Thursday, December 29, 2016
What’s a Rural Landowner’s Responsibility Concerning Crops, Trees and Vegetation Near an Intersection?
A question that I get periodically involves the responsibility, if any, of a farmer or rural landowner to make sure that crops, trees or other vegetation on their property don’t obscure a motorist’s view on a public roadway. It’s an interesting question, and the answer involves a discussion of the negligence principles of tort law. The answer can also depend on the particular jurisdiction, and it may be surprising.
Every negligent tort case contains four elements that a plaintiff must establish in order to prevail – (1) duty (2) breach (3) causation and (4) damages. The defendant must have had a duty to act in a certain way towards the plaintiff, must have breached that duty, and the breach of the duty must have caused the plaintiff’s damages. There usually isn’t any question about the breach or damages elements – those are typically self-evident in most cases. Sometimes a question does arise concerning the duty element. But, most of the controversy in any given negligent tort case is commonly focused on the causation element. Did the defendant’s breach of the duty owed to the plaintiff actually cause the plaintiff’s damages? In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred.
Some things are reasonably foreseeable and other things are not, and an individual will be held liable for harm that is reasonably foreseeable or reasonably expected to result from the defendant's actions. For example, in a Georgia case, a landowner was not liable for the death of a motorist struck by a falling tree. While the tree leaned over the road, there was no visible decay present and the landowner had no notice of the dangerous condition. Wade v. Howard, 499 S.E.2d 652 (Ga. Ct. App. 1998). There must be a causal connection - a causal linkage - between the defendant's action and the plaintiff's harm. But, what about crops, trees or other vegetation that obstructs a motorist’s view? Does the landowner have a duty to maintain crops, trees and other vegetation in a manner that doesn’t block the view of the motoring public? That issue came up in a recent Kansas case. If there is no duty, then the causation issue is moot.
In Manley v. Hallbauer, No. 115,531 (Kan. Ct. App. Dec. 23, 2016), the defendants (a married couple) owned about 11 acres of land that abutted an intersection of an infrequently traveled gravel county road. The intersection was uncontrolled – there were no traffic signs. Trees on the defendants’ property completely obstructed the view for the last 50 to 60 feet before the intersection. Two vehicles collided at the intersection, with the driver of one of the vehicles dying in the crash. The decedent’s estate sued the landowner for negligence, claiming that the defendants had a duty to trim their trees to maintain visibility at the intersection. The trial court granted summary judgment for the defendants and the estate appealed.
The appellate court affirmed. The court noted that the trees had been on the property when the defendants acquired it about five years before the accident, and that the defendants had not received any complaints from the County or anyone else about the trees. The court also noted that there was no record of any prior accidents at the intersection and also no evidence that either driver attempted to stop or slow down before entering the intersection.
On the duty issue, the court noted that it existed if the plaintiff was a foreseeable plaintiff and the probability of harm was foreseeable. In other words, the question was whether a reasonable landowner would have foreseen a probability of harm to motorists from the obstructed view. But, as the court noted, that question cuts both ways. Drivers also have responsibility to drive with more caution when view is obstructed. Similarly, under the Restatement [Second] of Torts §343A, the court noted that landowners don’t have a duty to protect people from open and obvious dangers. That, principle, the court noted, relates to the foreseeability issue. The defendants could reasonably assume that motorists would protect themselves from the obvious visual obstruction by taking additional precaution. Also, under the Restatement [Second] of Torts §363, a provision that Kansas courts have applied numerous times, a rural landowner has no liability for physical harm caused to someone outside the land itself when the injury was caused by a natural condition on the land, such as trees. The court rejected the approach of the Restatement [Third] of Torts §54 that makes landowners liable if the landowner knew of the risk or the risk was obvious as not being consistent with Kansas law. Instead, the rule in Kansas is one of no-liability, no-duty. The court noted that was also the rule in Arkansas, Florida, Illinois, Iowa, Massachusetts, and Virginia. In all of these jurisdictions, landowners don’t owe a duty to motorists to cut down naturally occurring vegetation that obstructs the view at an intersection. If the condition on the land is artificial, however, a different rule applies. In that situation, landowners owe a duty of reasonable care to motorists.
Hallbauer points out the general rule that if a natural object on the premises injures another person, the landowner is not liable. There is no duty to remedy a natural hazard. That is particularly the case with respect to rural land. But, over time, some states have modified the common-law rule, particularly as applied to trees and entrants onto the property. See, e.g., Lewis v. Krussel, 101 Wash. App. 178, 2 P.3d 486 (2000); Cobb, et al. v. Town of Blowing Rock, No. COA09-1443, 2011 N.C. App. LEXIS 1398 (N.C. Ct. App. Jul. 5, 2011). In such situations, landowners owe a duty to ensure that their trees (and other natural conditions) do not cause harm. However, that’s not the rule in Kansas (and some other states).
While Hallbauer was brought on negligence principles, another theory that could have possibly applied was nuisance. Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property. Nuisance cases exist that involve encroaching limbs and roots of neighboring trees. The courts have adopted four basic rules for determining if trees constitute a nuisance. Under the “Massachusetts Rule,” a landowner’s right to protect property from encroaching limbs and roots of an adjacent property owner’s trees is limited to self-help (i.e., cutting-off branches and roots at the point they cross the property line). The “Virginia Rule” is a slight modification of the Massachusetts Rule and can result in a tree owner being held liable for damage caused by the tree and being required to cut back roots and limbs if the tree poses a risk of actual harm or an imminent danger. In such situations, if self-help is inadequate as a permanent remedy, complete removal of the tree may be an available remedy. The “Restatement Rule” (based on Restatement (Second) of Torts §§839-840 (1979)) requires a landowner to control vegetation that encroaches upon adjoining land if the vegetation has been planted or is maintained by a person, but not if the vegetation is “natural.” Under the “Hawaii Rule,” living trees and plants are ordinarily not nuisances. However, trees and plants can become a nuisance when they cause harm or pose an imminent danger of actual harm to adjacent property.
It may come as a surprise to some that in numerous states rural landowners have no duty to make sure that crops, trees and other vegetation don’t obstruct the view on public roadways. But, remember, motorists also have a duty to operate their vehicles in a safe manner. Is it foreseeable that a motorist might not operate their vehicle in a safe manner? Probably, but that’s not a landowner’s problem with respect to natural conditions that present an open and obvious danger. Even so, it’s still a good idea not to plant crops so that when they are grown they could cause a visual obstruction. The same can be said for other vegetation too. It’s just a common courtesy. Not necessary under the law, but certainly a good thing to do.
Tuesday, December 27, 2016
For tangible depreciable personal property (and some types of qualified real estate improvements), all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer's trade or business), regardless of the time of year the asset was actually placed in service. This is an off-the-top depreciation allowance that may be taken at the taxpayer's election each year. On a joint return, the aggregate basis amount eligible for the deduction is $510,000 at the federal level (for 2017), except for certain types of vehicles. But, the maximum amount that can be claimed is limited to the taxpayer’s aggregate business taxable income (including I.R.C. §1231 gains and losses and interest from the working capital of the business). Treas. Reg. §1.179-2(c).
The provision is a “biggie” for many farmers and ranchers. But, there is a potential trap that can apply to farm landlords that is often overlooked. That’s the focus of today’s post.
As noted above, to claim expense method depreciation, the taxpayer must have income from the active conduct of a trade or business. That’s determined in accordance with a facts and circumstances test to determine if the taxpayer “meaningfully participates in the management or operations of the trade or business.” Treas. Reg. §1.179-2(c)(6)(ii). Wages and salaries that the taxpayer receives as an employee are included in the aggregate amount of active business taxable income of the taxpayer. Moreover, a spouse's W-2 wage income is considered income from an active trade or business for this purpose if they file a joint income tax return.
The limitation applies at the entity level for pass-through entities in addition to also applying at the individual taxpayer level. That’s an important point for farming operations where family members are sharing ownership of equipment. If a co-ownership arrangement is construed as a partnership, only one I.R.C. §179 limitation would apply to equipment purchases. If the co-ownership is not a partnership, each taxpayer could count their respective share of equipment purchases for purposes of the I.R.C. §179 limitation.
Here are some other key points about the provision:
- Property that is eligible for expense method depreciation is tangible, depreciable personal property. This includes costs to prepare and plant a vineyard, including labor costs. C.C.A. 201234024 (May 9, 2012).
- Expense method depreciation is tied to the beginning of the taxpayer’s tax year.
- Qualified leasehold improvement property and qualified retail improvement property are eligible for expense method depreciation as are air conditioning and heating units (beginning in 2016).
- Certain items of tangible depreciable personal property are not eligible for expense method depreciation. In general, any property that would not be eligible for investment tax credit (under the rules when the investment tax credit was available) is ineligible for expense method depreciation.
- In addition, property acquired by gift, inheritance, by estates or trusts and property acquired from a spouse, ancestors or lineal descendants is not eligible for expense method depreciation. For property traded in, only the cash boot that is paid is eligible for expense method depreciation.
- Expense method depreciation is phased out for taxpayers with cost of qualifying property purchases exceeding $2,030,000 (for 2017). For each dollar of investment in excess of $2,030,000 for the year, the allowable expense amount is reduced by $1. Thus, for 2017, at $2,030,000, the full deduction is available, and at $2,540,000, nothing is available.
- Upon disposition of property on which an expense method depreciation election has been made, special income tax recapture rules may apply.
- For expense method depreciation assets disposed of by installment sale, all payments received under the contract are deemed to have been received in the year of sale to the extent of expense method depreciation claimed on the property.
- The expense method election for eligible property must be made on the first return (or on a timely filed amended return) for the year the elected property is placed in service. However, an expense method depreciation election can be made or revoked on an amended return for an open tax year (generally the most recent three years).
For the farmer or rancher, expense method depreciation can be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks and business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins and silos. But, of course, the trade-off is that if expense method depreciation is selected for a particular asset, the basis of the asset must be reduced by the amount of the expensing deduction.
Non-Corporate Lessor Rule
Non-corporate taxpayers that lease property to others that contains tangible property on which the landlord seeks to claim expense method depreciation, must satisfy two additional requirements. I.R.C. §179(d)(5). First, the term of the lease must be less than 50 percent of the class life of the property. Second, during the first 12 months of the lease, the deductions of the lessor with respect to the property (other than taxes, interest and depreciation) must exceed 15 percent of the rental income produced by the property. The rule makes it difficult for farm landlords to claim expense method depreciation with respect to many real estate improvements, particularly those that don’t require repairs and maintenance in that first 12-month period.
A Tax Court case a few years ago illustrates the peril posed to farm landlords by the non-corporate lessor rule. In Thomann v. Comm’r., T.C. Memo. 2010-241, the taxpayers were a farm couple that owned and operated a 504-acre farm. Around 2000, the couple orally leased 124 acres of their farmland along with buildings, grain storage bins and equipment to Circle T Farms, Inc., a hog farrow-to-finish business that the couple owned for $70,000 annual cash rent. They orally leased the balance of their farmland to C&A, Inc., an unrelated party. The husband also entered into an oral farming agreement with C&A that was put in writing in 2006 to state that the agreement “covered any future year[‘]s crops, so long as neither party requested a change on or before Sept[ember] 1 of the calendar year.” In 2004, 2005 and 2006, they purchased property that qualified for expense method depreciation. On their tax return for 2004, they expensed $52,000 for drainage tile and a fence that was installed on the land that they leased to C&A, and $10,000 for material they purchased to remodel their farm office, including furniture and fixtures. For 2005, they expensed $63,488 for a grain bin. For 2006, they expensed $8,467 for a pickup truck and $31,000 for a grain bin and grain dryer. The bin and dryer (and, presumably, the pickup truck) were orally leased to Circle T Farms – for the $70,000 annual “cash rent.” The IRS disallowed all of the expense method depreciation deductions for the farm-related property - citing the non-corporate lessor rule.
As for the office equipment, the court agreed with the IRS that the couple didn’t substantiate the deduction on their return and, as such, the court couldn’t determine whether the office material was eligible for expensing as “other property” under I.R.C. Sec. 1245. Importantly, the court did not hold that the office materials were not I.R.C. §1245 property, but did hold that the taxpayers failed to present sufficient evidence to allow the court to determine whether the office materials were not “structural components” and would, therefore, be eligible for expense method depreciation. So, an expense method deduction was denied for those items. The court did not address the non-corporate lessor rule with respect to the office equipment.
As for the grain bins, grain dryer, drainage tile, pickup truck and fence, the non-corporate lessor rule was applicable. The couple claimed that the lease was for a year, renewable annually for another year and was, therefore, less than 50 percent of the class life of the farm-related property. But, the IRS and the court disagreed. None of the leases were in writing and the couple didn’t provide any evidence of the actual lease terms. As a result, the court concluded that the leases were for an indefinite period of time and did not have a term of less than 50 percent of the class life of the property. The court also imposed an accuracy-related penalty.
When it comes to many improvements on farmland, the non-corporate lessor rule is a major hurdle for farm landlords irrespective of whether the lease is cash rent or crop-share. Farm leases may be short term, if they are in writing, but many may not even be in writing. As Thomann illustrates, an oral lease can end up violating the rule. Even if the test involving the length of the lease as compared to the class life of the farmland improvements is met, the improvements may not need repair and maintenance sufficient enough to allow the landlord to meet the other part of the non-corporate lessor rule. That means that satisfaction of the “overhead” test may come down to how operating costs, if any, are allocated between the landlord and the tenant and how those costs relate to the rental amount.
The bottom line is that, for non-corporate farming operations, leases need to be in writing and drafted carefully with the non-corporate lessor rule in mind.
Friday, December 23, 2016
Diffused surface runoff of agricultural fertilizer and other chemicals into water sources as well as irrigation return flows are classic examples of nonpoint source pollution that isn’t discharged from a particular, identifiable source. The primary source of nonpoint source pollution is agricultural runoff. As nonpoint source pollution, the Clean Water Act (CWA) leaves regulation of it up to the states rather than the federal government. But, that’s not to say that the federal government doesn’t have a role to play in the regulations of nonpoint source pollution. It does. But, it’s a role that plays out in the background as a potential backstop to what a particular state does. The CWA sets-up a “states-first” approach to regulating water quality when it comes to nonpoint source pollution.
A recent case illustrates the deference that courts give to the decision of the Environmental Protection Agency (EPA) to not create federal rules for agricultural runoff and instead let the states take the lead in addressing the issue.
The CWA and Nonpoint Source Pollution
The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. As noted, point source pollution is the concern of the federal government.
Pollution from nonpoint agricultural sources, particularly that originating from soil erosion, is more extensive than pollution resulting from feedlot operations. But, because nonpoint source pollution is largely dependent upon local topographical conditions, the Congress believed it was best left to the control of the states through the continuing planning process required by §303 (relating to water quality standards) and §208 (areawide waste management plans) of the CWA. In addition, in 1987, the Congress amended the CWA to establish a national nonpoint source program under §319.
Section 303 (“Water Quality Standards and Implementation Plans”), requires states to adopt water-quality standards, to the extent not previously done, and to carry forward those already adopted subject to EPA approval. Standards are to be set for both interstate and intrastate waters, and the standards must be updated periodically and submitted to EPA for review and approval. The standards are to take into account the unique needs of each waterway including “propagation of fish and wildlife” as well as “agricultural...and other purposes.” Any state that fails to set water quality standards is subject to the EPA imposing its own standards on the state. Section 303 does not exempt any rivers or waters, but covers all waters to the full extent of federal authority over navigable waters.
Total Maximum Daily Loads (TMDLs)
The states are to establish total maximum daily loads (TMDLs) for watercourses that fail to meet water quality standards after the application of controls on point sources. A TMDL establishes the maximum amount of a pollutant that can be discharged or “loaded” into the water at issue from all combined sources on a daily basis and still permit that water to meet water quality standards. A TMDL must be set “at a level necessary to implement water quality standards.” The purpose of a TMDL is to limit the amount of pollutants in a watercourse on any particular date.
Regulation of nonpoint source pollution via TMDLs. A couple of legal issues related to TMDLs have arisen recently. Both of them are important to agriculture. One issue involves the question of whether the EPA has the authority to regulate nonpoint source pollutants under §303 through the TMDL process and thereby require reductions in nonpoint source discharges. Indeed, the TMDL requirements were challenged in early 2000 by farm interests as being inapplicable to nonpoint source pollution. In Pronsolino v. Marcus, 91 F. Supp. 2d 1337 (N.D. Cal. 2000), aff’d, sub. nom., Pronsolino v. Nastri, 291 F.3d 1123 (9th Cir. 2002), cert. denied, 539 U.S. 926 (2003), the plaintiffs had obtained a permit to harvest timber and became subject to restrictions designed to reduce soil erosion. The plaintiffs theorized that the restrictions were a by-product of the TMDL criterion and challenged the EPA’s authority to impose TMDL requirements on rivers polluted only by timber-harvesting and other nonpoint sources. The court, however, held that the TMDL requirements, as a comprehensive water-quality standard under the CWA, were designed to apply to every navigable river and water in the country. Although the court noted that the CWA applied TMDL to point and nonpoint sources differently, it stressed that TMDL was clearly authorized for nonpoint sources. Thus, according to the court, any polluted waterway – whether the source of pollution is point or nonpoint – is subject to TMDL requirements.
The case was affirmed on appeal, but the appellate court, in dictum, noted that the statute did not require states to actually reduce nonpoint source pollution flowing into these waters. The appellate court made clear that TMDL implementation of nonpoint source pollution is a matter reserved to the states. Thus, the court appeared to substantially limit the EPA’s ability to require nonpoint source pollution reduction - the EPA can develop TMDLs that highlight the need for aggressive control of nonpoint source pollution, but cannot address nonpoint source pollution by itself. Where a state fails to establish TMDLs, the EPA has the power to implement them. TMDL rules exemplify cooperative federalism between the EPA and the states. See, e.g., American Farm Bureau Federation, et al. v. United States Environmental Protection Agency, et al., No. 1:11-CV-0067, 2013 U.S. Dist. LEXIS 131075 (M.D. Pa. Sept. 13, 2013).
Deference to the EPA. In two recent cases involving TMDLs, the courts denied attempts by environmental groups to force the EPA to create additional federal regulations involving TMDLs. In Conservation Law Foundation v. United States Environmental Protection Agency, No. 15-165-ML, 2016 U.S. Dist. LEXIS 172117 (D. R.I. Dec. 13, 2016), the plaintiff claimed that the EPA’s approval of the state TMDL for a waterbody constituted a determination that particular stormwater discharges were contributing to the TMDL being exceeded and that federal permits were thus necessary. The court, however, determined that the EPA’s approval of the TMDL did not mean that EPA had concluded that stormwater discharges required permits. The court noted that there was nothing in the EPA’s approval of the TMDL indicating that the EPA had done its own fact finding or that EPA had independently determined that stormwater discharges contributed to a violation of state water quality standards. The regulations simply do not require an NPDES permit for stormwater discharges to waters of the United States for which a TMDL has been established. A permit is only required when, after a TMDL is established, the EPA makes a determination that further controls on stormwater are needed.
In the other case, Gulf Restoration Network v. Jackson, No. 12-677 Section: “A” (3), 2016 U.S. Dist. LEXIS 173459 (E.D. La. Dec. 15, 2016), numerous environmental groups sued the EPA to force them to impose limits on fertilizer runoff from farm fields. The groups claimed that many states hadn’t done enough to control nitrogen and phosphorous pollution from agricultural runoff, and that the EPA was required to mandate federal limits under the Administrative Procedure Act – in particular, 5 U.S.C. §553(e) via §303(c)(4) of the CWA. Initially, the groups told the EPA that they would sue if the EPA did not write the rules setting the limits as requested. The EPA essentially ignored the groups’ petition by declining to make a “necessity determination. The groups sued and the trial court determined that the EPA had to make the determination based on a 2007 U.S. Supreme Court decision involving the Clean Air Act (CAA). That decision was reversed on appeal on the basis that the EPA has discretion under §303(c)(4)(B) of the CWA to decide not to make a necessity determination as long as the EPA gave a “reasonable explanation” based on the statute why it chose not to make any determination. The appellate court noted that the CWA differed from the CAA on this point. On remand, the trial court noted upheld the EPA’s decision not to make a necessity determination. The court noted that the CWA gives the EPA “great discretion” when it comes to regulating nutrients, and that the Congressional policy was to leave regulation of diffused surface runoff up to the states. The court gave deference to the EPA’s “comprehensive strategy of bringing the states along without the use of federal rule making…”.
Both of the recent cases reemphasize that the CWA leaves the regulation of nonpoint source pollution up to the states. The cases also point out that the EPA is owed substantial deference under the CWA when it decides not to regulate water quality issues in situations where it is clear that the Congress has left the regulation up to the states under a scheme of cooperative federalism.
Environmental groups have pushed for many years for the direct federal regulation of nutrient pollutants found in farm field runoff. They have also pushed for federal regulation of field tile drainage systems even though such systems are exempt from CWA regulation via the exemption for return flows from irrigated water, and even though the EPA has repeatedly said that it has no interest in regulating farm field tile drainage. These two recent opinions bolster the point that diffused surface runoff is not subject to federal regulation, and that EPA can’t be forced to give the environmental groups what they want, when what they want is contrary to the statute and Congressional intent. The cases also illustrate that sometimes the EPA refuses to enter into a settlement agreement with special interest groups that have sued them in order to get federal rules created outside of the normal process of rulemaking that are beyond public review and comment.
Both of these points also have implications for the ongoing Des Moines Water Works litigation against Iowa farmers.
To all of the readers, a very Merry Christmas!
Wednesday, December 21, 2016
The U.S. legal system has a long history of allowing debtors to hold specified items of property exempt from creditors (unless the exemption is waived). This, in effect, gives debtors a “fresh start” in becoming reestablished after suffering economic reverses. Procedurally, exempt property is included in the debtor's estate in bankruptcy, but any particular exempt asset can be removed from the bankruptcy estate if no objections to the exemption claim is made within 30 days from the meeting of the creditors. In that case, the debtor can then fully utilize the exempt asset. Only nonexempt property is used to pay the unsecured creditors.
Because of the availability of exemptions, debtors may be tempted to convert nonexempt property (such as cash) into exempt assets prior to bankruptcy filing. They may also be tempted to transfer property (either exempt or not) to a spouse or other family member to get the property out of their name. There is no general prohibition on such conversions, but courts closely examine attempted conversions with respect to the adequacy of the purchase price and the bargaining position of the parties involved. If the primary purpose of the move is to hinder, delay or defraud creditors, the conversion can be challenged. In addition, transfers made by insolvent debtors within one year of filing a bankruptcy petition in exchange for less than equivalent value may be avoidable transfers. See 11 U.S.C. § 548(a)(2).
Actual intent to defraud must generally be present, but a court may infer actual intent from the circumstances of the debtor's conduct. In other words, a debtor could engage in actual fraud as defined by 11 U.S.C. §548 (a)(1)(A) or constructive fraud under 11 U.S.C. §548 (a)(1)(B). In addition, the funds used to acquire exempt assets must not be from the sale of collateral or as a result of wrongdoing by the debtor. In addition, some states have enacted limits on acquiring some types of exempt property (notably life insurance policies) within a specified time before bankruptcy filing.
But, if a bankruptcy trustee objects to a debtor’s transfer as being fraudulent, how soon must the trustee act to avoid the transfer? Does it matter that the IRS also has a claim against the debtor? A recent case from a bankruptcy court in Florida dealt with the issue. The answer that the court provided could serve as a wake-up call to some debtors and their legal counsel.
The Bankruptcy Code’s “Strong-Arm” Provision
The “strong-arm” provision, 11 U.S.C. §544, gives the bankruptcy trustee the authority to “avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of this title…” So what does that mean? Generally, when a bankruptcy trustee uses the provision, the trustee will rely on a state’s fraudulent transfer statute as the basis for avoiding transfers the debtor makes when the debtor is trying to avoid paying creditors what they are owed. The effect of using the “strong-arm” provision is that the trustee steps into the shoes of an unsecured creditor. That also means that the trustee then becomes subject to the statute of limitations applicable under state law, which is typically four years for fraudulent transfers. But what if the unsecured creditor is the federal government – the IRS?
Recent case. In In re Kipnis, 555 B.R. 877 (Bankr. S.D. Fla. 2016), an individual was a partner with another person in the general contracting business. The business had big losses which passed through proportionately to the individual who then claimed them on his 2000 and 2001 returns. In 2005, the individual transferred via quitclaim deed a condominium to his wife in accordance with a pre-marital agreement that the couple had entered into during the prior month. Later that day, the individual changed the title ownership of his bank account from his name only to include his wife along with himself as tenants by the entirety (a marital form of joint tenancy). The IRS audited the partners’ returns for 2001 and 2001 and disallowed the losses, and in 2012 the Tax Court agreed with the IRS, and little over a year later the individual (now “debtor”) filed for Chapter 11 and then converted it to Chapter 7. The IRS filed a proof of claim for $1,911,787.23. Of that amount, $25,629.51 was unsecured, but prioritized under 11 U.S.C. §507(a)(8). The bankruptcy trustee tried to avoid the transfers under state (FL) law governing fraudulent transfers. The debtor’s wife moved to dismiss on the basis that the four-year statute of limitations that applied under FL law to challenge fraudulent transfers had run and barred the trustee’s claim. She cited In re Vaughan Co., 498 B.R. 297 (Bankr. D.N.M. 2013), where the court determined that the IRS was subject to the state-based statute of limitations. However, the bankruptcy trustee cited cases from numerous other states where the courts in those states determined that the “strong-arm” statute allowed the trustee to step into the shoes of the IRS and take advantage of the 10-year statute of limitations under I.R.C. §6502(a)(1). The court agreed with the trustee, holding that In re Kaiser, 525 B.R. 697 (Bankr. N.D. Ill. 2014) was persuasive and that the court’s rationale should apply to the facts of the case. One of the key aspects of In re Kipnis was the court’s reasoning that the IRS can avoid a state’s statute of limitations because of sovereign immunity, but that a trustee can avoid it via the “strong-arm” statute which provides a derivative form of sovereign immunity.
So, the wife’s attempt to dismiss the trustee’s action was denied, but the court seemed dismayed that the court’s finding could tempt bankruptcy trustees to aggressively go after a debtor’s funds in a bankruptcy proceeding. The court stated, “The Bankruptcy Code’s strong-arm provision (Section 544) provides a bankruptcy trustee the authority to “avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of this title…”. The court went on to state that, “The IRS is a creditor in a significant percentage of bankruptcy cases,… “The paucity of decisions on the issue may simply be because bankruptcy trustees have not generally realized that this longer reach-back weapon is in their arsenal. If so, widespread use of [Bankruptcy Code Section] 544(b) to avoid state statutes of limitations may occur and this would be a major change in existing practice.”
In re Kipnis illustrates that bankruptcy trustees have a fairly strong weapon in the bag to ultimately effect larger distributions to creditors of a bankruptcy estate. When the IRS is a creditor, that weapon can be powerful and can be used, as in In re Kipnis, to reach transfers that weren’t made to avoid creditors. For bankruptcy lawyers with debtor-clients having facts similar to In re Kipnis, perhaps look into paying outstanding taxes before the debtor files bankruptcy.
Monday, December 19, 2016
Before the Tax Reform Act of 1986, taxpayers had the option of either capitalizing or deducting expenses incurred during a business asset's pre-productive period. However, for taxable years beginning after 1986, taxpayers must capitalize the direct costs of production and the “proper share” of indirect costs which are assignable to the production of property that the taxpayer uses in their trade or business. I.R.C. §263A. This is known as the uniform capitalization rule, and it prevents the current deduction of these costs during the pre-productive period.
Plants and certain animals have pre-productive periods, so what’s the impact of the rule on farmers and ranchers? In addition, what are “indirect costs of production? Do they include interest and property taxes? A recent Tax Court decision sheds some light on these questions.
Does the Rule Apply To Animals?
The 1986 rule change applied to both animals and plants. As applied to animals, if the pre-productive period was more than two years, a taxpayer could not deduct expenses associated with the pre-productive period of replacement heifers for a cow/calf or dairy herd, for example. Instead, the taxpayer had to keep track of costs and capitalize them. This became known as the “heifer tax.”
In 1988, the Congress repealed the capitalization rule as to animals produced by the taxpayer in a farming business for costs incurred after 1988. The repeal provisions refer to animals and not livestock. So this rule as to animals has been eliminated effective for costs incurred after 1988, but the trade-off for repeal was that, starting in 1989, all farm property of a taxpayer engaged in a farming business slowed to a 150 percent declining balance depreciation method as a maximum.
Application to Plants
The uniform capitalization rules are still in effect for plants that are used in a farming business. Consequently, taxpayers who have a long-term crop with more than a two-year pre-productive period are not permitted to deduct the costs associated with that crop during the pre-productive period. There are some nuances to the application of the rule, but it primarily impacts taxpayers that are in the nursery business and almost all tree, vine or bush crops that require at least two years to reach production. For example, the IRS has said that a nursery could deduct the cost of purchasing “bare root” trees as an ordinary and necessary business expense where the trees were all very young Tech. Adv. Memo. 9818006 (Jan. 6, 1998). Many trees did not survive and all required years of development and cultivation to ensure future marketability. In essence, the trees qualified as “seeds and young plants” under Treas. Reg. § 1.162-12. Where some grow-out is contemplated, nursery operators do not need to capitalize associated costs if the pre-productive period is two years or less. IRS Ann. 97-120, I.R.B. 1997-50, 61. Also, IRS has stated that costs incurred between the harvest of a grape crop and the end of the pre-productive period must be capitalized unless they are “field costs” (i.e., irrigation, fertilization, spraying and pruning) that provide no benefit to the already severed crop. ILM 200713032 (Nov. 20, 2006).
The pre-productive period begins when the seed is planted or the plant is first acquired by the taxpayer, and it ends when the plant is ready to be produced in marketable quantities or when the plant can reasonably be expected to be sold or otherwise disposed of – basically from the time of planting to the time of first harvest. The pre-productive period, however, is determined not in light of the taxpayer's personal experience but in light of the weighted average pre-productive period determined on a nationwide basis. In other words, a taxpayer can’t use its own experience to determine whether a plant or crop has a pre-productive period of two years or less. See, e.g., Pelaez and Sons, Inc. v. Com’r., 2000-1 U.S. Tax Cas. (CCH) ¶50,395 (11th Cir. 2001), aff’g, 114 T.C. No. 28 (2000). In addition, the uniform capitalization rule applies even if the taxpayer acquires land with a growing crop in the midst of the crop’s pre-productive period and there is less than two year left until the crop becomes marketable.
The IRS has provided a list of plants grown in commercial quantities in the United States that have a nationwide weighted average pre-productive period in excess of two years. IRS Notice 2000-45, I.R.B. 2000-36. Included on the list are almonds, apples, apricots, avocados, blueberries, cherries, chestnuts, coffee beans, currants, dates, figs, grapefruit, grapes, guavas, kiwifruit, kumquats, lemons, limes, macadamia nuts, mangoes, nectarines, olives, oranges, peaches, pears, pecans, persimmons, pistachio nuts, plums, pomegranates, prunes, tangelos, tangerines, tangors and walnuts. Blackberries, raspberries and papayas used to be on the list, but the IRS removed them in 2013. Rev. Proc. 2013-20, Sec. 2.06.
Do Capitalized Costs Include Interest and Property Taxes?
Under the uniform capitalization rules, certain costs of production must be capitalized. Do those costs include interest associated with the acquisition of land on which a crop with a more than two-year pre-productive period is grown and property taxes paid on that land? I.R.C. §263(A)(f)(1) specifies that “interest is capitalized when (1) the interest is paid during the production period and (2) the interest is allocable to real property that the taxpayer produced and that has a long useful life, an estimated production period exceeding two years, or an estimated production period exceeding one year and a cost exceeding $1 million. The corresponding regulation states that “…capitalization of interest under the avoided cost method described in Treas. Reg. §1.263A-9 is required with respect to the production of designated property…”. The rules also require the capitalization of real property taxes incurred during the production period.
In Wasco Real Properties I, LLC, et al. v. Comr., T.C. Memo. 2016-224, the taxpayer was three partnerships that bought land that they planned to use for growing almonds. They financed the purchase by borrowing money and paying interest on the debt. They deducted the interest and property taxes on their return. The IRS objected on the basis that the interest and real property taxes were indirect costs of the “production of real property (i.e., the almond trees that were growing).
In determining whether the uniform capitalization rules applied to interest and real property taxes, the court noted that I.R.C. §263A(b)(1), (c)(1) applies to real property produced by the taxpayer for the taxpayer’s use in a trade or business or in an activity conducted for profit, and that the definition of “real property” includes “land” and “unsevered natural products of land.” “Unsevered natural products of land” generally include “[g]rowing crops and plants where the pre-productive period of the crop or plant exceeds two years.” While almond trees are on the IRS list as having a pre-productive period of more than two years, the taxpayer claimed they could currently deduct the interest and property taxes because those costs related to the land and not the almond trees. In other words, the taxpayer claimed it was not in the business of producing land, but almonds. The court didn’t buy the argument. While the court agreed that the taxpayer was in the business of growing almonds, the trees grew on the land. As such, land itself need not be produced because the almond trees are intertwined with the land and cannot grow without it. Thus, the placing in service of the almond trees required that the land be placed in service, and the interest and tax cost of the land was a necessary and indispensable part of the growing of the almond trees. The unit of property was the land and the almond trees. So the property taxes and interest associated with the portion of the land benefiting the almond trees had to be capitalized.
Accounting Method Issues
The Tax Court, in Wasco, said that the taxpayer had to change its method of accounting for the interest and property tax cost, and pick up the amounts deducted in prior years that should have been capitalized. That will trigger an I.R.C. §481(a) adjustment. So, a Form 3115 will be required to change the method of accounting. While an accounting method cannot be changed more frequently than once every five years, Form 3115 does not cover blanket accounting method changes. It applies to a particular trade or business activity. That means that if, for example, a Form 3115 had been filed (even if unnecessarily) within the immediately preceding five years for purposes of the recently implemented repair/capitalization regulations, another Form 3115 can be filed for purposes of the uniform capitalization rules.
Avoiding the Rule
An election can be made to avoid capitalization of pre-productive costs, but if the election is made, all farm assets must be depreciated using the alternative depreciation system. I.R.C. §263A(d)(3) and (e)(2). That requires straight-line depreciation over the class life of the property for all farm assets of the taxpayer that are used in the farming business. There is, however, a limitation on the use of the election that applies to citrus and almond growers. I.R.C. §263A(d)(3)(C). In addition, the election (made via Form 3115) must be made for the first year in which costs subject to the capitalization rules apply. That means that the election might be a good move for taxpayers just starting out in farming who don’t have a lot of income to offset with farm deductions or those that don’t have a great deal of depreciable assets. Conversely, agricultural producers that don’t raise many crops with a more than two-year pre-productive period probably don’t want to make the election and thereby preserve their ability to use MACRS depreciation on farm assets (as well as first-year “bonus” depreciation).
Another way to avoid the impact of the uniform capitalization rules is to make an I.R.C. §179 election. Treas. Reg. §1.263A-4(d)(4)(ii). Also, starting in 2016, a taxpayer can elect bonus depreciation for fruit/nut plants at the time of planting or grafting rather than waiting until the plants become productive. Rev. Proc. 2015-48, 2015-40 IRB 469.
The uniform capitalization rules have an important impact of growers of many trees and plants. The Tax Court’s Wasco opinion illustrates that pre-productive costs include a wide array of costs incurred during the pre-productive period.
Thursday, December 15, 2016
The Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA) takes a preventative approach with respect to air, water and land pollution. The Act is administered by the EPA and requires registration of all pesticides intended to prevent, destroy, repel or mitigate certain pests. FIFRA also regulates pesticide use and requires certification of pesticide applicators. The EPA administrator must assess the risks of using a pesticide at the time of registration and the submission of scientific data to aid in that decision. The Act requires that pesticide registrants disclose expert opinions on adverse effects of pesticides to the EPA, along with all other “factual information” so that EPA can reach a proper determination concerning potential registration.
But, are seeds are seeds that are coated with pesticides subject to the FIFRA registration process? Does the coating of the seed with pesticides transform the seed into the functional equivalent of a pesticide that is subject to FIFRA regulation? That’s a key question for agriculture, and it the focus of today’s post.
The Registration Process
At the time of registration, the EPA must classify a pesticide as to use. Classification may be for general use, restricted use, or both. 7 U.S.C. §136a(d)(1)(A). The EPA may also issue an experimental use permit if it determines that the applicant needs the permit in order to accumulate information necessary to register a pesticide under FIFRA. A general use pesticide is one that the EPA determines will not cause “unreasonable adverse effects” on the environment when used as directed or in accordance with commonly recognized practices. Restricted use pesticides are those determined to have the potential to cause adverse environmental effects. In addition, restricted use pesticides may be applied only by individuals who are approved by the EPA as certified applicators. A certified applicator may be either a private applicator or a commercial applicator. To be certified as a private applicator, the applicant must possess a practical knowledge of the pest problems and control practices associated with agricultural operations, being familiar with the proper handling, use, storage and disposal of pesticides and containers as well as related legal responsibility.
The EPA cannot register a pesticide for use (or approve its label) unless it determines the product will not have “unreasonable adverse effects on the environment.” More specifically, in registering any pesticide, EPA must conclude that the product does not pose any “unreasonable risk to man or the environment, taking into account the economic, social and environmental costs and benefits of [its] use.” 7 U.S.C. §136(bb). Pesticides are registered for a five-year period, and are cancelled at the end of that period unless the registrant (or other interested person with the consent of the registrant) requests, in accordance with regulations, that the registration be continued in effect. The sale of an unregistered pesticide is a violation of FIFRA.
The EPA can review pesticides which have previously been registered if there is a concern the product is causing environmental problems or human injury. This procedure is known as a “special review.” For example, the EPA initiated a special review for granular forms of carbofuran (Furadan) in 1985 because of concerns over its poisoning birds. In 1989, the EPA proposed banning granular uses of carbofuran, and in October 1990, the manufacturer agreed to amend the label of the product to delete certain uses.
FIFRA also makes it unlawful to sell or distribute any pesticide that is not registered, that differs in composition from that described in the registration forms, or any pesticide that is misbranded or adulterated. But, are agricultural seeds that are coated with an insecticide a “pesticide”? If so, they can’t be sold or distributed without going through the FIFRA registration process.
The Exemption for Coated Seeds
In a recent case, Anderson v. McCarthy, No. C16-00068 WHA, 2016 U.S. Dist. LEXIS 162124 (N.D. Cal. Nov. 21, 2016), a consortium of individuals and groups with concerns about the effect of pesticide-treated seeds on bees and other pollinators claimed that the EPA failed to enforce the FIFRA with respect to pesticide-treated seeds. They claimed that seeds coated with neonicotinoids (a type of pesticide that distributes throughout the resultant plant and kills insects by direct contact and when the insects eat the plant) are subject to the FIFRA registration process as a regulated pesticide. Importantly, they also claimed that the pesticide-treated seeds can release pesticidal “dust-off” that spreads the insecticide beyond the seeds themselves. As a result, the argument went, the use of such seeds has a systematic and catastrophic impact on bees and the beekeeping industry in the United States. Thus, according to the plaintiffs, the seeds were subject to FIFRA regulation which requires their registration before usage. The court disagreed, noting that a specific 1988 FIFRA exemption applied. Under that exemption, coated seed are not subject to FIFRA if the pesticide itself is registered for coating seeds. The court noted that, in 2003, the EPA published a document in which it said that such seeds were exempt from FIFRA regulation if the pesticide protection of the seed does not extend beyond the seed itself to offer pesticidal benefits or value attributable to the treated seed. Thus, when a treated seed is planted and the seed is treated with a registered pesticide, the seed itself is exempt from FIFRA. In addition, a 2013 EPA guidance document discussed pesticide-related bee deaths and the plaintiff claimed that the guidance document was a final action that needed to be supported by an exhaustive record and is reviewable under the Administrative Procedures Act (APA) and subject to the APA’s rulemaking requirements. The court disagreed.
FIFRA plays a significant role in regulating the use and application of agricultural pesticides. But, at least for now, farmers can continue to buy and plant seeds coated with insecticides without worrying that the seeds themselves are FIFRA-regulated seeds.
Tuesday, December 13, 2016
Normally, federal estate tax is due nine months after death. For estates that are illiquid, and that can include many taxable farm and ranch estates, there is an option that can come in handy. The estate executor can elect under I.R.C. §6166 to pay the federal estate tax in installments over (approximately) fifteen years. However, to make sure that the deferred estate tax is paid in full, the IRS can require a bond to secure payment of the deferred tax. The IRS can also require the executor to provide the IRS with a special lien as a condition of the IRS accepting the election. I.R.C. §6324A. But what if, during the installment payment period, the value of the assets in the estate drop below the remaining amount of tax due to the IRS and the executor hasn’t been fully paid? Does the IRS lien get paid first? If so, are there any planning steps that can be taken to ensure that the executor’s fee gets paid in full? That’s the focus of today’s post.
If an installment payment election is made, interest only need be paid for the first five years after the due date for the federal estate tax return (which is nine months after the date of the decedent’s death) with the tax paid in two to ten annual installments thereafter with interest on the unpaid balance beginning 69 months after death. The maximum installment payment period is 177 months after death.
Interest at 2 percent (compounded daily) is imposed on the amount of deferred estate tax attributable to the first $1,480,000 in value of taxable estate attributable to a closely-held business for deaths in 2016. For deaths in 2016, the amount eligible is the federal estate tax attributable to a closely-held business between $5,450,000 and $6,930,000. If the estate holds an interest in a closely-held business of $6,930,000, the 2 percent portion would be $592,000 (the $2,717,800 estate tax on $6,930,000 minus $2,125,800, the credit for the applicable exclusion amount for 2016). To determine the amount of estate tax that can be deferred and paid in installments, the total estate tax (reduced by available credits) is multiplied by a fraction equal to the value of the closely held business interest divided by the value of the adjusted gross estate.
Two eligibility tests must be satisfied for an estate to qualify for installment payment of federal estate tax. The first test, known as the Tier I test, requires that the decedent have an interest in a closely held business. I.R.C. §6166(a)(1). That means at least 20 percent of corporate voting stock or the corporation has 45 or fewer shareholders. The same percentage and number of shareholder applies with respect to partnerships. For sole proprietorships, the interest in the sole proprietorship counts. Land held in a revocable living trust continues to be eligible for installment payment of federal estate tax if it is a “grantor” trust. Also, land rented under a lease constitutes an interest in a closely held business if it is a crop share lease or a livestock share lease with active involvement in decision making by the decedent-to-be, or an agent or employee of the decedent-to-be. Passive rental arrangements, such as cash rent leases, are not eligible and deferred tax is accelerated if the value of assets involved (plus all distributions, sales or disposition of assets after death) equals 50 percent or more of the date-of-death value of the interest in the closely-held business which qualified for installment payment. For assets leased to business entities, the Tier I test is applied separately to the business entity and the leased assets.
In 2006, IRS clarified that, to be an interest in a trade or business under I.R.C. §6166, a decedent must conduct an active trade or business or must hold an interest in a partnership, LLC or corporation that itself carries on an active trade or business. Rev. Rul. 2006-34, 2006-1 C.B. 1171. In the ruling, IRS set forth a list of non-exclusive factors to determine whether a decedent’s interest is an active trade or business. The factors are: (1) the amount of time the decedent (or agents or employees) spent in the business; (2) whether an office was maintained from which the activities were conducted or coordinated and whether regular office hours are maintained; (3) the extent to which the decedent was actively involved in finding new tenants and negotiating and executing leases; (4) the extent to which the decedent provided landscaping, grounds care or other services beyond the furnishing of the leased premises; (5) the extent to which the decedent personally made, arranged for or supervised repairs and maintenance on the property; and (6) the extent to which the decedent handled tenant repairs and requests.
The second test, known as the Tier II test, requires that the interest in the closely held business exceed 35 percent of the value of the decedent’s adjusted gross estate. I.R.C. §6166(a)(1). For a corporation, corporate stock of any kind, common or preferred, meets the requirement. In the Tier I test, only the voting stock counts. In the Tier II test, any stock can count. For a partnership, an interest in a partnership carrying on a business will count. In a sole proprietorship, the interest in the sole proprietorship will count towards the 35 percent test. Rental arrangements that meet the Tier I test will also meet the Tier II test. Thus, assets under an active lease arrangement may be applied toward the 35 percent amount.
For purposes of the 35 percent requirement, interests in residential buildings and related improvements which are occupied on a regular basis by the owner, tenant or an employee of the owner or tenant for purposes of operating or maintaining the property can be included. However, if the buildings have been carved out and occupied by someone working off the farm, it’s no longer a business asset. Acreage under the Conservation Reserve Program (CRP) or other federal acreage diversion programs apparently is eligible. Priv. Ltr. Rul. 9212001 (Jun. 20, 1991).
Points to Watch After Death.
If one-half or more of the interest in the closely-held business is distributed, sold, exchanged or otherwise disposed of or is withdrawn from the business, the remaining installments become due. Transfers involving the decedent’s interest in a closely-held business at the death of the original heir, or at the death of any subsequent transferee, do not accelerate federal estate tax payment if each subsequent transferee is a family member of the transferor. Therefore, while property can be left at death to a family member without violating the 50 percent requirement, property devised to non-family members always counts against the 50 percent test. Property sold or given away during life even to family members counts against the 50 percent test.
Mere changes in organizational form or tax-free exchanges of property do not accelerate installment payments. Apparently, mortgaging the property in the post-death period does not accelerate the payment if the funds are used to pay the costs of refinancing and liens. But, the only authority on this particular point consists of a few IRS rulings. While the use of funds received from mortgaging the property to pay the costs of refinancing and liens is not a very exciting way to refinance, it apparently is the only possibility for which there is clear authority except that property can be sold to pay indebtedness existing at death.
Cash renting is always considered a disposition. As a result, cash renting of assets during the 15-year installment payment period must be avoided. Similarly, a dividend payment is a disposition if it involves payment out of pre-death earnings and profits. That is a problem only with big dividend distributions out of earnings and profits that accumulated before death.
Bankruptcy will not itself count against the 50 percent requirement, but if there is any transfer after bankruptcy filing, it counts against the 50 percent requirement. Thus, one must always keep track of one’s precise position with respect to closeness to the 50 percent mark.
The IRS Lien and Unpaid Executor Fees
As noted earlier, the IRS can require an estate executor to grant the IRS a special estate tax lien in accordance with I.R.C. §6324A in connection with an I.R.C. §6166 election to pay the estate tax in installments. In a recent case, United States v. Spoor, 838 F.3d 1197 (11th Cir. 2016), the executor’s fees had not been fully paid at the time the lien was granted. During the 15-year period, the value of the estate property subject to the IRS lien dropped below the amount due the IRS for unpaid estate tax. The executor claimed that he had a priority claim against the estate assets for the amount of his unpaid fee. The IRS claimed that it had a priority claim on the estate assets for the amount of the unpaid estate tax. The trial court granted the executor’s motion for summary judgment on the basis that the operative statute was silent as to the payment of administrative expenses. Thus, the trial court gave the executor’s claim priority on a “first in time, first in right” theory.
On appeal, the appellate court reversed. The appellate court reasoned that the executor’s claim for unpaid fees was not a lien and, as such, the trial court’s priority theory had no application. The appellate court then noted that I.R.C. §6324, the IRS general estate tax lien provision, does provide for administrative expenses to have priority over a government lien. However, the government’s lien in this case was a special lien under I.R.C. §6324A which did not provide any special rule for administrative expenses. The executor claimed that he should prevail on the basis that if his claim did not have priority it would be hard to find executors to serve. The court disagreed, and noted that the executor could have planned for payment before granting the IRS the special lien. The court pointed out that the executor could have granted the lien on less than all of the estate property, or not make the I.R.C. §6166 election, or simply make other arrangements to make sure the fee was paid. The appellate court also noted that if the IRS special lien were subject to administrative expenses, then partially unsecured deferred payment obligations under I.R.C. §6166 could result. Also, the court noted that the executor’s claim for unpaid fees would not have priority over any bond to secure the estate tax deferred under I.R.C. §6166 and, thus, should not be given priority over the IRS claim.
Installment payment of federal estate tax can be useful in those taxable estates that are characterized by a lack of liquidity. But, when estate values drop during the installment period, problems can arise. The Spoor case points out that the estate tax lien can beat out a claim for executor’s fees. But, with proper planning the executor can make sure that fees will get paid in full.
Friday, December 9, 2016
Cash method taxpayers generally can deduct their expenses for the tax year in which they are paid. However, for business and tax purposes, farmers often find it advantageous to prepay and deduct the cost of supplies. If structured properly, prepayment provides deductions in the year of the payment, favorable prices may be received, and planting and harvesting may be more efficient due to having adequate input supplies on hand. But, certain rules must be followed and the IRS can challenge transactions that aren’t within the guidelines.
In recent years, the IRS has indicated its opposition to the cash method of accounting for farmers. Up until the Tax Court decision in 2015, litigation involving a California farming operation using the cash method and prepaid expenses had been ongoing for several years. Another Tax Court case, decided yesterday, involved an IRS attempt to deny a deduction for prepaid expenses under the “tax benefit” rule. The IRS lost both cases.
Basic Rules on Pre-Paying and Deducting Input Costs
In accordance with Rev. Rul. 79-229, 1979-2 CB 210, to properly structure prepayments, the expenditure must be an actual payment rather than simply a deposit, and the prepurchased materials or supplies must be used within the next year to avoid a conflict with the IRS about whether the expense needs to be capitalized. Zaninovich v. Comm’r, 616 F.2d 429 (9th Cir. 1980), rev’g, 69 TC 605 (1978). In addition, farmers may not deduct prepaid farm supplies in excess of 50% of the otherwise deductible farming expenses (the “50% rule”). IRC §464(f).
2015 Tax Court Opinion
In Agro-Jal Farming Enterprises, Inc., et al. v. Comm’r, 145 T.C. No. 5 (2015), the plaintiff raised strawberries and vegetables. It used field-packing materials such as plastic clamshell containers and cardboard trays and cartons in its in-field packing process. It purchased these materials in bulk, in advance of the harvest. The supplies not used by yearend were reflected as expenses in its accrual basis financial statements in the year consumed, rather than when paid. The plaintiff reported its income for tax purposes on the cash basis, but prepared GAAP financial statements for financing purposes. The plaintiff also kept detailed records of the field packaging materials on hand at the end of the year, which it capitalized on its yearend financial statements.
The Tax Court was faced with the issue of whether the plaintiff could deduct the packaging materials in the year the materials were paid for or whether they could only deduct the amounts as the materials were used
The IRS conceded that cash method farmers may deduct farm supplies immediately upon purchase but argued that the farming syndicate rules limited an immediate deduction for expenses attributable to “feed, seed, fertilizer or other similar farm supplies.” It asserted that the plaintiff’s field packing materials were not “other similar farm supplies” for this purpose. The IRS cited the 50% rule of IRC §464(f) for the definition. However, if the field packing materials were farm supplies under this provision, the 50% limit would not be exceeded, and their cost would be fully deductible. In essence, the IRS argued that only feed, seed, fertilizer, or other similar farm supplies may be deducted immediately upon purchase but that all other supplies could only be deducted as consumed.
The plaintiff presented two counter-arguments. The first was that the field packing materials constituted “other similar farm supplies.” The second argument, based upon the farm syndicate rules, was that only those farmers who were within the definition of a farming syndicate were barred from using cash accounting. Because Agro-Jal did not fall under that definition, the plaintiff argued they could utilize the cash method for all farm supplies that were consumed within a year.
The Tax Court agreed with the plaintiff and held that the plaintiff’s expenses for field packing materials were fully deductible in the year of purchase. The court noted that the farm syndicate rules were aimed at abusive taxpayers (i.e., “farming syndicates” as that term is defined) and to certain especially abused expenses (i.e., feed, seed, fertilizer, or other similar farm supplies). Those situations were not present under the facts of the case.
The Tax Court also viewed feed, seed, and fertilizer as evoking a class of expenses associated with the growing of crops or the raising of livestock. The field packing materials were neither, the court reasoned, which would appear to place them outside the reach of the 50% test and the farm syndicate rule. Thus, the court agreed with the IRS on this point: because the named items in the statutory list (feed, seed, and fertilizer) are used directly in production activities, the field packaging materials were not “similar” to those items and were, therefore, outside the scope of IRC §464.
The court then proceeded to analyze the issue under the general rules for supplies (i.e., those supplies that are not “farm supplies”) contained in Treas. Reg. §1.162-3. That regulation was amended by TD 9636 (the tangible property regulations) effective for tax years beginning after 2013. However, under the version in effect for the tax years at issue, the court held that the supplies were not limited to deductibility in the year consumed because the taxpayer deducted them when paid. According to the court, Treas. Reg. §1.162-3 merely prevents a double deduction, once in the year paid and once in the year consumed, when it states: “provided that the costs of such materials and supplies have not been deducted … for any previous year.” Thus, the plaintiff was allowed to deduct the supplies when purchased, even though it accounted for the supplies not consumed by deferring the expense on its financial statements.
By determining the amount to report as a deferred expense on the balance sheet, the plaintiff had determined a physical inventory, meaning that the supplies were nonincidental. That is a distinction made by the tangible property regulations for tax years beginning after 2013. However, because the years at issue predated the effective date of the revisions made by the tangible property regulations, the Tax Court did not address the distinction between incidental and nonincidental materials and supplies. A different and more specific regulation, Treas. Reg. §1.162-12(a), applies to agriculture. This regulation provides that, “A farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming.” The court did not address Treas. Reg. §1.162-12(a) or mention it because it was not necessary. Because the IRS based its arguments solely on Treas. Reg. §1.162-3, the court kept its focus there. The court determined that Treas. Reg. §1.162-3 did not require capitalization because the amounts for the field packing materials were properly claimed in an earlier year.
2016 Tax Court Opinion
In Estate of Backemeyer v. Comr., 147 T.C. No. 17 (2016), the husband was a sole proprietor farmer who purchased crop inputs (herbicides, seeds, fertilizer and lime, fuel, etc.) worth over $200,000 in the fall of 2010 that he planned to use in connection with planting the spring 2011 crops. However, the husband died on March 13, 2011, before using any of the inputs. The inputs were listed in his estate’s inventory with their value pegged to their purchase price. Shortly before he died, he sold his 2010 crop in January of 2011 and that income was reported on line 3b of his 2011 Schedule F. His estate did not include any interest in any stored grain. The farm inputs passed to a family trust that named his surviving wife as the trustee.
The wife ran the farming operation after her husband’s death and took an in-kind distribution of the farm inputs from the trust which she used to grow corn and soybeans in 2011. She sold a portion of the crops grown in 2011 later that fall and reported those sale proceeds ($301,000) on line 3b of her 2011 Schedule F. She sold the balance of the 2011 crops in 2012, a year that she filed as a single taxpayer.
The couple filed a joint return for 2010 on which they claimed over $230,000 as pre-paid expenses. On the joint 2011 return, which included two Schedule Fs, the wife’s Schedule F claimed as expenses the exact same amount that had been claimed as pre-paid expenses on the husband’s 2010 Schedule F. The IRS rejected the deduction on the wife’s 2011 Schedule F, thereby increasing taxable income by $235,693 and resulting in a tax deficiency of $78,387. The IRS explained its reason for denying the deduction was because “the petitioners use the cash method for [their] farming activity, prepaid expenses that were paid in 2010 are deductible in 2010, and are not added to basis.” According to the IRS, the taxpayers were getting a double deduction which they were not entitled to, and if the court were to allow the deduction on the wife’s 2011 Schedule F, then that same amount should be included in the husband’s 2011 Schedule F. If that didn’t happen, the IRS claimed, a material distortion of income would result. The IRS also claimed that the surviving wife was not entitled to a step-up in basis under I.R.C. §1014 in the inherited farm inputs. The IRS also tacked on an accuracy-related penalty under I.R.C. §6662(a) of $15,864.
In its reply brief, the IRS jettisoned all of those arguments and claimed that the tax benefit rule controlled the outcome of the case. Thus, the surviving spouse properly deducted the inputs on her 2011 return because she had received the inputs with a stepped-up basis and proceeded to use them in her farming business. But, IRS claimed, the tax benefit rule required the inclusion in the husband’s 2011 return of the amount of the prepaid input expense that had previously been deducted in 2010. The IRS claimed that Bliss Dairy, Inc. v. Comr., 460 U.S. 370 (1983) required that outcome. In that case, a cash method corporate dairy deducted the purchase cost of cattle feed. Early in the next year, the corporation liquidated while there was a significant amount of feed remaining on hand. The corporation distributed its assets to its shareholders in a nontaxable transaction. The shareholders continued to operate the dairy and deducted their basis in the feed as an expense of doing business. The U.S. Supreme Court said that the tax benefit rule applied because the liquidation of the corporation changed the cattle feed to being used in a non-business use which was now inconsistent with the earlier deduction. The IRS said the facts of the current case were the same and should produce the same result. The IRS claimed that because the husband died before using the inputs in his farming business, the inputs were converted to a non-business use at the time they were transferred to the trust. Then, upon distribution to the wife for use in her farming business, the inputs were converted back to business use which entitled her to deduct their cost, but also required the husband’s return to recognize income because he converted the inputs from one use to another by dying unexpectedly at the wrong time.
The Tax Court didn’t buy the IRS argument. In Frederick v. Comr., 101 T.C. 35 (1993), the Tax Court laid out a four-factor test for application of the tax benefit rule: (1) a deduction was taken in the prior year; (2) the deduction resulted in a tax benefit; (3) an event occurred in the current year that is inconsistent with the premises on which the deduction was originally based; and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income. While the first two factors were satisfied, the Tax Court determined that factors (3) and (4) were not. As to factor (3), the court noted that neither the husband’s death nor the distribution of the inputs to his wife for use in her farming business were inconsistent with the deduction on his 2010 return. The Tax Court noted that had the wife inherited the inputs in 2010 and used them in 2010, the initial deduction would not have been recaptured for income tax purposes because of the estate tax. They were subject to the estate tax on their purchase price, which was the same basis for the income tax deduction. Thus, application of the tax benefit rule would result in double taxation of the value of the inputs.
Factor (4) had also not been satisfied. Upon the husband’s death, the basis step-up rule applied. Also, the gross income of the recipient of an asset does not include the value of the inherited assets. Upon disposition by the heir, the heir has taxable gain only to the extent the proceeds exceed the stepped-up basis. Also, upon death, depreciation recapture is not triggered under either I.R.C. §1245 or I.R.C. §1250. Those rules are a partial codification of the tax benefit rule and don’t apply at death.
Thus, the tax benefit rule did not apply and require the inclusion in the husband’s 2011 Schedule F of the amount that had been deducted for the pre-paid inputs that were claimed on the 2010 Schedule F. In addition, the court also removed the accuracy-related penalty.
Farmers are specifically allowed to deduct amounts actually expended that are attributable to items used in conducting their farming business. This general principle is only limited if other specific Code provisions provide otherwise (e.g., IRC §263A for the uniform capitalization rules, IRC §464 for the 50% rule, IRC §175 for soil and water conservation expenditures, etc.). In addition, Treas. Reg. §1.162-12(a) was not impacted in any manner by the tangible property regulations, and it remains the authority for farmers to deduct “all amounts actually expended in carrying on the business of farming.” In addition, the tax benefit rule is inapplicable where crop inputs are deducted in an earlier year and then again in a later year by a surviving spouse who inherits the inputs as the result of a spouse’s unexpected death and uses them in the surviving spouse’s farming business.
Wednesday, December 7, 2016
For readers of this blog, you know that I address technical legal and tax issues. I don’t get into news stories of the day, or theoretical issues that law school (and undergraduate) classrooms are often known for. I deal with real nuts-and-bolts issues where the goal is to provide a resource for practitioners representing farm and ranch clients to turn to that addresses practical problems that they face and need assistance with.
I am deviating from that path today. At age 97, Orville Bloethe passed away (see obituary). After 67 years of practicing in the same rural community that he grew up in (and 2 years of “retirement”), America’s rural lawyer passed away.
“Well, I was born in a small town
And I live in a small town
Prob’ly die in a small town
Oh, those small communities”
“Small Town” John Mellencamp
My first contact with Orville was in the early 1990’s. I was starting out in practice in North Platte, NE, and working on a client matter that involved a special use valuation election (I.R.C. §2032A) in a farm client’s estate. The lead partner that was helping me on the estate, Don Kelley (an icon himself in ag law and tax circles), said to call “Orville” and get his input. There was no last name. It was assumed that anyone who worked with ag clients on this type of an issue didn’t need the last name. I figured out who “Orville” was and called him with my questions. He was excited to learn of a new attorney working with ag clients in a rural area. He gave me his view of the statutory provisions at issue and said to convey his greetings to Don. He also gave me the historical background behind the statutory provisions which provided keen insight into their application.
Over the years, I got to know Orville better and had more contact with him. Before I came to Iowa for my professional career, I would get to see him once or twice annually at continuing legal education events. He would sit in the front row. He would also always talk to me after the presentation was over and tell me that was an “outstanding” presentation I had made, whether it actually was or not. That did a lot to build my confidence.
Orville also played an important role in getting me to Iowa. He was always supportive of my vision to provide educational programming focusing on farm and ranch issues and rural practitioners. Over the years, I would get the occasional handwritten letter with a question or just a note of encouragement. Sometimes, the communication would come via fax. Always typewritten, never produced by a computer.
Orville practiced all those years in Victor, Iowa, a town with a population of less than 900. His home was just a few blocks from the office. He was involved in the community, to say the least. He was the attorney for the local school for many years, and contributed generously to support the community. On my trips to eastern Iowa to speak or just when passing through his area, my wife and I would sometimes stop in Victor just to see Orville for a bit. He always took the time to visit, even if his office was full of farm clients needing their estate plan updated or having legal issues associated with a farm sale, or dealing with some other legal matter. When farmers went through the cycles of boom and bust that characterize agriculture, Orville was there. For 67 years, Orville was there. Different issues, same Orville.
What made Orville stay in Victor? Why do so few newly-minted attorneys end up in the small rural communities? It’s a large problem all across rural America. Rural counties in the Midwest and Great Plains are losing population. Numerous counties in Kansas and Nebraska, for example don’t have any lawyers that reside in the county. When I started out in practice, for example, I was the only lawyer that resided in Logan county, Nebraska. But, while the rural areas don’t have the big city lights and entertainment venues and big-firm salaries that can be found in the urban areas, they also don’t have a lot of the downsides of living and practicing in a large urban area. There are opportunities for lawyers in small towns. From a professional standpoint, there is the opportunity to get involved in many legal issues, rather than simply learning one thing and billing lots of hours for it (which often characterizes big-firm practice). The other benefits are varied and might include golfing on sand greens, officiating eight-man football because the real official couldn’t make the two-hour drive to the game, having groceries put on “your tab” or watching one’s daughter play t-ball on a baseball field carved out of a cow pasture and then run the wrong way around the bases after successfully hitting the ball! Orville knew of these opportunities and benefits and illustrated them for others to see for 67 years.
One law school that is trying to make a difference in the rural areas is Washburn - the law school that I am proud to be associated with. Washburn is dedicated to ensuring that there is readily-available legal representation in rural Kansas. To that end, the law school has partnered with Kansas State University on the “Rural Legal Practice Initiative.” The goal of the program is to help students (and potential students) identify and consider career opportunities in rural communities. A component of the program is Washburn’s commitment to repopulate lawyers in rural communities by giving them the chance to live, work and experience a rural community while engaged in an internship with a practicing lawyer. That’s how it works in a rural law practice. A young lawyer learns from an experienced one. The experienced one retires and the young lawyer takes over the practice.
Orville would be pleased with what Washburn and, probably, some other law schools are trying to do to address the shortage of lawyers in rural areas. I can still hear what he would say to a young lawyer coming out of school – that it’s “just great” to live and practice in a small town. Others can testify to that too. I think of Phil and Pat Ridenour, and Kyler and Barbara Knobbe in Cimarron, Kansas, as well as John Thomas in Center, Nebraska. There are others that come to mind from such areas as Algona, Iowa, and the Sandhills of Nebraska, and those from other rural areas across the country that I have come into contact with over the years.
The mantle is now on these rural lawyers to carry the torch and handle the myriad of legal issues that farm and ranch clients bring to the table. For, you see, America’s rural lawyer has passed away.
“Well I was born in a small town
And I can breathe in a small town
Gonna die in this small town
And that’s prob’ly where they’ll bury me. "
“Small Town” John Mellencamp
Thank you, Orville, for the legacy you left to the rural practitioner and farm families. You will be missed.
Monday, December 5, 2016
When a farm is acquired, it is important from a tax standpoint to allocate value to depreciable items and set those items up on the appropriate depreciation schedule beginning with the tax year in which possession is obtained. Of course, land is not depreciable, but when a farm is acquired, there may be items on the land that are depreciable such as fences, drainage tile, buildings, corrals, timber, wells, water lines and residual fertilizer supply. There may be other items (such as a gravel road) that should also have cost allocated to them.
While ag land values have leveled off or have fallen in recent years, there was a preceding significant run-up in value. How to properly allocate value to depreciable items is always important, but is even more important when land values are high and the total transaction cost of buying a farm is large. In that situation, greater amounts of the overall purchase price might be able to be allocated to depreciable items. Unfortunately, many purchase contracts or documents associated with gifted or inherited assets do not identify any purchase price allocation for the various assets involved. But, IRS will generally respect whatever agreement the parties to the transaction can agree upon if the parties are not related. I.R.C. §1060(a)(2).
A crucial point is that real estate acquisition allocations must, in every case, be justifiable on audit. So, practitioners must first make sure that sufficient documentation exists to bolster whatever allocated amount is claimed on the tax return. Substantiation is the key. So, what are the main points when making cost allocations that will survive IRS scrutiny?
The first step is to determine the reasonable fair market value of all of the items associated with the acquisition. Fair market value for such items as roads, tile line and fences should be based on the price that a reasonable buyer and seller would arrive at where neither party is under compulsion to buy or sell and both parties have full knowledge of all of the relevant facts concerning the items in question. For such items as tile lines and fences, that approach will reflect the status of such items at the time of their acquisition rather than what it cost the prior owner to put such items on the property.
The second step is to make the necessary allocations. That may be an allocation of the purchase price for purchased property (based on the percentage of fair market value for each item to the total fair market value times the actual purchase price), or an allocation of the total fair market value of the acquired property if received by gift or inheritance. Treas. Reg. §1.167(a)-5. See also, Weiss v. Comr., 94 T.C. 28 (1990) and Wyatt v. Comr., T.C. Memo. 1991-621. There is an ordering rule that applies to a “multiple asset acquisition,” and the purchase of a farm often involves a “multiple asset acquisition” of trade or business assets. However, those rules don’t change the result that allocation of basis on the purchase of a farm will be in accordance with fair market values of depreciable assets.
The final step is to establish the appropriate depreciation schedules for the various depreciable assets. Fencing is depreciable over seven years, but it’s 15 years for tile lines and well/water systems, 10 years for single-purpose agricultural structures and 20 years for machine sheds and farm buildings (that are general purpose farm buildings). Overall, the point of the exercise is to create a tax deduction attributable to the depreciable items involved in the acquisition. That deduction can be a large sum given that many farm items, such as tile lines, are eligible for I.R.C. §179 depreciation (if used in the active conduct of a farming business) and potentially eligible for first-year bonus depreciation.
In many parts of the United States, subsurface drainage tile does not exist in farming areas, but it is common in many parts of the Cornbelt. In these areas, a significant question that has arisen in recent months is how to arrive at the proper depreciable cost of drainage tile on acquired farmland. Tiling costs have risen recently along with the rise in farmland values. That has made allocating tax cost to drainage tile difficult in light of the need to stay within guidelines that IRS has issued in the past. Allocations are presently varying widely with some reports of amounts being allocated to tile that exceed actual replacement cost. So, what are the guidelines for determining the appropriate depreciable cost of drainage tile?
Basic concepts. As noted above, it is critical to make sure that sufficient documentation exists to bolster whatever allocated amount is claimed on the tax return. That’s particularly the case if the allocation to land improvements (such as drainage tile) is high as compared to non-depreciable real estate. A 2006 IRS MSSP Audit Technique Guide (ATG) for Farmers, provided an example of a ranch purchase for $300,000 which included farm equipment, well and 40 acres of grape vineyards. The purchase price did not show any allocation of assets, and the ATG warned IRS auditors that the buyer may, as a result, try to assign more than the appropriate amount to depreciable assets. To determine if that occurred, the ATG advises IRS examiners to request the buyer’s property tax statement. That statement, IRS noted, will show the ratio between land and improvements. IRS points out in the ATG that if the statement shows that the land is 40 percent of the total property value, then at least 40 percent is not depreciable with the balance to be allocated among the depreciable assets that were purchased. But, that may only be a partial solution, and could still result in too much being allocated to drainage tile even though the total amount allocated to depreciable assets remains within the overall percentage that can be allocated to such assets. In addition, in some states, the statement may only be applicable if there are building improvements on the property. In a previous IRS training manual for the examination of farm returns, IRS suggested that unless sufficient facts and evidence existed, the depreciable cost of tile for a purchased farm with tile should approximate 5 percent of the cost of the bare land (i.e., the value of the land without tile). But, does that percentage still work in today’s agricultural land market? A five percent allocation to tile on land that is worth $8,000.00 per acre would mean that $400 is allocated to tile. That seems low given the present replacement cost of tile which has risen dramatically in recent years. So, care must be taken to substantiate any allocation made to depreciable tile. Without such documentation, IRS may argue that the amount to be allocated to drainage tile is not to exceed 5 percent of the cost of the land. For land valued at $6,000 per acre, that would result in $300 per acre allocated to drainage tile. That would seem to be lower than what proper documentation would readily support.
Establishing the presence of drainage tile. The starting point in allocating value to drainage tile is to establish the tile’s existence. Tile presents a practical problem in that it cannot readily be seen. So, if possible, tile maps should be acquired from the prior owner (or the person that installed the tile, if different from the owner) along with depreciation schedules. In addition, it may be possible to identify subsurface drainage tile by infrared aerial photographs that are taken within one to two days after a heavy rain. Also, it may be possible to obtain records from local USDA offices that establish the existence and extent of drainage tile. Finally, for some farm clients, it may be possible to have them hand-draw existing tile lines on a map of the property.
Establishing replacement cost. One common approach for determining the amount to be allocated to depreciable tile is to determine the cost of replacing the tile. That would include the cost of the tile itself and the cost of installation. But, when land values went up in recent years, the price of tile and the installation cost also rose. One fairly common approach (at least in central Iowa) has been to assign a value of $2.00 per foot to 8-inch tile, $1.65 per foot to 6-inch tile and $1.25 per foot to 4-inch tile. Whether those numbers remain valid is an open question. Other factors that can impact replacement cost might be the proximity of existing tile lines to the tile main, and whether dredge ditches run through the property. Also, once replacement cost is established, that value will have to be discounted to reflect the character of the tile at the time the property was acquired. Remember, the procedure is to produce a value for tile that would reflect what a willing buyer would deem it to be worth – that’s not the replacement cost of brand new tile for tile that’s five years old, for example. So, when land values and tile cost rose in the recent past, those full increases would not necessarily be reflected in a replacement cost approach that is done accurately. The allocation will be a percentage of new cost, tied to the age of the existing tile on the property.
A common approach (at least in Iowa) for allocating cost to fencing has been $1.50 per foot. That tends to work fairly well for fencing that is in good shape, but may be an entirely inaccurate measure for broken-down fencing (which may not warrant any cost allocation).
Residual Soil Fertility
Upon acquisition of farmland, it may be possible for the new owner to claim expense deductions for above average residual soil fertility (so long as the party acquiring the property had not farmed the property during the prior crop year). In essence, the tax law allows the new owner to account for the carryover (i.e., “residual”) fertilization in the soil that is present at the time of the transfer. That makes sense because, at least for purchased farmland, a willing buyer would pay more for well-fertilized land. Taxpayers that are engaged in farming can make an election to expense, on an annual basis, the cost of soil conditioners (such as fertilizer, lime or potash). The election is made by deducting the expense on the return. If not expensed, the costs must be capitalized and the costs recovered over the useful life of the conditioners (probably 3-5 years) by an operating farmer, crop-share or cash-rent landlord. Presently, excess soil fertility rates are ranging from $50 to $300 per acre in north-central Iowa. Typically, the expected amortization (i.e., consumption) of the excess fertilizer supply is about 60 percent in during the first crop year, 30 percent the next year, and then about 5 percent per year thereafter.
In 1995, the IRS produced a Market Segment Specialization Program (MSSP) guideline on Grain Farmers which illustrates that the farm owner allocating purchase price to residual soil fertility must show the amount of soil fertility that is attributable to the prior owner. In addition, the IRS noted that the buyer must be able to show beneficial ownership of the residual supply, the presence and extent of the residual fertilizer and that it is being exhausted. The MSSP points out that the amount allocated to residual fertilizer supply (and other depreciable items) must be “reasonable.”
Measurements and valuation. The key issue is how to measure the extent of and determine the value of such excess fertilizer supply. Fortunately, grid soil samples can be utilized to assist in measuring soil fertility. Likewise, agronomists have established guidelines for determining average (base) soil fertility for various soil types. The grid soil samples can be compared to base fertility on comparable soil types to establish the amount of “excess” fertility (if any) on any particular tract of farmland. If possible, soil sampling should be completed no later than the time the party acquiring the property takes possession. If that can’t be done, soil samples will have to be taken before any additional fertilizer is applied by or on behalf of the person acquiring the property. Once the excess amount is determined, current fertilizer costs can be used to value the excess.
Documentation. Most likely, any purchase contract involving the farmland will not document existing soil fertility. In that case, the person acquiring the property will need an expert opinion (such as from a professional agronomist) summarizing the extent of soil fertility, that it is above average when compared to comparable land and the timeframe over which the additional amount of soil fertility would diminish due to crop production. That documentation is necessary in the event of audit – the taxpayer must establish the extent and period of effectiveness of the residual soil fertility.
When farmland is acquired (whether by purchase, gift or inheritance) it is important to allocate value to depreciable items. Being careful to properly allocate such value and maintain documentation of how such allocations were arrived at can convert a portion of the purchase price (or value of the transferred land) into valuable tax deductions. Of course, it's always best if the parties to the transaction can agree on the allocations. For purchased farmland, the portion of the purchase price that is allocated to depreciable items such as fences, tile and residual fertilizer supply can trigger ordinary income to the seller at a 35 percent rate. IRS monitors inconsistent allocations on the returns of the buyer and seller by assessing the buyer based on the seller's return and vice versa. So consistent tax reporting is a must.
Thursday, December 1, 2016
Section 121 of the Internal Revenue Code provides for the exclusion of gain that is attributable to the sale of the taxpayer’s principal residence. The maximum exclusion is $500,000 for taxpayers that are married and file jointly. It’s one-half of that amount for single filers. Of course, the IRS just doesn’t give the exclusion away. The taxpayer has to meet certain requirements. In addition, the provision only applies to the taxpayer’s “principal residence.” But, what if the residence is sold with the farm? In that event, how much (if any) of the farmland and outbuildings can be included with the residence under the provision? Also, what if the taxpayer uses a part of the residence for business? How does that impact the exclusion? What if the farm and residence are sold on an installment basis and the buyer defaults and the seller gets the property back? What then? These issues are the focus of today’s blog post.
To be able to claim the I.R.C. §121 exclusion, the taxpayer must have owned the residence for at least two years or more (in the aggregate) during the five years immediately preceding the sale date. Also, the taxpayer must have occupied and used the home as the taxpayer’s principal residence for at least two years (in the aggregate) of the five years preceding the sale date. In addition, the taxpayer must not have used the gain exclusion during the immediately preceding two years before the sale.
Regulations finalized in late 2002 address the eligibility of vacant land for the exclusion. Under the regulations, vacant land can be treated as part of the principal residence if it is adjacent to land containing the principal residence, the taxpayer sells or exchanges the dwelling in a sale or exchange that meets the requirements to the exclusion within two years before or two years after the date of sale or exchange of the vacant land, the taxpayer owned and used the vacant land as part of the taxpayer’s principal residence, and the requirements have otherwise been met for the exclusion with respect to the vacant land. Treas. Reg. § 1.121-1(b)(3).
Based on those requirements, land that has been used in farming within the two-year period before the sale won’t be eligible. Also, the sale of the principal residence and the adjacent land are treated as a single sale for purposes of the gain limitation amount. That’s the case even if the sales occur in different years. In addition, because the separate transactions are treated as a single sale for purposes of applying the rule under I.R.C. §121 that bars use of the provision more frequently than every two years. Thus, if the principal residence is sold in a later tax year than the qualified adjacent land is sold that is after the filing date (including extensions) for the return that includes the land sale, the gain from the land sale has to be reported as a taxable event. When the residence is later sold, the taxpayer then can claim the I.R.C. §121 exclusion with respect to the vacant land by filing an amended return. Procedurally, when calculating the maximum limitation for the gain exclusion, the sale of the principal residence is excluded before any gain for the sale of the vacant land. Treas. Reg. §1.121-1(b)(3)(ii)(C).
Business Use of the Residence
If part of the principal residence is used for business purposes, the I.R.C. §121 exclusion does not apply. At least that’s the rule to the extent any depreciation is claimed. Also, the exclusion is inapplicable to a portion of the property that is separate from the dwelling unit. On that separate portion, the problem is that the taxpayer hasn’t satisfied the personal occupancy requirement. So, in that case, only the gain that is allocated to the residential portion is excludible. But, no allocation is required is both the residential and business portions of the property are within the dwelling unit, other than to the extent that the gain is attributable to depreciation.
It might also be possible to trade the home that has an office in it for qualified replacement property and qualify the transaction as a tax-deferred exchange under I.R.C. §1031. Of course, this can only happen if both the principal residence that is traded away and the replacement property that is received both have at least a portion of the property that is used in the taxpayer’s trade or business or held for investment. But, legislation enacted in 2004 denies the I.R.C. § 121 exclusion to property acquired in a like-kind exchange within the prior five-year period beginning with the date of property acquisition. The provision is designed to counter situations where (1) the property is exchanged for residential real property, tax-free, under I.R.C. § 1031; (2) the property is converted to personal use; and (3) a tax-free sale is arranged under I.R.C. § 121. The provision applies to sales or exchanges after October 22, 2004. Legislation enacted in late 2005 clarifies that the five-year ineligibility period also applies to exchanges by the taxpayer or by any person whose basis in the property is determined by reference to the basis in the hands of the taxpayer (such as by gift)
However, if like-kind exchange treatment applies to the residence, the homeowner may also be able to benefit from exclusion of gain. In early 2005, IRS published guidance (Rev. Proc. 2005-14) on coupling the I.R.C. § 121 exclusion with like-kind exchange procedures. Under that guidance, the IRS said that the I.R.C. §121 exclusion is applied before the I.R.C. §1031 like-kind exchange rules, and that the I.R.C. §121 exclusion cannot apply to gain attributable to depreciation of the residence after May 6, 1997. But, the I.R.C. §1031 rules may apply to that gain. Also, the IRS said that when the I.R.C. §1031 rules are applied, any boot or non-like-kind property that is received is taxable only to the extent the boot exceeds the gain excluded under I.R.C. §121. In addition, when determining basis of the property received in the exchange, any gain that is excluded under I.R.C. §121 on the former property is treated as providing basis to the taxpayer in the replacement property. The impact of the guidance is that, for farm residences, the amount of the allowable exclusion will more than cover the gain involved. In other situations, the Rev. Proc. may allow deferral of realized gain into replacement property.
What if the principal residence and the farmland are sold via an installment sale and the seller claimed the I.R.C. §121 exclusion on the principal residence? The normal rules would apply and the gain attributable to the principal residence would be excluded up to the applicable limit. But what if the buyer, after making a few payments, defaults on the contract and the seller gets the property back – including the principal residence on which the gain was previously excluded? This is not an unlikely possibility given the downturn in the farm economy in recent years which could result in a buyer not having the ability to make the annual payments that the installment contract requires. This situation occurred in Debough v. Comr., 142 T.C. No. 17 (2014). In that case, the taxpayer had purchased a personal residence in 1966 along with 80 acres for $25,000. He agreed to sell the residence and the land in 2006 for $1.4 million with the purchase price to be paid in installments through 2014. He reported the gain for the year of sale (computed in accordance with the calculated gross profit percentage) after excluding the gain attributable to the principal residence, and then received another $505,000 in payments that he reported on the installment method. The buyer defaulted and the seller reacquired the property in 2009. The reacquisition triggered tax to the taxpayer, but he didn’t report the portion of the gain that was previously excluded under I.R.C. §121. The IRS disagreed, pointing out that I.R.C. §1038(e) specifies that, with respect to I.R.C. §121, a taxpayer that reacquires property and sells it within one year can treat the subsequent sale as the original sale for I.R.C. §121 purposes. The taxpayer didn’t do that, so the provision didn’t apply. That meant that the only way to exclude the gain was to move back into the residence to meet the two-out-of-five-year ownership and use test. Of course, the taxpayer didn’t want to do that. The only relief available was that the reacquisition would cause an increase in the basis of the residence to the extent of the gain recognized on repossession which, in turn, would result in less gain on resale. In 2015, the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court.
The home sale exclusion rule comes in handy when a principal residence is sold. But, careful planning is needed when the residence is sold with the farm, when a portion of the residence is used for business purposes, or when the transaction is structured as a deferred exchange or installment sale.