation could differ from that of a shareholder-employee in a livestock operation.
For those interested in digging into the issue further, I suggest reading the following cases:
- Watson v. Comr., 668 F.3d 1008 (8th Cir. 2012)
- Sean McAlary Ltd., Inc. v. Comr., T.C. Sum. Op. 2013-62
- Glass Blocks Unlimited v. Comr., T.C. Memo. 2013-180
- Scott Singer Installations, Inc. v. Comr., T.C. Memo. 2016-161
Each of these cases provides insight into the common issues associated with the reasonable compensation issue. The last two also address distributions and loan repayments in the context of reasonable compensation of unprofitable S corporations with one case being a taxpayer victory and the other a taxpayer loss.
In the context of an S corporation, "reasonable compensation" is defined in terms of the services that the S corporation owner provides on behalf of the S corporation. There is no safe harbor. So, close is not good enough. Do your homework, keep good records and revisit the issue on an annual basis. If you do that, you will have a much better chance of withstanding an IRS audit if they examine the issue.
Thursday, October 6, 2016
In the 1990s when ag production contracts were more in the ag law news than they are now, I remember visiting with Washburn Law School Professor Jim Wadley on the subject because I was getting numerous calls from farmers about perceived (and real) contract abuses. I wanted Jim’s thoughts on the issue so that I could respond to the inquiries and also because I was beginning my research for what would become my college/law school text on agricultural law. Jim was a big help in framing the issues for me. He was working on a book on Kansas ag law at the time with Sam Brownback (now the Governor of Kansas) and many of his thoughts ended up in his book. I dusted off my notes from that original conversation the other day and also revisited the topic in the contracts chapter of my book after getting a couple of new emails on the issue. So, today’s blog post focuses on the issue and also illustrates how relevant Jim’s thoughts from two decades ago remain.
Crop farmers and livestock producers often enter into contracts with a vertically integrated processor to raise animals for the processor that meet a particular quality requirement. These contracts are known as “production contracts.” They are different from forward contracts. Forward contracts are entered into for tax and marketing purposes, but production contracts largely form the entire foundational basis for the farming operation. A producer may enter into a production contract if there is a belief that the market for his production isn’t stable either in terms of buyers or in terms of price.
Pros and Cons
So, what are the primary advantages and disadvantages of a production contract? They do tend to reduce the capital investment requirements, and economic returns tend to be more predictable. Similarly, less operating capital is required, and better use of available labor and facilities might result. Conversely, the big disadvantages include the producer losing control over management, and a limit on the return from the operation. Also, the facility use is not guaranteed and economic returns may not equal facility costs or replacement costs. Another possible negative factor is that the producer does not own the animals, but the producer could be liable for any death loss.
Many ag production contracts authorize the processor or an agent to inspect the producer’s facilities at any time and require any changes the processor deems necessary. Those changes can include such things as material changes in the facility (without any assurance or guarantee of a future contract); processor control over feeding rations and medication; and delivery at a particular time irrespective of market price at that time.
When it comes to a production contract, what should a producer know? The following are suggested items that a producer should have information on before the contract is signed:
- Which party is responsible for the cost of production inputs such as feed, medicine, transportation, facility upkeep, water, labor and utilities, and marketing costs;
- The extent of the processor’s right to enter and inspect the premises and require changes in the facilities;
- The extent of the producer’s control over the health and quality of the animals that the processor delivers to the producer;
- The extent of the producer’s control of the daily activity of raising the animals and whether there will be field employees of the processor who will serve as supervisors of the producer’s activity;
- How payment is to be made? There are various ways that the economic structure can be set up - flat fee per animal; the number of days that it will take to raise the animals; the final weight of the animals; a guaranteed price that is tied to cost per pound; or a profit-sharing arrangement;
- The manner in which marketing decisions are to be made and the party that is to make them;
- The circumstances and conditions under which the contract may be broken and the resulting consequences if there is a breach;
- The party that controls the quality and quantity of feed;
- Whether the processor will receive any liens on the property of the producer as a result of the contract.
Broder Economic Concerns
Clearly, very few farmers have anywhere near the level of bargaining power that the contracting firm (such as a seed supplier, livestock supplier or meatpacker) has. Consequently, the contracting firms can be expected to capture most of the yield premium as the division of revenue shifts over time to the party that has market power. The likely result is that less revenue, in the long run, will go to the producer, resulting in less compensation to producers and less to capitalize into land values. The contracting firm will receive more revenue and control of the rights to any associated technology, with more revenue capitalized into corporate stock. A key point is that the party holding the rights to any technology involved will capture the majority of the revenue, not the producer. Also, as indicated above, the contracting firm is likely to negotiate for ownership of the product involved with the producer only having the right to receive a contract payment for labor services rendered. But, while the producer receives only compensation under the contract, the producer still bears significant economic and legal risk.
Clearly, a producer thinking about entering into a production contract should have legal counsel examine any proposed contract and go through the issues listed above. Contract production of agricultural commodities is very important and comprises a great deal of agricultural production. It’s also important to get the best deal that you can and get fairly compensated for the risk that you are bearing.
Tuesday, October 4, 2016
The Domestic Activities Production Deduction (DPAD) is a very complex provision and is codified at I.R.C. §199. Except for domestic oil related production activities the deduction is equal to nine percent of the lesser of the qualified production activities income (QPAI) of the taxpayer for the year; or the taxable income of the taxpayer (but in the case of an individual, this limitation is applied to AGI). The deduction can’t exceed 50 percent of the wages expense of the taxpayer. As a result, the taxpayer income limitation excludes taxpayers with current year net operating losses or with NOL carryovers that eliminate current year taxable income.
The deduction is allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings), however it is not allowed in computing self-employment income. It is also available to pass-through entities such as S corporations, partnerships, and estates or trusts, but the deduction is applied at the shareholder, partner or beneficiary level. S corporations and partnerships with qualified activities are required to separately pass through to each owner the share of QPAI and the corresponding Form W-2 wage amount, or corresponding detail information, to allow computation of the overall deduction at the Form 1040 level.
The patrons of an agricultural cooperative may not claim a DPAD with respect to income generated from sales to cooperatives or patronage dividend income. The cooperative may claim the deduction; the cooperative may choose to allocate the DPAD to the patrons. If so allocated, the patrons may claim the DPAD. DPAD allocated from a cooperative is not subject to the 50 percent of wages limitation.
The FICA wage expense is used for determining the 50 percent limitation. Thus, for farmers, neither ag wages paid in-kind nor wages paid to children under age 18 count toward the 50 percent limit. Thus, farm proprietors and partnerships that don’t issue W-2s cannot claim the DPAD (except that which is allocated from a cooperative).
QPAI is derived from domestic production gross receipts (DPGR) which includes gross receipts from various sources that are derived from the active conduct of a taxpayer’s trade or business. For example, gross receipts from growing and producing tangible property such as grain and livestock would count as DPGR. However, support/service activities including gross receipts from seed and/or chemical sale endeavors would not qualify as DPGR because manufacturing or growing is not involved. Similarly, gross receipts from services provided to others such as trucking, combining, spraying, plowing, etc., also would not qualify.
Other activities in the agricultural context that implicate DPGR include the following:
- Crop Insurance/FSA Subsidies. The proceeds from business interruption insurance, governmental subsidies, and governmental payments not to produce are treated as gross receipts that qualify for the production deduction. Accordingly, crop insurance and FSA subsidies qualify as production receipts.
- Sales of Productive Livestock. The sale of raised livestock as well as purchased livestock, further grown and held for resale, qualifies for the production deduction based on the “growing” definition of DPGR.
- Raised livestock. The regulations are silent on whether raised livestock that is placed into a breeding herd, and subsequently culled in later years after productive use as a breeding or dairy animal, qualifies as DPGR. However, based on the definition of DPGR arising from the sale of personal property grown by the taxpayer, and that there is no distinction in the DPGR rules requiring that the asset be held as inventory versus held for productive use, it would appear that proceeds from raised breeding and dairy stock would qualify as DPGR.
- Purchased breeding and dairy livestock. Purchased breeding and dairy stock that has been acquired as a mature animal, and held by the taxpayer for productive use, depreciated, and subsequently sold may not meet the “manufactured, produced, grown or extracted” (MPGE) definition. Further, the regulations specify that only one taxpayer can claim the deduction with respect to an item of tangible personalty.
- Hedging Transactions. Gains or losses from hedges qualify and count as DPGR if the hedge involves the purchase of supplies used in the taxpayer’s business, the hedge involves sales of stock in trade of the taxpayer or other property of a kind that would be included in inventory if on hand at the close of the taxable year, or property held for sale to customers in the ordinary course of the trade or business. If the hedge involves the purchase of stock in trade, inventory property or property held for sale, gains and losses are taken into account in determining the cost of goods sold.
- Storage and handling. Storage, handling, or other processing activities (other than transportation activities) within the U.S. related to the sale, exchange or other disposition of agricultural products qualify as DPGR, provided the products are consumed in connection with, or incorporated into the MPGE of qualified production property, whether or not by the taxpayer.
- Mineral interests. Gross receipts from operating mineral interests count as DPGR. Receipts from mineral royalties and net profits interests (other than those derived from operating mineral interests) are treated as returns on passive interests in mineral properties, with the owner making no expenditure for operation or development, and are not treated as DPGR.
Change in the Benefits and Burdens Test
Under the initial version of Treas. Reg. §1.199-3(f)(1), the taxpayer must bear the benefits and burdens of ownership and be the exclusive owner of the underlying property such that the taxpayer is the only taxpayer that could claim the DPAD. In contractual settings, several factors are important in making this determination – whether legal title has passed, how the parties treat the transaction, whether rights of possession are vested in the buyer, which party controls the production process, and whether the taxpayer actively and extensively participated in the management and operations of the activity, among other factors.
However, new temporary regulations became effective on August 27, 2015. Under these new temporary regulations, it’s now a question of which party performed the activity under the contract. The party that performs the activity gets the DPAD. This new interpretation does seem to run counter to the statute, and it will likely have an adverse impact on companies that outsource production domestically. That means that contracts will have to be renegotiated in some situations. There are numerous contract situations in agriculture that will be impacted by the new regulation, including livestock feeding arrangements. Feeding arrangements may qualify either way, however, if the custom feeder is responsible for providing the feed. In this situation, the feed is converted into a different product by the custom feeder, which is the manufacturing process that will qualify in the income of the custom feeder for the DPAD computation.
The DPAD is a complex tangled web of various rules. While it can provide a nice tax deduction for businesses that qualify, it would be simpler to eliminate it and reduce the tax rate applicable to corporations, sole proprietorships and businesses conducted in other forms.