Tuesday, November 29, 2016
The U.S. Citizenship and Immigration Service (USCIS) has updated Form I-9 and the related instructions. While the new Form is now available for use, employers must begin using it by January 22, 2017. After that date, all prior versions of the Form will no longer be valid. The new Form contains significant changes and new features.
The Form I-9 is a big deal when applied to workers for agricultural operations. According to USDA data, the approximately one-million hired farmworkers make up a third of all of the people working on farms. About half of these are full-time workers, and about twenty-five percent are ag service workers that are contract hires. A slight majority of the hires work in crop agriculture with the balance working in the livestock industry. Two states – California and Texas account for more than a third of all farmworkers. According to the USDA data, 59 percent of farm laborers and supervisors are U.S. citizens (compared to 91 percent for all U.S. workers). The data also show that about 70 percent of hired crop farmworkers are born in Mexico.
So, Form I-9 compliance is often encountered in agriculture. When is the Form required to be completed? Why complete it? What other rules apply? What are the penalties that might apply? That’s the focus of today’s blog post.
What is Form I-9?
The Form is used for verifying the identity and employment authorization of individuals hired for employment in the U.S. All U.S. employers must ensure proper completion of Form I-9 for each individual they hire for employment in the U.S., whether the employment involves citizens or noncitizens. While agriculture is often exempt from or treated differently in many situations, that is not the case with respect to Form I-9. There is no exception based on the size of the farming operation or for farming businesses where a majority of the interests are held by related persons.
Form I-9 applies to employment situations. It doesn’t apply to situations where a farmer hires custom work or other work to be done on an independent contractor basis. Whether a situation involves the hiring of an employee or an independent contractor basically comes down to the issue of control over the work. If the farmer controls the means and method of the work, then it’s likely to be an employment situation that will trigger the use of Form I-9.
Completing the Form
Both employees and employers (or an employer’s authorized representative) must complete the form within three days of the hire. On the form, an employee must attest to their employment authorization. The employee must also present his or her employer with acceptable documents evidencing identity and employment authorization. The employer must examine the employment eligibility and identity document(s) an employee presents to determine whether the document(s) reasonably appear to be genuine and relate to the employee. The employer must also record the document information on the Form I-9. The list of acceptable documents can be found on page three of Form I-9. Employers must retain Form I-9 for a designated period and make it available for inspection by authorized government officers.
The form itself is comprised of three sections.
- Section 1 is for the reporting of employee information and attesting to that information. The employee has to attest that they are a citizen, a noncitizen national of the U.S., a lawful permanent resident or an alien that is authorized to work until the time specified in the document. If the employee is an alien that is authorized to work, they must provide their alien registration number/USCIS number or their Form I-94 admission number, or their foreign passport number and list the country of issuance. The employee must sign the form and date it. Likewise, the employer must also sign and date the form and provide their address. The employee selects the appropriate Citizenship/Immigration status in this section. Also, the new Form I-9 contains a box where the employee indicates if they did not use a translator or preparer in completing Section 1.
- Section 2 is a certification of the employer’s review and verification of the documents of the new hire. On the new form, there is a “Citizenship/Immigration Status” field where the employer is to select (or write) the number that corresponds with the Citizenship/Immigration status that the employee selected in Section 1.
- Section 3 pertains to reverifications and rehires. This section lists the acceptable documents that employees can select from to establish their identity and their employment authorization.
The form is to be completed in English, unless it involves and employer and employees that are in Puerto Rico.
Filing the Form
The I-9 doesn’t get filed with any government agency. It doesn’t get filed with the USCIS or the U.S. Immigration and Customs Enforcement (ICE). Instead the employer simply keeps the completed Form I-9 on file for each person on their payroll who is required to complete the form. An employer has to retain Form I-9 for three years after the date of hire or for one year after employment is terminated, whichever is later. It must also be made available for inspection by authorized U.S. Government officials from the Department of Homeland Security, Department of Labor, or Department of Justice.
The form can be completed via computer, but it is not an electronic Form I-9 that is subject to the electronic Form I-9 storage regulations. Instead, Form I-9 is to be printed, signed and stored as a hard copy. If it is completed on a computer, the new form has new drop-down screens, field checks and instructions that are easily accessible.
Earlier this year the U.S. Department of Justice increased the penalties that can be imposed on employers that hire illegal immigrants. The minimum penalty for a first offense is now $539 (up from $375) and the maximum penalty is $4,313 (up from $3,200). These new amounts are effective August 1, 2016. The minimum penalty for failing to comply with the Form I-9 employment verification requirements is $216 for each form (first offense) and the maximum penalty is $2,156 per form. There are also other penalties that can apply, and the failure to complete the Form I-9 paperwork properly and completely can lead to multiple fines getting stacked together. For example, in 2015, an employer was ordered to pay a fine of over $600,000 for more than 800 Form I-9 violations. The fines were primarily the result of the failure of the employer to sign Section 2 of Form I-9. That’s the section, as noted above, where the employer certifies within three days of a hire that the employer has reviewed the verification and employment authorization documents of a new hire. The penalties arose from the hire of union employees who worked for the employer on a project-by-project basis during the term of a collective bargaining agreement. The workers were not terminated when they completed a project and remained “on-call.” The employer didn’t complete a separate Form I-9 apart from what the union provided and didn’t sign Section 2 of the union form.
Mistakes - Potential Problem Areas
So, with the possibility for penalties for improper completion of Form I-9, what are the biggest potential areas of pitfalls? Some basic ones come to mind – incorrect dates, missing signatures, transposed numbers and not checking boxes properly. Also, the correct document codes have to be recorded for each identification method. An employer should also make sure to ask for only those documents that are necessary to identify the employee. Not too many or too few. Requesting too many can lead to a charge of discrimination; too few can trigger a violation for an incomplete form.
Other mistakes can include failure to comply with the three-day rule, failure to re-verify and get updated documents from employees. Also, it is a good idea to get rid of outdated forms. Any outdated forms that exist can lead to penalties if discovered in an audit.
The proper documentation of employees is critically important. With a change in Administration coming and a new view toward enforcement of existing laws with respect to immigration, the compliance with Form I-9 requirements should be at the top of each employer’s list, ag or non-ag.
Wednesday, November 23, 2016
What is the impact on the future of agricultural policy in a Trump Administration? My guess is that it will be significant. I also suspect that this time the Secretary of Agriculture will have some background in and a significant tie to agriculture and that the USDA will serve a greater purpose than simply doling out food stamps. USDA policies will likely shift significantly. Rural America voted overwhelmingly for President-elect Trump, and he will be the President largely because of the sea of red all across the country in the non-urban areas. That leads me to believe that the USDA will better represent a broad array of agricultural interests across the country.
So, what can farmers, ranchers and agribusinesses anticipate the big issues to be in the coming months and next few years and the policy responses? That’s the focus of today’s blog post.
Agriculture is one of the most highly regulated industries in the country. From water to genetically modified organisms to cropping and fertilization practices to federal range land policies to drones, farmers, ranchers and rural landowners have to deal with federal (and state) regulations on a daily basis. Many of those regulations are developed without being put through any realistic cost-benefit analysis. Expect that to change. The President-elect is a businessman, not a politician. In that realm, the bottom-line controls. So, it’s probably reasonable to expect that same approach will be applied to regulations impacting agriculture. Those with minimal benefit and high cost could be eliminated or retooled such that they are cost effective. Overall, the pace of the generation of additional regulation will be slowed. Indeed, the President-elect has stated that for every new regulation, two existing regulations have to be eliminated.
Agriculture depends on and benefits from trade. U.S. agriculture has a natural advantage when it comes to producing food products. Because of that, U.S. agriculture views trade with other countries as a positive. That’s just the way economics works with respect to agriculture. That doesn’t mean that trade deals are always good for the country, though. It just means that agriculture benefits from trade. The Trans-Pacific Partnership, while on the whole good for ag, has some really questionable elements to it that the President-elect opposes. The same thing can be said for NAFTA. So, I think it is reasonable to expect the President-elect to attempt to renegotiate those agreements to get a better overall deal for the United States and make sure they comport with U.S. constitutional values. It’s also more likely that trade agreements will be negotiated on a much more bi-lateral basis – the U.S. negotiating with one other country at a time rather than numerous countries. Importantly, the day after the election some foreign leaders said they were willing to renegotiate NAFTA. They obviously believe that the President-elect is serious about renegotiating NAFTA to make it a better deal for the U.S.
China is a big customer of U.S. agricultural products. However, the President-elect has pointed out the Chinese manipulation of currency, and we are all too familiar with the Chinese using GMOs to harm U.S. grain markets. So, we will have to see how strong the President-elect is on dealing with the Chinese and other countries that attempt to interfere with U.S. grain and livestock markets. Canada and Mexico are also huge trading partners. The U.S. doesn’t have too many bones to pick with Canada at the present time, but there are a few with Mexico.
“Renewable” Energy Sources
The President-elect is largely against government hand-outs and is big on economic efficiency. That bodes well for the oil and gas industry (and perhaps nuclear energy). But, what about less efficient forms of energy that are heavily reliant on taxpayer support? Numerous agricultural states are heavily into subsidized forms of energy with their state budgets littered with numerous tax “goodies” for “renewable” energy.” However, the President-elect won those states. So, does that mean that the federal subsidies for ethanol and biodiesel will continue. Probably. The Renewable Fuels Standard will be debated in 2017, but will anything significant happen? Doubtful. It will continue to be supported, but I expect it to be reviewed to make sure that it fits the market. Indeed, one of the reasons that bio-mass ethanol was reduced so dramatically in the EPA rules was that it couldn’t be produced in adequate supplies.
What about the wind energy production tax credit? What about the various energy credits in the tax code? My guess is that there won’t be much change when it comes to the energy credits. In addition, if the domestic production deduction remains in the code, I suspect that the level of the credit for the domestic production of oil and gas will be increased to the same level that applies for other domestic production activities.
The head of the Senate Ag Committee will be Sen. Roberts from Kansas. As chair, he will influence the tone of the debate of the next farm bill. So, can we glean anything from Sen. Roberts past that would indicate how the farm bill might be shaped and what its focus might be? I suspect it means that the farm bill will have provisions dealing with livestock disease and biosecurity issues. Also, I suspect that it will contain significant provisions crop insurance programs and reforms of existing programs.
The House Ag Committee head will be Rep. Conaway from Texas. I don’t know as much about Rep. Conaway, but given that he is from Texas I think it is safe to say that he would push for cottonseed to be an eligible commodity for Agricultural Risk Coverage (ARC) and Price Loss Coverage (PLC). I think it is also probably safe to assume that for the significant Midwest crops (and maybe some additional crops) their reference prices will go up.
It also might be possible that food-stamps will get separated from the farm bill. Is that likely? No, but reform is needed with respect to food-stamps. With somewhere between 40 and 50 million Americans on food-stamps it is easy to suspect that the President-elect will work to get that number reduced. Of course, an improving economy should result in that number coming down. But, other measures to tighten the rules to minimize fraud could also bring it down. It just may not be possible at this time to get a farm bill passed if food-stamps are parceled out of it.
New food safety measures are set to go into effect in 2017, and those can be expected to be implemented. But, expect them to get reviewed for their effectiveness and necessity. Also, maybe, just maybe, it will be possible to get the I.R.C. §179 issue involving the income limitation for qualification for farm program payments (i.e., the discrepancy of the treatment between S corporations and C corporations) straightened out.
Look for the incoming ag secretary to have an ag background. I think that is a given. With the Vice President-elect heading up the agriculture aspects of the transition team, that could mean that the next ag secretary will come from Indiana or some other Midwestern state.
Other Related Appointments
The Secretary of Agriculture is not the only agency appointment that the President-elects makes that will have an impact on agriculture. As I noted earlier in today’s post, agriculture is a heavily-regulated industry. There are at least five other federal agencies that have a significant regulatory impact on agriculture and agricultural activities. It is important that the type of leadership provided to these agencies in the Trump Administration be carefully evaluated for the potential impact on ag. For example, the Environmental Protection Agency (EPA) also impacts farmers, ranchers and rural landowners in significant (and often negative) ways from a regulatory standpoint. The President-elect has stated that he would like someone with a farm background to head the EPA. That would be a huge step in the right direction if it happens. The Interior Department has a significant regulatory impact in the western part of the U.S. concerning its regulation and management of federal grazing lands. The Energy Department also impacts ag, as does the Food and Drug Administrations with respect to food produce rules (among other things) and the Occupational Safety and Health Administration with respect to certain types of ag employers and laborers. So, it’s not just the USDA head that’s important. Leadership of all of these other agencies is important too.
These are just my thoughts. This is what it looks like to me at the present time as to where ag policy might be headed in the next few years. What do you think?
Monday, November 21, 2016
In recent days, I have often been asked the question by lawyers, CPAs as well as farmers and ranchers of what the impact of the election of Donald Trump as President will be on the future of the federal estate tax. The President-elect has proposed far-reaching changes to the tax system that will impact practically all taxpayers. Consequently, tax advisors will be busy keeping up with the changes and determining how to implement them for their clients. This is particularly true for practitioners trying to determine how to estate plans for clients. In addition, it’s likely that the President-elect will be able to get many of his proposed tax changes through the Congress given the fact that the Republicans maintained control of both the U.S. House and Senate.
What About Repeal?
The President-elect has proposed a full repeal of the federal estate tax. With the ramp-up in recent years of the estate tax exemption to $5 million and the indexing of it to inflation such that it is at $5.45 million for deaths in (and gifts made in) 2016, the tax doesn’t generate much revenue and impacts relatively few estates. IRS data for 2015 indicates that that just under 5,000 estates (out of 2,626,418 deaths) owed federal estate tax and generated approximately $17 billion in federal estate tax revenue. That’s 0.6 percent of all federal revenue in 2015, but is an average tax liability of $3.4 million per taxable estate. That is a huge number for those estates impacted by the tax, but the total revenue generation is less than one percent of all federal revenue in 2015. Also, about forty-four percent of that amount came from 266 estates. So, clearly, the estate tax is not much of a revenue-raiser, and it also hasn’t done a good job at minimizing the concentration of wealth – the purported primary reason for the creation of the tax. Just based on these facts, there doesn’t appear to be much merit in keeping the tax around.
So, if the federal estate tax were to be repealed, when might it occur? The options are that repeal could be effective January 1, 2017, or perhaps put off until the beginning of 2018. Another option is that repeal could be phased-in over a certain period of time. Also, while it appears at the present time that any repeal would be “permanent,” that’s not necessarily a certainty. Similarly, it’s not known whether the current basis “step-up” rule would be retained if the estate tax is repealed. That’s particularly a big issue for farmers and ranchers. It will probably come down to a cost analysis as to whether step-up basis is allowed. The President-elect has already proposed a capital gains tax at death applicable to transfers that exceed $10 million (with certain exemptions for farms and other family businesses). One factor to keep in mind is that a repeal bill would require 60 votes in the Senate to avoid a filibuster unless repeal is done as part of a reconciliation bill. In that event, however, the repeal of the federal estate tax would have to “sunset” in ten years.
Would the federal gift tax also be repealed? Under current law, the gift tax and the estate tax are “coupled.” That means that the exemption of $5.45 million can be used to offset taxable gifts during the donor’s life or offset taxable estate value at death. The President-elect has proposed repealing the gift tax along with repeal of the estate tax. That’s really interesting because the gift tax is not just simply tied into the estate tax, it also has income tax implications. For instance, if there is no estate tax and no gift tax, it becomes much easier to shift income with zero tax cost to another person in the family (likely a child) who is in a lower tax bracket. So, if a parent, for example, wishes to sell an asset, the tax-saving technique would be to gift the asset to the child in the lower tax bracket, have the child sell the asset and recognize the gain and then gift (tax-free) the proceeds of sale back to the parent. Remember, the strategy works because capital gain tax rates are tied to the income tax rate of the seller. The lower the income tax rate the seller is in, the lower the applicable capital gain rate on sale of an asset. But, also remember, with the high level of the gift tax exemption currently, this strategy is largely possible already. But, what a repeal of the gift tax would do is allow the easy transfer of assets into irrevocable trusts for asset protection planning purposes without gift tax complications. But, if a capital gains tax at death is imposed will the transfer avoid the tax? That’s a big question for planners to worry about and determine what to do with existing plans involving trusts particularly in light of planning that might already have been engaged in anticipating the finalization of the proposed I.R.C. §2704 regulations. Relatedly, what should be done if basis step-up is retained and there is no estate tax? That would mean that inclusion of property value in the estate at death won’t cause a tax problem, but exclusion would create an income tax problem!
So, with the gift tax in the mix, what are the possible legislative options? One option is the permanent repeal, effective January 1, 2017, of the estate, gift and generation-skipping transfer tax. Another option is that all of those taxes would be permanently repealed on a phase-out basis over a period of years. Still another option is estate tax repeal with the retention of the gift tax. Or, there could be an estate tax repeal and no step-up in basis. Or, the estate tax could be repealed and a capital gains tax imposed on death (with certain exceptions).
An estate planning option, as always, is to simply wait and see what happens. Perhaps the only downside to this approach would be an untimely death. Even in that event it’s hard to see the downside given that the current exemption is relatively high and it doesn’t appear likely that the proposed I.R.C. §2704 regulations will actually get finalized (and even if they do, they will likely get removed by the new Administration). For those clients that have already started the estate planning process, they could simply stop for the time being and adopt the wait and see approach. But, there still might be the need for asset protection for high-wealth clients which could be accomplished by following through with the process to completion.
Should existing plans be modified? At this point, it’s too early to modify. If (perhaps more likely, “when”) the estate tax is repealed, there will be many issues to be addressed by planners. For instance, one of the issues I am addressing at the tax schools this fall concerns the use of Grantor Retained Annuity Trusts (GRATs). What if one of those is already in place? Would the note-sale transaction and the related contractual obligations be impacted by repeal? What if the GRAT no longer serves its purpose and it is modified by a court? Would that trigger gift tax (assuming the gift tax is retained)? What’s the responsibility of the trustee in this situation? What if a GRAT is presently under IRS audit?
For existing wills and revocable trusts, repeal of the estate tax will require a review of those documents. Estate tax repeal would call into question the purpose and relevance of marital deduction/credit shelter trusts in wills. Funding language will have to be examined. Existing language that funds the credit shelter trust with the maximum amount resulting in no federal estate tax could result in wiping out the credit shelter trust. Does the client want that result? Practitioners will have to revisit their clients’ goals and objectives. If there is a capital gains tax at death, will the courts view it as a “federal estate tax” such that the credit shelter trust would still be funded?
For irrevocable trusts that were set up to minimize or eliminate federal estate tax, does the client still want the trust solely for asset protection purposes? In addition, how will trust (and will) provisions utilized under prior law be interpreted under a new transfer tax system that wasn’t thought of at the time the language was drafted?
Continuing with trusts for the moment, what about qualified terminable interest property (QTIP) trusts that have to pay out at least annually to qualify for the marital deduction? Is that still what the client wants when it no longer has to be done? Will a court grant any request to end the income interest?
What about life insurance? Don’t let clients drop it! Even if the estate tax is repealed, it could be re-enacted by a subsequent Administration and a new Congress. Plus, the client has already incurred the cost of getting the policy and is getting a build-up of wealth without income tax. For many clients, life insurance is a pretty good investment right now.
Also, factoring into the planning discussion is state-level death taxes. For those states that have an estate tax, the repeal of the federal estate tax will also kill-off the state death tax. States, such as Nebraska for example, that have an inheritance tax will still have that tax, but may be forced to reconsider whether they should because they will be putting themselves on a rather small “island” of states having such a tax.
But, trust planning and usage will remain. Asset protection from creditors and in the event of divorce (or death and remarriage) indicate why trusts will remain beneficial even without any federal estate tax. Plus, trusts can be used to distribute income to beneficiaries in lower income tax brackets. Irrevocable trusts can also be beneficial to provide protection and control to an older client suffering from failing health to help prevent loss of wealth by unscrupulous family members, supposedly trusted professionals and others. But, from a technical standpoint, any mandatory income distribution provisions should be changed to discretionary. After all, it won’t be necessary to have mandatory distributions to meet QTIP requirements. Also, discretionary powers of appointment should be used to get the assets back into the grantor’s estate to get a basis step-up if that rule is retained. Also, flexible trust language should be used to produce the intended result – inclusion in the estate when that is desired and exclusion when that is desired.
What To Do Now
Common year-end planning is still the thing to do. Make annual exclusion gifts to fund an I.R.C. §529 plan, make Crummey-type transfers, or make a zeroed-out gift to a GRAT. From an income tax perspective, accelerate deductions to 2016 and defer income to 2017 because 2017 rates are likely to be lower than 2016. One way to accelerate deductions would be to make some of the charitable contributions in 2016 that would have been made in 2017, contribute to retirement plans, and pay state and local taxes this year.
If you had a family member die this year and the estate tax return has not yet been filed (if Form 706 is due, it is due within nine months from the date of death), the return probably should be put on extension to determine whether the extra cost associated with a portability election should be incurred.
The repeal of the estate tax will significantly change estate planning for many clients. We’ll have to wait and see exactly how repeal shapes up and what is included with it. But, clients will be asking questions. Are you prepared to provide them answers? Hopefully, today’s post helps on that point.
Thursday, November 17, 2016
Now that fall is here it’s time for “hoops” season. Hoops means one thing when it comes to the hardwood, but it can mean something else on the farm or ranch. A “hoop structure” is basically a shelter that can house livestock (swine, cattle, sheep, goats and horses), but it can also be used to store hay and/or machinery. If used for storage, they are an alternative to the more traditional pole barn.
A hoop structure is built with steel arches that are mounted on wood or concrete sidewalls. The steel arches are securely fastened to the sidewall to transmit the wind forces to the sidewalls and the ground. They can be used for numerous purposes. If the structure is used for livestock, then a feed bunk is placed outside the sidewall. Putting the feed bunk outside the sidewall eliminates and need of an interior drive path. Also, in this situation, an overhang is added to reduce the rainwater entering the bunk. A polyethylene fabric tarp is stretched over the steel framing to form the roof of the structure, and the tarp is designed to reflect solar radiation to prevent heat stress. Lighting is not necessarily utilized. The structure is either installed directly on the ground or on concrete or wooden walls. A hoop structure can also be used to store ag commodities or machinery.
What are the tax implications of a hoop structure? How is it classified for depreciation purposes? Is it eligible for expense method depreciation under I.R.C. §179? Is it eligible for first-year bonus depreciation?
These are issues that myself and Chris Hesse and Paul Neiffer of CLA kicked around earlier this year. Today’s blog post takes a look at these issues.
Depreciation Recovery Period
Without a doubt a hoop structure is farm real property. Farm real property can be classified at least four ways (in accordance with Rev. Proc. 87-56):
- A land improvement (class 00.3) has a cost recovery period of 15 years.
- A single purpose agricultural or horticultural structure (class 01.4) has a cost recovery period of 10 years.
- I.R.C. §1245 real property with no class life has a cost recovery of seven years.
- A farm building (class 01.3) has a cost recovery period of 20 years.
A land improvement is an item that is added directly to land and is either I.R.C. §1245 or I.R.C. §1250 property if it is depreciable. Fences, landscaping, roads, sidewalks, canals and waterways fit in this category under Rev. Proc. 87-56. Also, included in this category are silage bunkers, concrete ditches, wasteways and pond outlets as well as irrigation and livestock watering wells. None of these look like buildings. Thus, a hoop structure would not fit in this category.
I.R.C. §48(p), even though it has been repealed, contains the current, valid definition of a single purpose agricultural or horticultural structure. That provision (and subsections thereunder) defined property which qualified for I.R.C. §38 (investment tax credit). Tax legislation in 1986 moved that language into I.R.C. §1245 for depreciation recapture purposes. Under that definition, a single purpose ag structure is used for housing, raising and feeding a particular type of livestock and their produce, and the housing of the necessary equipment. I.R.C. §48(p)(2). Structures that fit this definition include hog houses, poultry barns, livestock sheds, milking parlors and similar structures. Also included within the definition are greenhouses that are constructed and designed for the commercial production of plants and a structure specifically designed and used for the production of mushrooms. Thus, only livestock structures and greenhouses qualify under this category. A hoop structure is not a single purpose structure and doesn’t fit in this category. It can house various types of livestock, and store commodities and/or machinery. If you have any doubt, a flat storage building has been held not to be a single purpose agricultural or horticultural structure. Bundy v. United States, 59 AFTR 2d 87-682 (1986). A flat storage building is pretty much the same as a hoop structure – not a single purpose ag or horticultural structure.
Assets that look like a building but qualify as I.R.C. §1245 assets (and not separately classified as single purpose ag or horticultural structures) are not “buildings.” Treas. Reg. §1.48-1(e)(1)(i). These assets are, basically, machinery and equipment which are an integral part of manufacturing or production. I.R.C. §1245(a)(3)(B)(i). This category includes storage facilities for potatoes, onions and other cold storage facilities for fruits and vegetables. If the asset is used for other purposes after the commodities have been removed, the structures are buildings, rather than I.R.C. §1245 property. So, if the property is easily adaptable to other uses, it is a building and not I.R.C.§1245 real property. But, if the property is specially designed and unsuitable for other uses, it is not a building. Olson v. Comr., T.C. Memo. 1970-296 (1970). It really comes down to what “easily adaptable” means. That is determined on a case-by-case basis based on the economical cost of the structure in of each situation. Whether a hoop structure fits in this category either depends on each particular situation.
A farm building, then, by default, is a real property item that is not included in another class. Such things as shops, machine sheds and other general purpose buildings on a farm that are not integral to the manufacturing, production or growing process are included in this category. Hoop structures generally fit in this category and would have a cost recovery period of 20 years. They are a general purpose farm building. At least that’s the likely IRS position. Granted, a fact-dependent argument can be made that a hoop structure is used as an integral part of production or is akin to a bulk storage facility used in connection with production. If that argument prevails, a hoop structure is I.R.C. §1245 property with no class life.
Assets that are used in the farming business (as defined in I.R.C. §168(b)(2)(B)) must use the 150 percent declining balance method rather than the 200 percent declining balance method. It is the business of the taxpayer that controls the method available for depreciation, rather than the function of the equipment in the business.
Expense Method Depreciation
To be eligible for expense method depreciation (I.R.C. §179), property must be acquired by purchase, used more than 50 percent in the active conduct of a trade or business, and be I.R.C. §1245 property that is either MACRS property or off-the-shelf computer software. We have already established the general rule that a hoop structure is a general purpose ag building that is not I.R.C. §1245 real property. Thus, under the general rule, a hoop structure is not eligible for I.R.C. §179 depreciation unless it is not a building and is an integral part of production like fences, and drainage tile, machinery and equipment, etc., or is akin to a bulk storage facility. But, if the argument is that they qualify as a storage facility, the argument is a tough one to make because of the hoop structure’s ability to be adapted to different uses. If such adaptation is economically reasonable, and the structure provides working space in addition to storage space, a hoop structure won’t qualify as bulk storage. See Brown & Williamson Tobacco Corporation v. United States, 369 F. Supp. 1283 (W.D. Ky. 1973). So, the IRS view is likely to be that a hoop structure is a general purpose ag building that is not eligible for I.R.C. §179. The facts of an individual situation might change that conclusion, however.
In general, property that is eligible for first year “bonus” depreciation (set at the 50 percent level for 2016) must have its original use commence with the taxpayer, be tangible depreciable property with a MACRS recovery period of 20 years or less and not be “excepted” property (basically, property that is not placed in service and disposed of in the same tax year or be converted from business to personal use in the tax year that it was acquired). A hoop structure would meet the test if its original use commenced with the taxpayer and it is not excepted property (unlikely). Unless an election out of bonus depreciation is made, it is claimed before any applicable MACRS depreciation is claimed.
Hoop structures have been gaining in popularity in recent years due to their economic efficiency and utility. But, they present some tricky tax issues primarily associated with depreciation. That’s because of their less than permanent character, and the lack of specific guidance from the IRS. Fitting them within the existing framework for agricultural assets leads to the likely IRS conclusion that they are a general purpose farm building with a cost recovery period of 20 years, ineligible for I.R.C. §179 and potentially eligible for first-year “bonus” depreciation. But, the facts of a particular situation could result in a hoop structure being determined to be I.R.C. §1245 real property with no class life that qualifies for I.R.C. §179 and is potentially eligible for first-year “bonus” depreciation.
Tuesday, November 15, 2016
One of the issues that has generated numerous questions at the tax schools this fall has involved rental real estate income and the possibility of the recharacterization of those rents as non-passive. The questions have been primarily associated with farmland rental income, but not exclusively so. What is involved are the passive loss rules and the ability to avoid them by recharacterizing passive rental income as active income so that it fully offsets losses from other activities. With many ag producers sustaining large losses again this year. The passive loss rules and recharacterization are important.
Today, we take a look at the issue and why it matters.
Passive Losses – What Are They?
The passive loss rules of I.R.C. §469 were enacted in 1986 to reduce the possibility of offsetting passive losses against active income. The passive loss rules apply to activities that involve the conduct of a trade or business and the taxpayer does not materially participate in the activity or in rental activity on a basis which is regular, continuous and substantial. If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains).
Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. If an individual can satisfy the material participation test, the person is able to deduct passive losses against active income. If, for example, a physician is materially participating in a farming or ranching activity, the losses from the farming or ranching activity can be used as a deduction against the physician's income from the practice of medicine.
An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.” In determining whether an individual taxpayer materially participates (or actively participates), the participation of the taxpayer's spouse is taken into account, whether or not they file a joint income tax return. In addition, the governing statute refers to material participation by the taxpayer, but does not specifically bar imputation of the services of an agent or specifically embrace I.R.C. § 1402, which does bar imputation of activities of an agent to a principal. A Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and no individual performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer. The regulations provide seven tests for material participation. I won’t get into those tests in today’s post in order to keep the post relatively short.
If none of the material participation tests can be satisfied, there is a fallback text of active participation. More on that test in a moment.
The Recharacterization Rule
In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469. But, there are a couple of major exceptions to this general rule. Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Treas. Reg. §1.469-2T(f)(3). What this exception does is result in the conversion of rental income (and any gain on disposition of the activity) from passive to portfolio income. But, that is only the result if there is net income from the activity. If the activity loses money, the loss is still passive. That’s all fine and dandy you say, but how does this apply to me? Well let’s take an example (thanks to Chris Hesse of CLA for providing the general framework for the examples in today’s post):
Jack is a lawyer in the big city. He is involved in multiple investment activities that have suspended losses (losses that he couldn’t deduct in prior years and have been carried over to later tax years). Jack is in a tax position where the use of the losses would be valuable to him. On the advice of his accountant, and to help his father and brother who are having some difficult financial times, Jack buys 500 acres of land from his father for $400,000. Jack allocated $100,000 of the purchase price to depreciable items – fences, drainage tile, grain bins, etc., and cash leased the 500 acres to his brother. Because less than 30 percent of the purchase price is allocated to depreciable property, the cash rent that Jack receives from his brother is recharacterized as portfolio income in Jack’s hands. The rental income may not offset Jack’s suspended passive losses from his investment activities, but if the cash rent of the farmland produces a net loss after taxes, interest and depreciation, the loss is a passive loss. In addition, the cash rent income will be subject to the additional 3.8 percent net investment income tax even though it has been recharacterized as portfolio income (which is generally taxed at ordinary income rates).
Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6). But, if a loss occurs, the loss is passive. For example, consider the following:
Ralph began farming in the 1960s and was encouraged in the 1970s to put his farming operation in a corporation. He did so, and is the sole shareholder of the corporation. However, Ralph retained personal ownership of farm buildings, a machine shed and some livestock facilities. He leased all of these personally retained assets to the corporation. Ralph reports the rental income on Schedule E and then it is carried directly to Ralph’s Form 1040 because the rental income is non-passive. Ralph would get the same tax treatment if leased the assets to a business in which his wife materially participates. There is a spousal rule that produces that result. I.R.C. §469(h)(5). However, in either situation, the income is still considered to be “rent” that is subject to the 3.8 percent NIIT.
So why does this rule matter? If a taxpayer has other passive losses, those losses can be offset with passive income. But, the rule works to recharacterize what normally would have been passive income to non-passive. Thus, the passive losses could not be offset.
While various rental activities can be aggregated for purposes of meeting the material participation test under the passive loss rules, it actually may not advantageous to do so. As noted above, rents are passive, but if the taxpayer is a real estate professional, rents are not passive. A real estate professional is one who puts more time into rental activities than in non-rental activities and more than 750 hours in the rental activities in which the taxpayer materially participates. For a real estate professional, rents are not passive. Also, rental activities could be grouped together to meet the material participation test under I.R.C. §469. But, if rental activities are grouped instead of each rental activity being a separate activity, lost is the ability to claim suspended losses on the disposition of any single rental activity.
Mitigating against aggregation is the 30 percent rule mentioned above which makes the net rental income non-passive, and the self-rental rule that recharacterizes passive rents to non-passive. In any event, the self-rental regulation takes precedence over a grouping election. Carlos v. Comr., 123 T.C. No. 16 (2004). But, remember, if the rental activity loses money, the losses are passive. Those losses will likely end up suspended. However, remember that fallback test of active participation mentioned earlier? That rule allows individuals to offset losses from rental real estate without necessarily having passive income. I.R.C. §469(i)(8). Under this rule, a taxpayer can deduct up to $25,000 in rental real estate losses if the taxpayer actively participates and modified adjusted gross income is $100,000 or less. At $150,000 of MAGI, no deduction is allowed. Active participation is a much less rigorous test to meet than is material participation.
Also, it’s not possible to aggregate self-rentals. Consider the following:
John and Marcia operate their overall farming operation as an S corporation. They materially participate in the farming operation. They have two tracts of farmland. During 2016, the income from one tract showed net rental income and the other tract showed a net loss. The two rental activities would not be able to be grouped together. The self-rental property with net income is recharacterized as non-passive, but the other rental activity remains a passive loss. So, the income from the one tract cannot offset the loss from the other tract. Instead, the loss is a suspended loss. However, they could group their rental activities with the S corporation farming business to get around the bar on grouping self-rentals. That would allow the full deductibility of any losses.
The example points out that a business activity can be grouped with a rental activity. That is the case if each owner has the same proportionate ownership interest in the rental activity and the business activity. Also, a rental activity can be grouped with a business activity if the rental activity is “insubstantial” in relation to the business activity. What that accomplishes is that the rental activity is not passive if the owner materially participates in the business. Unfortunately, there is no precise regulatory definition of “insubstantial”. However, court decisions have allowed grouping when the rental property is leased to the business activity and when the gross receipts of one activity (usually the rental) are insubstantial (generally less than 10 percent of total gross receipts). See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 174242 (W.D. Ark. Nov. 12, 2015).
It’s also not possible for a real estate professional to group a rental real estate activity with another type of real estate activity. Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016).
In addition, there are disclosure rules that apply to groupings, and special rules apply to groupings by pass-through entities.
The passive loss rules can be confusing and the grouping rules complicate matters. But, the proper use of the rules can provide a good tax result as they are incorporated with other tax planning moves for taxpayers.
Friday, November 11, 2016
Water issues in agriculture are significant. The headline-grabbers are the stories involving the allocation of water due to drought. Last year, in California, we all heard about the impact of the drought on California farmers and ranchers. Similarly, water issues loom large in the Great Plains and the battle between water usage between Colorado eastern slope farmers and the Denver-area suburbanites has been well documented.
But water allocation issues are not the focus of today’s blogpost. There’s another water-related issue that’s important to rural landowners. It’s an issue that involves a tract’s boundary. That’s the focus of today’s blog post.
How is a Watercourse Boundary Defined?
Typically, the description of the boundary of a watercourse bed is defined by state law. Most states use the ordinary high water line of the boundary, but a few states use the low water line as the boundary. This difference in definition may be significant in terms of access along navigable streams. If the water level in a stream fluctuates, the bed below the ordinary high water line may be exposed. This means that the owner of upland property, if the property ends at the ordinary high water line, is separated from the stream by a strip of public land during times of low water. The public may be entitled to access over this. If the low water line is used, a strip of public land will not appear adjacent to the stream, and there may not be any public use of the bank allowed.
How Does the Watercourse Move?
Agricultural landowners owning land adjacent to a watercourse may be faced with a changing property line due to shifts in the size and location of the watercourse. The property boundary may be slowly eroded away or may change suddenly as the result of a flood or similar natural disaster. In general, the location of the new boundary depends upon whether the watercourse is navigable or non-navigable, and how fast the change has occurred.
An accretion occurs when soil is deposited in an area that was once under water, thereby creating new land. An accretion need not be continuous in the time sense. Alternatively, an avulsion is a change in a watercourse boundary that is not gradual or imperceptible. If a watercourse shifts bodily, taking a new course without removing piece by piece from its bank, it is said to shift by avulsion. Consequently, avulsion may be defined as a lateral movement discontinuous in the space sense. In the time sense, the actual avulsion is almost instantaneous. In one Nebraska case, for example, the creation of bridges and dams caused a river to split into two main channels creating a braided stream. The court determined that the doctrine of avulsion applied to determine the boundary between the properties. Anderson v. Cumpston, 258 Neb. 891 N.W.2d 817 (2000).
In general, slow changes (accretions) that occur through such things as erosion or any other similar process, results in a shift in the property boundary. Thus, a landowner whose property is being slowly eroded will have a constantly changing land area. If the change is rapid (avulsion), then the boundary lines do not shift, and ownership disputes should not arise as frequently.
The issue of whether a boundary had moved due to a gradual accretion was involved in a case decided by the U.S. Supreme Court in 2010. Stop the Beach Renourishment, Inc. v. Florida Department of Environmental Protection, et al., 560 U.S. 702 (2010). Under the facts of the case, owners of Florida beachfront property sued local governments and the state on the basis that the governments’ beach restoration projects (which the state had approved) were unconstitutional takings of their property. The Florida Supreme Court determined that no takings had occurred, and the U.S. Supreme Court agreed. The projects involved placing sand along beaches seaward from the mean high-water line, which was the boundary between the state's submerged land and the owners' properties. The beachfront owners claimed that the state's ownership of the new dry land out to the sea deprived the owners of their rights to accretion and a water boundary, and that the state court's decision was a taking of the owners' properties. The U.S. Supreme Court disagreed with the beachfront owners because the change in the mean high-water line resulted from a relatively sudden avulsion, rather than a gradual accretion. As a result, the previous mean high-water line remained the boundary between the state and the beachfront owners. Thus, the newly exposed land belonged to the state. However, a plurality of the Court did note that the takings clause applies as fully to the taking of a landowner’s riparian rights as it does to the taking of an estate in land.
Boundary issues are not infrequent in agriculture. But, when a watercourse forms the boundary some rather unique issues can arise. The facts surrounding the movement of the watercourse will go a long way to determining the proper boundary. Understanding the basic rules is also very helpful.
Wednesday, November 9, 2016
My good friend Paul Neiffer, the author of farmcpatoday.com, often explains that the answer to many tax questions is that “it depends.” So true it is. Change the facts just a bit and you can get a completely different result. The “it depends” answer also applies when it comes to the definition of a farmer for tax purposes. It depends on the particular Code provision that is involved. There are many unique definitional rules. It’s important to have an understanding of the various definitions because special tax breaks often apply to a taxpayer that is a “farmer.” Also, a “farmer” is potentially eligible for federal farm programs.
So, on today’s post, let’s take a look at some of the variation in the definitions.
In general, the I.R.C. §61 definition of a farmer for purposes of determining gross income is a person engaged in agriculture, raising live organisms for food or raw materials. “Farming” includes cultivating, operating, or managing a farm for profit, either as owner or tenant. A “farm” includes a stock, dairy, poultry, fish, fruit, or truck farm. It also includes a plantation, ranch, range, or orchard. A “farmer,” for purposes of inventory and accounting methods, and estimated gross income for estimated tax purposes, is also someone who is engaged in oyster farming, the raising of bees, breeding and raising chinchillas, mink, foxes and other furbearing animals. Treas. Reg. §1.6073-1(B)(2) and Rev. Rul. 57-588, 1957-2 C.B. 305.
However, if a person’s main source of income is from providing agricultural services such as soil preparation, veterinary, farm labor, horticultural, or management on a fee or contract basis, the person is not a farmer for tax purposes and would report their business income on Schedule C rather than Schedule F. Similarly, if a person owns farmland and cash rents it to a tenant to conduct farming activities, the owner is engaged in a rental activity rather than a farming activity. That is important point for numerous provision of the Code, not the least of which are the passive loss rules of I.R.C. §469 and the Net Investment Income Tax of I.R.C. §1411. Cash rent often results in a less favorable tax result for a taxpayer than if that same taxpayer were a material participating landlord.
What it boils down to is that if a landowner is in the business of farming, the landowner's expenses and income are reported on Schedule F where the net income is subject to self-employment tax. Income and expenses associated with a material participation crop share lease are reported on Schedule F. The rental income is subject to self-employment tax and the owner is able to deduct soil and water conservation expenses attributable to the real estate, as well as qualify for the exclusion of cost-sharing payments associated with the rented real estate. Similarly, the landlord could qualify for expense method depreciation under I.R.C. §179. In addition, Conservation Reserve Program (CRP) payments received by a materially participating landlord are subject to self-employment tax if there is a nexus between the CRP land and the landlord’s farming operation.
A landlord who is not materially participating under a crop share lease receives the income from the lease not subject to self-employment tax. While the landlord still qualifies for special treatment of soil and water conservation expenses and is eligible for exclusion of cost-sharing payments, and may, as noted below, be eligible for expense method depreciation, the income is to be reported on IRS Form 4835 rather than the Schedule F.
Income under a cash rent lease is income from a passive rental arrangement and is not subject to self-employment tax. Cash rent landlords do not qualify for special treatment of soil and water conservation expenses but apparently qualify for the exclusion of cost sharing payments received from the USDA. Ltr. Rul. 9014041 (Jan. 5, 1990). As for expense method depreciation, the landlord must be “meaningfully participating” in the management or operations of the trade or business, and avoid the “noncorporate lessor” rules. Income from a cash rent lease is to be reported on the Schedule E -Supplemental Income and Loss.
Farmers are eligible for the cash method of accounting. Even though they have inventories, farmers this special rule makes the cash method available to them. In addition, for farmers on the cash method of accounting, grain, livestock and real estate can be sold on the installment method. Any contract for the sale of goods (other than inventory) is an installment sale and taxable on the installment method if any part of the payment is to be received in a subsequent year. Crops and livestock as inventory-type property are eligible for installment reporting by cash method farmers and ranchers. However, manufacturers and sellers of farm equipment are not eligible for installment reporting. Thom v. United States, 134 F. Supp. 2d 1093 (D. Neb. 2001), aff’d., 283 F.3d 939 (8th Cir. 2002). Along this line, a business that sells seed, fertilizer, pesticides, herbicides, and farm hardware to farmers is not a farmer for purposes of using the cash method of accounting because it does not cultivate, operate, or manage a farm for profit as an owner or a tenant. Ward AG Products, Inc., TC Memo 1998-84. As a result, such a business must use inventories and the accrual method of accounting. That’s the result for any business that is not a farm business where the purchase and sale of merchandise is a material income-producing factor.
In general, Christmas tree "farm" owners are treated as forest owners. Christmas tree "farms" are timber operations for tax purposes. Under the Code, "timber" includes evergreen trees that are more than six years old at the time they are harvested for ornamental purposes.
With respect to livestock pasturing, if an individual pastures someone else’s livestock and takes care of the livestock for a fee, the individual is a farmer and the income belongs on a Schedule F. But, if the individual simply rents pasture for a flat cash amount without providing services the individual is not a farmer and must report the rent on Schedule E. In that situation, the individual is engaged in a rental activity and not a farming activity. That passive status will also have other tax (and possible estate planning) implications.
A shareholder of an S-Corporation engaged in farming can treat compensation received from the corporation as farming income if the compensation is paid by the corporation in the conduct of farming. Also, amounts passed through to the shareholder, is treated as if it were realized directly. Rev. Rul. 87-121.
When employment is considered “farming-related,” the employer must file an annual Form 943.
In general, a taxpayer is an employer of farmworkers if the employees do any of the following types of work:
- Raise or harvest agricultural or horticultural products on a farm, including raising and feeding of livestock;
- Operate, manage, conserve, improve, or maintain a farm and its tools and equipment;
- Perform services in salvaging timber, or brush clearing and/or debris clearing as a result of a hurricane;
- Handle, process, or package any agricultural or horticultural commodity in certain situations; or
- Some other miscellaneous types of farm-related services.
Farmers and certain other persons may be eligible to claim a credit or refund of excise taxes on fuel used in the trade or business of farming.
“Farmers” in the farming business can exclude from income a cancelled debt that is a qualified farm debt owed to a qualified person. Also, a person that meets an income test and an aggregate debt test can file Chapter 12 bankruptcy and be eligible to have tax debts changed from priority to non-priority status. 11 U.S.C. §1222(a)(2)(A).
For purposes of special use valuation, a surviving spouse of a farmer can be considered to be a farmer by providing active management in the farming operation. I.R.C. §2032A(b)(5).
An individual is a farmer for purposes of estimated tax payment rules if:
- Gross income from farming is at least 66.67 percent of total gross income from all sources of the tax year (I.R.C. §6654(i)(2)(A); or
- Gross income from farming shown on the preceding tax year is at least 66.67 percent of the total gross income from all sources shown on the tax return. I.R.C. 6654(i)(2)(B).
An individual “farmer” can elect to average farm income from the farming business. For this purpose, the term “individual” does not apply to an estate or trust, corporations, partnerships or S-corporations. I.R.C. §1301.
USDA (Federal Farm Programs)
To be a farmer eligible potentially eligible for federal farm programs, a farmer must be “actively engaged” in farming to be eligible for certain farm programs. The term applies to either individuals or entities. As an individual/entity they must make a significant contribution to the farming operation of capital, equipment or land and a significant contribution of personal labor or active management. Additionally, the individual/entity share the profits/losses from the operation as well as the contributions would have to be deemed at risk.
It’s been said that agricultural law is “law by the exception.” What that means is that in numerous areas of the law, a different set of rules apply to someone (or an entity) that qualifies as a “farmer.”
The definition of a farmer is different for different provisions in the Code. It also matters for purposes of federal farm programs and other areas of the law. There’s even more detail on additional provisions than are mentioned here. This is just a thumbnail sketch. Further detail can be provided in additional posts. But, for now, this all shows that my friend Paul is correct. For many answers to questions involving tax and law, “it depends.”
Monday, November 7, 2016
Rural landowners often receive payment from utility companies, oil pipeline companies, wind energy companies and others for rights-of-way or easements over their property. The rights acquired might include the right to lay pipeline, construct aerogenerators and associated roads, electric lines and similar access rights. Payments may also be received for the placement of a “negative” easement on adjacent property so that the neighboring landowner is restricted from utilizing their property in a manner that might decrease the value of nearby land.
The receipt of easement payments raises several tax issues. The payments may trigger income recognition or could be offset partially or completely by the recipient’s income tax basis in the land that the easement impacts. Also, a sale of part of the land could be involved. In addition, a separate payment for crop damage could be involved.
Today, I take a brief look at some of the tax issues involved when a farmer or other rural landowner receives easement payments from utilities or other companies. Last year, I wrote a detailed section on this issue for the University of Illinois Tax Workbook and today’s post involves excerpts of that detailed work. So, a big hat-tip to U of I and the tax team of high quality tax pros there. If you haven’t attended a tax seminar that uses the Illinois Workbook or haven’t ever obtained a copy, you are missing a tremendous set of research materials. For those interested in listening in on a webinar taught out of the Illinois workbook, Kansas State University will be holding a tax seminar in in Pittsburg, Kansas on December 14 and 15. That seminar will also be live simulcast over the web. I will be teaching on the second day. You can find more information about that webinar here: http://commerce.cashnet.com/KSUAGECON (click the Kansas Income Tax Institute Webinar link)
The grant of a limited easement is treated as the sale of a portion of the rights in the land impacted by the easement, with the proceeds received first applied to reduce the basis in the land affected. Thus, if the grant of an easement deprives the taxpayer of practically all of the beneficial interest in the land, except for the retention of mere legal title, the transaction is considered to be a sale of the land that the easement covers. That means that gain or loss is computed in the same manner as in the case of a sale of the land itself under I.R.C. §1221 or §1231. In addition, only the basis of the land that is allocable to that portion is reduced by the amount received for the grant of the easement. Any excess amount received is treated as capital gain. The allocation of basis does not require proration based on acreage. Instead, basis allocation is to be “equitably apportioned” based likely on fair market value or assessed value at the time the easement is acquired.
In rare situations where the entire property is impacted by the easement, the entire basis of the property can be used to offset the amount received for the easement. This might be the situation where severance damage payments are received. These types of payments may be made when the easement bisects a landowner’s property with the result that the property not subject to the easement can no longer be put to its highest and best use. This is more likely with commercial property and agricultural land that has the potential to be developed. Severance damages may be paid to compensate the landowner for the resulting lower value for the non-eased property. If severance damages exceed the landowner’s basis in the property not subject to the easement, gain is recognized.
Severance damages. Under I.R.C. §1033, it is possible for the landowner to defer gain resulting from the payment of severance damages by using the severance damages to restore the property that the easement impacts or by investing the damages in a timely manner in other qualified property. There is no requirement that the landowner apply the severance damages to the portion of the property subject to the easement. Also, if the easement so impacts the remainder of the property where the pre-easement use of the property is not possible, the sale of the remainder of the property and use of the sale proceeds (plus the severance damages) to acquire other qualified property can be structured as a deferral transaction under I.R.C. §1033.
Temporary easements. Some easements may involve an additional temporary easement to allow the holder to have space for access, equipment and material storage while conduction construction activities on the property subject to the easement. A separate designation for a temporary easement for these purposes will generate rental income for allocated amounts. As an alternative, it may be advisable to include the temporary space in the perpetual easement which is then reduced after a set amount of time. Under this approach, it is possible to apply the payment attributable to the temporary easement to the tract subject to the permanent easement. Alternatively, it may be possible, based on the facts, to classify any payments for a temporary easement as damage payments.
Damage payments. Upfront payments that are made to a landowner by the easement holder for actual, current damage to the property caused by construction activities on the property subject to the easement may be able to be offset by basis in the affected property. Examples of this type of payment would be payments for damage to the property caused by environmental contamination and soil compaction. A payment for damage to growing crops, however, is treated as a sale of the crop reported on line 2 of Schedule F (landlord or tenant) or line 1 of Form 4835 for a crop-share landlord. Any payment for future property damage (e.g., liquidated damages), however, is generally treated as rent.
Negative easements. A landowner may make a payment to an adjacent or nearby landowner to acquire a negative easement over that other landowner’s tract. A negative easement is a use restriction placed on the tract to prevent the owner from specified uses of the tract that might diminish the value of the payor’s land. For instance, a landowner may fear that their property would lose market value if a pipeline, high-power transmission line or wind aerogenerator were to be placed on adjacent property. Thus, the landowner might seek a negative easement over that adjacent property to prevent that landowner from granting an easement to a utility company for that type of activity from being conducted on the adjacent property. The IRS has reached the conclusion that a negative easement payment is rental income in the hands of the recipient. F.S.A. 20152102F (Feb. 25, 2015). It is not income derived from the taxpayer’s trade or business. In addition, the IRS position taken in the FSA could have application to situations involving the government’s use of a taxpayer’s property to enhance wildlife and conservation.
A right of use that is not an easement generates ordinary income to the landowner and is, potentially, net investment income subject to an additional 3.8 percent tax. Thus, transactions that are a lease or a license generate rental income with no basis offset. For example, when a landowner grants surface rights for oil and gas exploration, the transaction is most likely a lease. Easements for pipelines, roads, surface sites and similar interests that are for a definite term of years are leases. Likewise, if the easement is for “as long as oil and gas is produced in paying quantities,” it is lease.
Some other points on lease payments should be made. A lease is characterized by periodic payments. A lease is also indicated when failure to make a payment triggers default procedures and potential forfeiture. In addition, lease payments are not subject to self-employment tax in the hands of the recipient regardless of the landowner’s participation in the activity. Accordingly, the annual lease payment income would be reported on Schedule E (Form 1040), with the landowner likely having few or no deductible rental expenses.
Proposed easement acquisitions can be contentious for many landowners. Often, landowners may not willingly grant a pipeline company or a wind energy company, for example, the right to use the landowners’ property. In those situations, eminent domain procedures under state law may be invoked which involves a condemnation of the property. The power of eminent domain is the right of the state government (it’s called the “taking power” for the federal government) to acquire private property for public use, subject to the constitutional requirement that “just compensation” be paid. While eminent domain is a power of the government, often developers of pipelines and certain other types of energy companies are often delegated the authority to condemn private property. The condemnation award (the constitutionally required “just compensation”) paid is treated as a sale for tax purposes.
The IRS view is that a condemnation award is solely for the property taken. But, if the condemnation award clearly exceeds the fair market value of the property taken, a court may entertain arguments about the various components of the award. Thus, it’s important for a landowner to preserve any evidence that might support allocating the award to various types of damages.
While a condemnation award that a landowner receives is treated as a sale for tax purposes, I.R.C. §1033 allows a taxpayer to elect to defer gain realized from a condemnation (and sales made under threat of condemnation) by reinvesting the proceeds in qualifying property within three years.
The election to defer gain under I.R.C. §1033 is made by simply not reporting the condemnation gain realized on the return for the tax year the award is received. A disclosure that the taxpayer is deferring gain under I.R.C. §1033, but not disclosing is treated as a deemed election.
Rural landowners are facing easement issues not infrequently. Oil and gas pipelines, wind energy towers, and high voltage power lines are examples of the type of structures that are associated with easements across agricultural land. Seeking good tax counsel can help produce the best tax result possible in dealing with the various types of payments that might be received.
Thursday, November 3, 2016
The USDA has sent to the Office of Management and Budget (OMB) interim final rules that provide the agency’s interpretation of certain aspects of the Packers and Stockyards Act (PSA) involving the buying and selling of livestock and poultry. The USDA issued proposed rules in 2010, but is now taking steps to finalize the revised rules in the waning days of the current Administration. The proposed rules generated thousands of comments, with ag groups and producers split in their support.
Today’s blog post takes a look at the issues involved, what the courts have had to say in recent years, and what the USDA’s interpretation is. The matter has been a hot one in the livestock sector for quite some time.
The PSA Provisions at Issue
Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. The “effect” language of the statute would seem to eliminate any requirement that the producer show that the packer acted with the intent to control or manipulate prices. The whole matter has been a distinct concern in the livestock industry.
In recent years, numerous courts have addressed the issue of whether the statutory language requires a producer to prove that a packer’s conduct had an adverse impact on competition. For example, in late 2001, a nationwide class action lawsuit was certified against Iowa Beef Processors (subsequently acquired by Tyson Fresh Meats, Inc.) on the issue of whether Tyson’s use of “captive supply” cattle (cattle acquired other than on the open, cash market) violated Section 202 of the PSA. The class included all cattle producers with an ownership interest in cattle that were sold to Tyson, exclusively on a cash-market basis, from February 1994 through and including the end of the month 60 days before notice was provided to the class. The claim was that Tyson’s privately held store of livestock (via captive supply) allowed Tyson to need not rely on auction-price purchases in the open market for most of their supply. Tyson was then able to use this leverage to depress the market prices for independent producers on the cash and forward markets, in violation of the PSA. In early 2004, the federal jury in the case returned a $1.28 billion verdict for the cattle producers. However, one month later the trial court judge, while not disturbing the economic findings that the market for fed cattle was national, that the defendant’s use of captive supply depressed cash cattle prices and that cattle acquired on the cash market were of higher quality than those the defendant acquired through captive supplies, granted the defendant’s motion for judgment as a matter of law, thereby setting the jury’s verdict aside. The trial court judge ruled that Tyson was entitled to use captive supplies to depress cash cattle prices to “meet competition” and assure a “reliable and consistent” supply of cattle. Pickett v. Tyson Fresh Meats, Inc., 315 F. Supp. 2d 1172 (M.D. Ala. 2004). On appeal, the U.S. Court of Appeals for the Eleventh Circuit affirmed (Pickett v. Tyson Fresh Meats, Inc., 420 F.3d 1272 (11th Cir. 2005)), and the U.S. Supreme Court declined to hear the case. Most of the other courts that have considered the issue have also determined that Section 202 of the PSA requires a producer to prove that a packer’s conduct adversely impacted competition. That includes the U.S. Court of Appeals for the Tenth Circuit, the Eleventh Circuit and the Sixth Circuit, among others. While the United States Court of Appeals for the Fifth Circuit, in a contract poultry production case, ruled that the plain language of Section 202 does not require a plaintiff to prove an adverse effect on competition (Wheeler, et al. v. Pilgrim’s Pride Corp., 536 F.3d 455 (5th Cir. 2008)) the court granted en banc review with the full court later reversing the 3-judge panel decision. The full court reversed because it believed that the PSA’s legislative history coupled with the interpretation of other courts on the issue required the plaintiff to show an anti-competitive effect to have an actionable claim.
In 2009, contract poultry growers in Texas, Arkansas, Oklahoma and Louisiana brought a PSA price manipulation case against the company that provided them with chicks, feed, medicine and other inputs. City of Clinton v. Pilgrim’s Pride Corporation, 654 F. Supp. 2d 536 (N.D. Tex. 2009). The company had filed for Chapter 11 bankruptcy and, as part of reorganizing its business activities closed certain facilities and terminated some grower contracts. The terminated growers claimed the defendant’s actions violated Section 192(e) of the PSA as actions that had the effect of manipulating the price of chicken by terminating those growers that were not near another poultry integrator so that they couldn’t sell their chickens to one of the defendant’s competitors, and terminating those growers who would not upgrade their chicken houses to include cool-cell technology even though not required by grower contracts. While the court held that the defendant could have a legitimate business reason for its decisions and might be able to show that the plaintiffs were not harmed by its actions, the court determined that the plaintiffs’ pleadings were sufficient to survive a motion to dismiss. In addition, the court held that the Texas growers had posed legitimate claims under the Texas Deceptive Trade Practices Act.
These cases (and other similar ones) spurred interest in revised PSA regulations by the USDA. Thus, in June of 2010, the USDA issued proposed regulations providing guidance on the handling of antitrust-related issues under the PSA. 75 Fed. Reg. No. 119, 75 FR 35338 (Jun. 22, 2010). Under the proposed regulations, "likelihood of competitive injury" is defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer, swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The proposed regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations also note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue.
Move To Finalize the Regulations
Recently, the USDA took steps to finalize the regulations after receiving volumes of comments on the proposed regulations. The USDA sent to the OMB for review three rules, known as the “Farmer Fair Practices Rules.” If the OMB approves the revised rules, they will be published in the Federal Register and then will be subject to a comment period and could again be delayed or blocked by the same procedure that has previously been used.
The rules are revisions to the proposed rules that were issued in 2010 to implement certain 2008 Farm Bill provisions. On several occasions, the Congress included riders in the annual USDA funding bill to block finalization of the proposed regulations, but didn’t do so with the 2016 funding bill. That’s what spurred the USDA to move forward with finalizing the rules.
The rules basically do three things: (1) as an interim final rule, a producer would not have to prove injury to or diminished competition, but only show that a packer’s practice was “unfair” or “undue” or that an “unreasonable” preference or advantage was given to another producer or producers; (2) a proposed rule concerns packer contracts that offer price premiums that could create pricing preferences; and (3) a proposed rule that addresses poultry “tournament” pricing contracts (where growers are grouped together and then ranked on performance) by setting requirements for contracting companies to comply with to determine a grower’s payment.
Ag groups are split on how they view the revised rules. Some have pushed long and hard to get these new regulations that they believe would better protect livestock and poultry producers from buying practices of livestock packers and poultry suppliers. Others view the rules as doing nothing but adding cost to the production process, disrupting the current system for marketing livestock and poultry, and triggering more litigation. In any event, if the rules are ultimately finalized, they would be reviewed by courts under a deferential standard which would mean that they would likely be upheld. The would only be overturned under that standard if they were arbitrary and capricious and did not comport with any reasonable interpretation of the PSA.
Tuesday, November 1, 2016
My post last week on casualty and theft losses generated A LOT of positive feedback and requests for more information about farm losses in general. The tax code does provide some help in dealing with farming losses – especially for taxpayers that are on the cash method (which most farmers are). That’s good news when faced with an economic downturn in the farm economy. It puts year-end tax planning at a premium and is one of the things I am focusing on at the tax schools I am teaching across the country this fall.
It’s also a topic that Andy Biebl of CliftonLarsonAllen’s National Tax Team addressed in a recent farm magazine column. Andy only has limited space for that column. I get to blabber here without limitation. So, let’s take a bit of a deeper look beyond the casualty and theft loss discussion of last week and expand on what Andy has already written on. It’s a big enough issue this fall that it deserves more attention. In addition, I have the feeling that this blog reaches a bit of a different audience than does the farm magazine column. That’s a good thing. It allows the issue to be discussed in front of the widest audience possible.
Farm Income Averaging and Farm Operating Losses
For persons engaged in farming (cultivating of land or the raising or harvesting of any ag or horticultural commodity), the ability to elect to average farm income back three years can be a very important income tax management tool. While farm income averaging is normally utilized to apply lower income tax rates from prior years to the current year taxable income, it can work in reverse when income is low in the current year. When the election is made in that situation, the power of the technique lies in combining an income averaging election with the loss carryback rule.
For example, assume that Joe has a large net Schedule F farming loss for 2016 (unfortunately, many farmers will experience this for 2016). Under the five-year carry back rule that applies to farming losses, Joe can carry that back to his 2011 tax year. If 2011 was a good year for Joe (as it was for many farmers), he was probably in one of the upper income tax brackets that year. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. In our example, if it offsets all of Joe’s income for the carryback year of 2011 before it is used up, the remaining amount simply carries forward to 2012 and any later years. This all points out that a loss from farming isn’t all bad news. It can generate an operating loss that can be carried back and generate a refund in a prior year.
Also, in our example, Joe has the option to decide not to carry back a loss five years. He can carry it back two years instead. Joe can do this by making an election to irrevocably forego the five-year carryback period for a farming loss. I.R.C. §172(i)(3). So, if it would be better from a tax standpoint for Joe to carry a farming loss back two years rather than five, that’s what he should do. It all depends on the level of income in those carryback years and the applicable tax bracket. Also, because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that Joe made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, Joe will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow him to claim future depreciation deductions. This is the case, at least, on Joe’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Note: Yes, you can make or revoke an I.R.C. §179 election on an amended return for an open tax year. Ignore any commentary to the contrary unless it comes from the IRS.
Ok. But, you ask, “where does farm income averaging fit into all of this?” That’s a good question. If we continue with Joe’s situation of a big 2016 loss that he carried back to 2011 (and triggered a refund), there is another piece to the tax puzzle that needs to be inserted here and it has to do with how the income averaging tax is calculated. Under the farm income averaging rules, the Code says that the tax imposed for the year in which income averaging is elected is the sum of the tax for that year on income reduced by the amount of the elected farm income, plus the increase in tax which would have occurred if taxable income for each of the three previous tax years was increased by an amount equal to one-third of elected farm income. I.R.C. §1301(a). That’s a mouthful. In addition, any adjustment to taxable income for a prior year because of the “elected farm income” amount averaged to that tax year is taken into account in applying the income averaging provision for any subsequent taxable year.
So, what does this Code language mean? It means that the income of the past years is adjusted upward for a future year’s computation after income averaging has been used. That means that farm income averaging doesn’t really change the taxable income or tax of any of the three base years. It doesn’t cause the current year’s income to get hauled back and added to the income from a base year. That’s a big deal. The income averaging election simply uses the prior three-year tax base to peg the rate for the year of the election. Any applicable phase-outs or percentage limitations for the base years are not impacted. Treas. Reg. §1.1301-1(d)(1).
So, back to our example with Joe, his tax practitioner might be able to get him a better tax result by amending his 2013 and 2014 tax returns to get more bang out of the income averaging election by not only getting a refund for 2011, but also reducing the applicable tax rate for 2013 and 2014 (for Joe, 2012 is a closed year that is not part of the base years for the income averaging calculation). That makes the bad income year not quite as bad after all. That’s the result that can be obtained with an income averaging election in a down year after a couple of good ones. How do you know whether it makes sense to do all of this? Get your pad and pencil out and run the numbers! Actually, your tax software will do it for you. But, just knowing the mechanics of the combined techniques is the key to being able to “eyeball” when it might be a good idea to plug the numbers into the software for a farm client.
Excess Farm Losses
The 2008 Farm Bill included a provision that limits the deductibility of an “excess farm loss” after 2009 for farmers that don’t operate in the C corporate form that receive any direct or counter-cyclical payment from the USDA, or any payment elected to be received in lieu of a direct or counter-cyclical payment, or any CCC loan. I.R.C. §461(j). CRP payments are not deemed to be a subsidy payment for purposes of this provision. The non-deductible portion of a farming loss is the excess of the aggregate deductions of the farmer for the year attributable to the farming business, or the sum of the aggregate gross income or gain of the farmer for the year attributable to farming, plus a threshold amount defined as the greater of $300,000 (MFJ) or the total of the net farm income for the previous five years. I.R.C. §461(j)(4)(B). There are other detailed rules on this provision, but these are the basics. Also, direct and counter-cyclical payments have now been repealed, so it looks like the only type of subsidy that would count and potentially limit a farmer’s ability to deduct losses would be the receipt of a CCC loan. Loan deficiency payments would appear to not be an “applicable subsidy” for purposes of the provision. Also, for purposes of the rule, losses arising from fire, storm or any other casualty, or because of disease or drought are not subject to the limitation.
Economic conditions in agriculture point toward another bad income year for both crop farmers and livestock producers, in general. This puts a premium on getting good tax advice and engaging in some serious year-end tax planning. The cash method of accounting provides the flexibility and the ability to use a farm income averaging election after the fact can be a powerful tool to manage income, especially when it is combined with the revocation of an I.R.C. §179 election for the open tax years.
Just some things to think about that might help soften the blow and get on your farm client’s Christmas card list!