Friday, March 31, 2017
Recent wildfires in Kansas, Oklahoma and Texas have resulted in thousands of livestock deaths and millions of dollars of losses to the agricultural sector in those states. Last week, one of the blog posts was devoted to casualty losses and involuntary conversions. Today, I tackle another related subject – the USDA Livestock Indemnity Program (LIP) and how to report LIP payments.
2014 Farm Bill – The LIP Program
The LIP program, administered by USDA’s Farm Service Agency (FSA), was created under the 2014 Farm Bill to provide benefits to livestock producers for livestock deaths that exceed normal mortality caused by adverse weather, among other things. The amount of a LIP payment is set at 75 percent of the market value of the livestock at issue on the day before the date of death, as the Secretary determines. Eligible livestock include beef bulls and cows, buffalo, beefalo and dairy cows and bulls. Non-adult beef cattle, beefalo and buffalo are also eligible livestock. The livestock must have died within 60 calendar days from the ending date of the “applicable adverse weather event” and in the calendar year for which benefits are requested. To be eligible, the livestock must also have been used in a farming (ranching) operation as of the date of death. Contract growers of livestock are also eligible for LIP payments. However, ineligible for LIP payments are wild animals, pets, or animals that are used for recreational purposes (i.e., hunting dogs, etc.).
As previously noted, LIP payments are set at 75 percent of the market value of the livestock as of the day before their death. That market value is tied to a “national payment rate” for each eligible livestock category as published by the USDA. For contract growers, the LIP national payment rate is based on 75 percent of the average income loss sustained by the contract grower with respect to the livestock that died. Any LIP payment that a contract grower is set to receive will be reduced by the amount of monetary compensation that the grower received from the grower’s contractor for the loss of income sustained from the death of the livestock grown under contract.
As for FSA payment limitations, a $125,000 annual payment limitation applies for combined payments under the LIP, Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. In addition, to the payment limitation, and eligible farmer or rancher is one that has average adjusted gross income (AGI) over a three-year period that is less than or equal to $900,000. For 2017, the applicable three-year period is 2013-2015. For a particular producer, that could mean that tax planning strategies to keep average AGI at or under $900,000 need to be implemented. That could include the use of deferral strategies, income averaging and amending returns to make or revoke an I.R.C. §179 election.
An eligible producer can submit a notice of loss and an application for LIP payments to the local FSA office. The notice of loss must be submitted within the earlier of 30 days of when the loss occurred (or became apparent) or 30 days after then end of the calendar year in which the livestock loss occurred. For contract growers, a copy of the grower contract must be provided. For all producers, it is important to submit evident of the loss supporting the claim for payment. Photographs, veterinarian records, purchase records, loan documentation, tax records, and similar data can be helpful in documenting losses. Of course, the weather event triggering the livestock losses must also be documented. In addition, certification of livestock deaths can be made by third parties on Form CCC-854, if certain conditions can be satisfied
Given that the wildfires occurred in the early part of 2017, it is likely that any LIP payments will also be received in 2017. That’s not always the case. Sometimes LIP payments are not paid until the calendar year after the year in which the loss was sustained. For example, livestock losses in South Dakota a few years ago occurred late in the year, but payments weren’t received until the following year. In any event, for LIP payments that are paid out, the FSA will issue a 1099G for the full amount of the payment.
Death of breeding livestock. While the 1099G simply reports the gross amount of any LIP payment to a producer for the year, there may be situations where a portion of the payment is compensation for the death loss of breeding livestock. If the producer would have sold the breeding livestock, the sale would have triggered I.R.C. §1231 gain that would have been reported on Form 4797. That raises a question as to whether it is possible to allocate the portion of the disaster proceeds allocable to breeding livestock from Schedule F to Form 4797. This is an issue that many producers that have sustained livestock losses will have. While it is true that gains and losses from the sale of breeding livestock sales are reported on Form 4797, the IRS will look for Form 1099-G amounts paid for livestock losses to show up on Schedule F – most likely on line 4a.
Income inclusion and deferral. The general rule is that any benefits associated indemnity payments (or feed assistance) are reported in income in the tax year that they are received. That would mean, for example, that payments received in 2017 for livestock losses occurring in 2017 will get reported on the 2017 return. Likewise, payments for livestock losses occurring in 2016 that were received in 2017 would also be reported in 2017.
The receipt and inclusion in income of LIP payments could also put a livestock producer in a higher income tax bracket for 2017. In that instance, there might be other tax rules that can be used to defer the income associated with the livestock losses. Under I.R.C. §451(e), the proceeds of livestock that are sold on account of weather-related conditions can be deferred for one year. Under another provision, I.R.C. §1033(e), the income from livestock sales where the livestock are held for draft, dairy or breeding purposes that are involuntarily converted due to weather can be deferred if the livestock are replaced with like-kind livestock within four years. The provision applies to the excess amount of livestock sold over sales that would occur in the course of normal business practices.
While I.R.C. §451(e) requires that a sale or exchange of the livestock must have occurred, that is not the case with the receipt of indemnity payments for livestock losses. So, that rule doesn’t provide any deferral possibility. The involuntary conversion rule of I.R.C. §1033(3) is structured differently. It doesn’t require a sale or exchange of the livestock, but allows a deferral opportunity until the animals acquired to replace the (excess) ones lost in the weather-related event Thus, only the general involuntary conversion rule of I.R.C. §1033(a) applies rather than the special one for livestock when a producer receives indemnity (or insurance) payments due to livestock deaths. Thus, for LIP payments received in 2017, they will have to be reported unless the recipient acquires replacement livestock within the next two years – by the end of 2019. Any associated gain would then be deferred until the replacement livestock are sold. At that time, any gain associated gain would be reported and the gain in the replacement animals attributable to breeding stock would be reported on Form 4797.
Livestock losses due to weather-related events can be difficult to sustain. LIP payments can help ease the burden. Having the farming or ranching operation structured properly to receive the maximum benefits possible is helpful, as is understanding the tax rules and opportunities for reporting the payments.
Wednesday, March 29, 2017
The drop in crop prices in recent months has introduced financial strain for some producers. Bankruptcy practitioners are reporting an increase in clients dealing with debt workouts and other bankruptcy-related concerns.
An important part of debt resolution concerns the income tax consequences of any debt relief to the debtor. One of those rules concerns the tax treatment of discharged “qualified farm indebtedness.” The rule can be a useful tool in dealing with the income tax issues associated with debt forgiveness for farmers that are not in bankruptcy. There’s also another option that might come into play in certain situations – a purchase price adjustment.
That’s the focus of today’s post.
Except for debt associated with installment land contracts and Commodity Credit Corporation loans, most farm debt is recourse debt. With recourse debt, the collateral stands as security on the loan. If the collateral is insufficient to pay off the debt, the debtor is personally liable on the obligation and the debtor's non-exempt assets are reachable to satisfy any deficiency.
When the debtor gives up property, the income tax consequences involve a two-step process. Basically, it is as if the property is sold to the creditor, and the sale proceeds are applied on the debt. There is no gain or loss (and no other income tax consequence) up to the income tax basis on the property. Then, the difference between fair market value and the income tax basis is gain or loss. Finally, if the indebtedness exceeds the property's fair market value, the debtor remains liable for the difference and if it is forgiven, the amount is discharge of indebtedness income.
However, special rules can apply to minimize the tax impact of discharge of indebtedness income.
Under I.R.C. §108(a)(1)(A)-(C), a debtor need not include in gross income any amount of discharge of indebtedness if the discharge occurs as part of a bankruptcy case or when the debtor is insolvent, or if the discharge is of qualified farm debt. If one of these provisions applies to exclude the debt from income, Form 982 must be completed and filed with the return for the year of discharge.
Qualified Farm Indebtedness
What is it? The qualified farm debt rule applies to the discharge of qualified farm indebtedness that is discharged via an agreement between a debtor engaged in the trade or business of farming and a “qualified person.” A qualified person includes a lender that is actively and regularly engaged in the business of lending money and is not related to the debtor or to the seller of the property, is not a person from which the taxpayer acquired the property, or is a person who receives a fee with respect to the taxpayer’s investment in the property. I.R.C. §49(a)(1)(D)(iv). Under I.R.C. §108(g)(1)(B), a “qualified person” also includes federal, state or local governments or their agencies.
In addition, qualified farm debt is debt that is incurred directly in connection with the taxpayer’s operation of a farming business; and at least 50 percent of the taxpayer’s aggregate gross receipts for the three tax years (in the aggregate) immediately preceding the tax year of the discharge arise from the trade or business of farming. I.R.C. §§108(g)(2)(A)-(B). Off-farm income and passive rental arrangements can cause complications in meeting the gross receipts test.
Solvency. The qualified farm debt exclusion rule does not apply to the extent the debtor is insolvent or is in bankruptcy. Farmers are also under a special rule – for all debtors other than farmers, once solvency is reached there is income from the discharge of indebtedness. The determination of a taxpayer’s solvency is made immediately before the discharge of indebtedness. “Insolvency” is defined as the excess of liabilities over the fair market value of the debtor’s assets. Both tangible and intangible assets are included in the calculation. In addition, both recourse and nonrecourse liabilities are included in the calculation, but contingent liabilities are not. The separate assets of the debtor’s spouse are not included in determining the extent of the taxpayer’s insolvency. Property exempt from creditors under state law is included in the insolvency calculation. Carlson v. Comr., 116 T.C. 87 (2001).
Maximum amount discharged. There is a limit on the amount of discharged debt that can be excluded from income under the exception. The excluded amount cannot exceed the sum of the taxpayer’s adjusted tax attributes and the aggregate adjusted bases of the taxpayer’s depreciable property that the taxpayer holds as of the beginning of the tax year following the year of the discharge.
Reduction of tax attributes. The debt that is discharged and which is excluded from the taxpayer’s gross income is applied to reduce the debtor’s tax attributes. I.R.C. §108(b)(1). Unless the taxpayer elects to reduce the basis of depreciable property first, I.R.C. §108(b)(2) sets forth the general order of tax attribute reduction (which, by the way occurs after computing tax for the year of discharge (I.R.C. §108(b)(4)(A)). The order is as follows: net operating losses (NOLs) for the year of discharge as well as NOLs carried over to the discharge year; general business credit carryovers; minimum tax credit; capital losses for the year of discharge and capital losses carried over to the year of discharge; the basis of the taxpayer’s depreciable and non-depreciable assets; passive activity loss and credit carryovers; and foreign tax credit carryovers.
Those attributes that can be carried back to tax years before the year of discharge are accounted for in those carry back years before they are reduced. Likewise, any reductions of NOLs or capital losses and carryovers first occur in the tax year of discharge followed by the tax year in the order in which they arose.
The tax attributes are generally reduced on a dollar-for-dollar basis (i.e., one dollar of attribute reduction for every dollar of exclusion). However, any general business credit carryover, the minimum tax credit, the foreign tax credit carryover and the passive activity loss carryover are reduced by 33.33 cents for every dollar excluded.
If the amount of income that is excluded is greater than the taxpayer’s tax attributes, the excess is permanently excluded from the debtor’s gross income and is of no tax consequence. Alternatively, if the taxpayer’s tax attributes are insufficient to offset all of the discharge of indebtedness, the balance reduces the basis of the debtor’s assets as of the beginning of the tax year of discharge.
Discharged debt that would otherwise be applied to reduce basis in accordance with the general attribute reduction rules specified above and also constitutes qualified farm indebtedness is applied only to reduce the basis of the taxpayer’s qualified property. I.R.C. §1017(b)(4)(A). The basis reduction is to the qualified property that is depreciable property, then to the qualified property that is land used or held for use in the taxpayer’s farming business, and then to any other qualified property that is used in the taxpayer’s farming business or for the production of income. This is the basis reduction order unless the taxpayer elects to have any portion of the discharged amount applied first to reduce basis in the taxpayer’s depreciable property, including real property held as inventory. I.R.C. §§108(b)(5)(A); 1017(b)(3)(E).
Purchase Price Adjustment
Instead of triggering discharge of indebtedness income, if the original buyer and the original seller agree to a price reduction of a purchased asset at a time when the original buyer is not in bankruptcy or insolvent, the amount of the reduction does not have to be reported as discharge of indebtedness income. I.R.C. §108(e)(5)(A). The seller also doesn’t have immediate adverse tax consequences from the discharge. Instead, the profit ratio that is applied to future installment payments is impacted. Priv. Ltr. Rul. 8739045 (Jun. 20, 1987).
Farmers often have favorable tax rules. The qualified farm indebtedness rule is one of those. In the right situation, it can provide some relief from the tax consequences of financial distress.
Monday, March 27, 2017
Charitable giving is an important part income tax and estate planning for some clients. Often the charitable gift is made directly by the individual, but there can be benefits to making the contributions from a trust. Individuals can be limited in the amount given to charity. For example, the amount an individual can deduct for charitable contributions generally is limited to 50% of adjusted gross income (AGI). The deduction may be further limited to 30% or 20% of AGI, depending on the type of property donated and the type of organization it is donated to. Other limits can apply to qualified conservation contributions, unless the donor is a qualified farmer or rancher. However, trusts are entitled to an unlimited deduction.
The benefit of making charitable contributions via a trust is the topic of todays’ blog post.
The general rule is that an individual can’t take a charitable deduction for more than 50 percent of AGI for the year. This limit applies to the so-called “50 percent organizations” unless the donation is of capital gain property and the taxpayer computes the deduction using the donated property’s fair market value without reducing for depreciation. In that instance, the limitation is 30 percent unless fair market value of the property is reduced by the amount that would have been long-term capital gain if the property had been sold rather than donated. A “50 percent organization” includes churches, educational organizations, hospitals, the U.S., publicly supported charities, and private foundations.
A 30 percent limitation applies to contributions to all other qualified organizations, except that the limitation is 20 percent if the contribution is of capital gain property.
For qualified conservation contributions, the limit is 50 percent of AGI, less the deduction for all other charitable contributions. A carryover rule applies. For qualified farmers and ranchers, the deduction for a qualified conservation contribution is 100 percent of AGI. A qualified farmer or rancher has gross income from the trade or business of farming that exceeds 50 percent of gross income for the tax year.
What About Trusts?
Unlimited deduction. There are advantages in making charitable contributions from a trust compared to contributions from an individual. Trusts are not subject to percentage limitations on the amount of the charitable deduction. The deduction is unlimited (I.R.C. §642(c)) unless the donated amount of the trust’s gross income consists of unrelated business income. I.R.C. §170. Thus, the trust language should specify that payments to charity should be paid from gross income first to the extent that gross income is not unrelated business income. But, it remains uncertain whether such clause language would prevail for tax purposes. In the right case, the IRS might challenge that language, and the law is not entirely clear on the point.
Flexibility and additional tax benefit. In addition, a trust takes a charitable deduction in the year in which the income is donated to charity even if it was earned in prior years. In that situation, the trust can make an election to treat the payment as having been made in the prior year in which the gross income was earned. I.R.C. §642(c)(1). In addition, if a trust is potentially subject to the 3.8 percent net investment income tax of I.R.C. §1411 (which is triggered when trust income reaches $12,500 for 2017), the trust can reduce its net investment income subject to the 3.8 percent tax by the amount donated to charity.
Obtaining the deduction. A trust can claim a charitable deduction under I.R.C. §642(c) if the donated amount is from gross income, is made in accordance with the trust’s terms, and is made for a charitable purpose – one that is specifically denoted in I.R.C. §170(c). For a case on the issue of having the payments being authorized by and made in accordance with the trust’s terms see Hubbell Trust v. Commissioner, T.C. Sum. Op. 2016-67. Also, a donation to charity from a trust made pursuant to the exercise of a power of appointment would appear to meet the test. However, for a contrary view see Brownstone v. United States., 465 F.3d 525 (2nd Cir. 2006).
What if a trust fails to contain language that authorizes distributions to charity and the objective now is to make such contributions? One possibility is to decant the asset to be contributed to charity to another trust. That trust could then contain a power of appointment granting the power to a third party to make charitable distributions. Whether this strategy would actually work is an open question. Does the original grantor have to have the charitable intent? Another possibility, according to an IRS revenue ruling is to contribute assets to a partnership where a partnership interest is a trust asset and then have the partnership make the charitable contribution from the partnership’s gross income. See Rev. Rul. 2004-5, 2004-3 IRB 295.
Are mandatory distributions required? That answer is clearer – as long as the trust authorizes discretionary charitable distributions, the distributions will qualify for the charitable deduction.
Also, the trust can authorize either the trustee, the beneficiaries or others to direct that charitable distributions be made. In addition, trust language can provide for beneficiary (or third party) consent before charitable distributions can be made. The same consent can be made applicable before the exercise of a power of appointment in a charity’s favor, and restrictions can be placed on distributions without eliminating the deduction.
What is “gross income”? What does it mean to satisfy the requirement that the donated amount come from “gross income”? That’s a more difficult question to answer because tracing the source of the income is not necessarily easy. A recent case provides some helpful, and some would assert, surprising guidance. In Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), a dynasty trust created in 1993 expressly authorized the trustee to “distribute to charity such amounts from the gross income of the Trust as the trustee determines appropriate.” The trust also provided that “[a] distribution may be made from the Trust to charity only when both the purpose of the distribution and the charity are as described in Section 170(c) of the Code.” The trust wholly owned a single-member LLC and, in 2004, the LLC donated properties that it had purchased to three qualified charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the U.S. The IRS claimed that the trust could not take a charitable deduction equal to the full fair market value, but instead took the position that the charitable deduction should be limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund. On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. Sec. 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. Sec. 170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor. The court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust – the trust was entitled to a deduction for the full fair market value of the appreciated property.
Donating to charity from a trust can be beneficial. There are no percentage limitations that apply. However, there are other requirements that apply and care should be taken in drafting trust language so that those requirements are satisfied.
Thursday, March 23, 2017
Farm and ranch property is exposed to weather-related events that can seriously damage or ruin the property. The massive wildfires in parts of Kansas and the horrific pictures have illustrated the devastation that the affected farmers and ranchers have suffered. It’s truly gruesome to see the pictures of dead livestock and the burned-up fences and pastures, not to mention the buildings, structures and homes that were lost. The financial losses are large, but there are some tax provisions that can be utilized to at least partially soften the blow. A blog post last fall visited this issue, at least in part. Today’s post revisits the issue.
A casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Casualty losses are deductible regardless of whether the property is used in the trade or business, held for the production of income or held for personal purposes although the rules differ slightly on how the loss is calculated.
Sometimes, the issue in a particular case comes down to drawing a line between what is a casualty and what is ordinary wear and tear. For purposes of this post, a casualty is assumed. The recent Kansas wildfire situation, for example, leaves no doubt that the losses are casualty losses for tax purposes.
The amount of the deduction for casualty losses is the lesser of the difference between the fair market value before the casualty or theft and the fair market value afterwards, and the amount of the adjusted income tax basis for purposes of determining loss. The deduction can never exceed the basis in the item that suffers the casualty. In effect, the measure of the loss is the economic loss suffered limited by the basis (and any insurance recovery).
Here's a simple example:
Assume a rancher has five Hereford cows and one Hereford bull in a pasture. A lightning strike ignites a wildfire, and the wildfire spreads rapidly by high winds and the cows and bull are caught in the fire and are killed. The cows were raised and have a basis of $0.00 and a fair market value of $4,500. The bull, which was purchased for $5,000, had a fair market value of $6,000 at the time of death. The amount of the casualty loss is the difference in the fair market value before and after the loss is $10,500 ($10,500 - $0.00). However, the total basis in all of the animals is only $5,000 - the basis of the bull. Since the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000.
In addition, any casualty loss must be reduced by any insurance recovery. Thus, returning to the example, if the rancher collected $4,500 of insurance on the dead cattle, the deductible loss would be limited to $500. The deduction is to be taken in the year in which the loss was incurred. It is claimed on Section B of Form 4684 and on Form 4797.
Note: If the rancher’s casualty loss causes his deductions to exceed his income for the year in which he claims the loss, the rancher may have a net operating loss (NOL) for the year of the casualty that is entitled to a two-year carryback and a 20-year carryforward. However, the portion of the NOL arising from the casualty loss has a three-year carryback period. I.R.C. §172(b)(1)(E).
What if, in the example above, the rancher’s pasture was destroyed by the wildfire but he had other livestock that survived? But, without usable pasture, the rancher had to sell the livestock. That’s where another tax provision can apply.
When a farmer sells livestock (other than poultry) held for draft, dairy or breeding purposes in excess of the number that would normally be sold during the time period, the sale or exchange of the excess number may be treated as a nontaxable involuntary conversion if the sale occurs because of drought, flood or other weather-related condition. The livestock sold or exchanged must be replaced within two years after the year in which proceeds were received with livestock similar or related in service or use (in other words, dairy cows for dairy cows, for example), and be held for the same purpose that the animals given up were held. Thus, dairy cows can be replaced with dairy cows, but they can’t be replaced with breeding animals.
The tax on the sale is triggered when the replacement animals are sold. If it is not feasible to reinvest the proceeds in property similar or related in use, the proceeds can be reinvested in other property used for farming purposes (except real estate). Similarly, if it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).
If the replacement property is livestock, the new livestock must be held for the same purpose as the animals disposed of because of the weather-related condition. Treas. Reg. § 1.1033(e)-1(d). The two-year replacement period is extended to four years in areas designated as eligible for assistance by the federal government (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The replacement property must be livestock that is similar or related in service or use to the animals disposed of. Also, the Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).
The election to defer the gain is made by attaching a statement to the return providing evidence of the weather-related condition that caused the early sale, the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices. The election can be made at any time within the normal statute of limitations for the period in which the gain is recognized, assuming that it is before the expiration of the period within which the converted property must be replaced. If the election is filed and eligible replacement property is not acquired within the applicable replacement period (usually four years), an amended return for the year in which the gain was originally realized must be filed to report the gain. But, if the animals are replaced, for the tax year in which the livestock are replaced, the taxpayer should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock. The election must be made in the return for the first tax year in which any part of the gain from the sale is realized. It’s also very important for a taxpayer to maintain sufficient records to support the nonrecognition of gain.
Note: For livestock that are partnership property and are sold by the partnership, the election is the responsibility of the partnership. The partners do not individually make the election to defer recognizing the gain. See Rosefsky v. Comr., 599 F.2d 515 (2d Cir. 1979).
The Interaction of the Two Rules
Returning to the example above, assume that the rancher received insurance proceeds exceeding $5,000, the net book value of the animals. For instance, if the rancher received $6,000 of insurance proceeds, the $1,000 exceeding the tax basis of the dead animals would be taxable. That is a potential taxable gain that can be deferred if the rancher makes a valid election to defer the gain, and the livestock are replaced within the applicable timeframe. In that instance, the $1,000 casualty gain can be deferred until the replacement animals are sold. However, it may be advantageous from a tax standpoint for the rancher to report the gain on the animals in order to claim ordinary depreciation on the replacement animals.
Another Rule – One-Year Deferral
Under another rule, if farm and ranch taxpayers on the cash method of accounting are forced because of drought or other weather-related condition to dispose of livestock (raised or purchased animals that are held either for resale or for productive use) in excess of the number that would have been sold under usual business practices, they may be able to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(e). The taxpayer's principal business must be farming in order to take advantage of this provision. This brings up a key observation – at the time the tax return is due for the year of the casualty, the livestock owner may not be sure of which election is the best one to make. In that event, a “protective” election can be made under I.R.C. §1033 for that tax year. If the livestock can be replaced within the applicable replacement period, the involuntary election can be revoked and the return for the casualty year can be amended to make the election to defer the gain for one year. In that instance, the return for the year after the casualty would also have to be amended to report the deferred gain.
Relatedly, a taxpayer can make an election under I.R.C. §451(e) until the four-year period for reinvestment of the property under I.R.C. §1033 expires. That means that if a livestock owner elects involuntary conversion treatment and fails to acquire the replacement livestock within the four-year period, the I.R.C. §451(e) election to defer the gain for one year can still be made. If that happens the livestock owner will have to file an amended return for the casualty year to make the I.R.C. §451(e) election and revoke the I.R.C. §1033(e) election, and the next year to report the gain deferred to that year.
Farming operations organized in a form other than as a C corporation which have received “applicable subsidies” are subject to an overall limitation on farming losses of the greater of $300,000 ($150,000 in the case of a farmer filing as married filing separately) or aggregate net farm income over the previous five-year period. Farming losses from casualty losses or losses by reason of disease or drought are disregarded for purposes of figuring this limitation. I.R.C. §461(j).
Farm income averaging can also be a useful tool as an election in a tax year in which a substantial casualty has been sustained. The interaction of the income averaging election, casualty loss rules, the tax treatment of livestock sold on account of weather-related conditions and loss carryback rules can provide some significant tax planning opportunities.
Sustaining a casualty loss can be extremely difficult for a farmer or rancher, or any other taxpayer for that matter. But, there are tax rules that can be used to soften the blow.
Tuesday, March 21, 2017
Several decades ago, many farmers had diversified crop and livestock operations. It was not uncommon for a farmer to have cows, hogs, sheep, chickens and also grow row crops such as soybeans and corn along with having hayfields and wheat. But, over time, the standard of living increased, agricultural production became increasingly mechanized and specialization took hold. Grain farming became profitable enough on its own that many farmers no longer needed to also raise livestock. Likewise, machinery costs rose to such a level that, for many farmers, it was no longer economical to have machinery for each of the separate facets of a diversified farming operation.
With this transformation of production agriculture came complexity. The process by which agricultural products are produced has become much more complex. Likewise, the associated tax and legal issues have also become more numerous and complex. In addition, farming operations are larger and also are more likely to employ others than in the past.
That last point brings us to today’s topic. Having employees means those employees need to get paid. Paying employees obliges the employer to withhold payroll taxes. Failing to withhold payroll taxes can lead to huge penalties, even if there was no intent to violate the tax law.
The Tale of Dr. McClendon
McClendon v. United States, No. H-15-2664, 2016 U.S. Dist. LEXIS 159271 (S.D. Tex. Nov. 17, 2016), involved a Texas doctor whose clinic got behind in withholding and paying payroll taxes – way behind. The doctor founded his clinic in 1979 and hired a Chief Financial Officer (CFO) in 1995. By 2009, the clinic had unpaid payroll and other withholding taxes exceeding $10 million. The doctor learned about the unpaid taxes in May of 2009, and the CFO pleaded guilty to embezzlement. The doctor ultimately shut the clinic down and sent the remaining receivables to the IRS in partial payment of the tax liability. But, thinking of the clinic’s employees, the good doctor loaned the clinic $100,000 so that the clinic could make payroll before shutting down. The employees got paid, but the IRS didn’t. In addition, the IRS didn’t care that he was nice to his employees. It assessed the good doctor a total of $4,323,343.70 in tax penalties under I.R.C. §6672. The doctor paid a small part of that liability and then sued for a refund and abatement of the remaining penalty amount. The IRS moved for summary judgment.
Trust Fund Recovery Penalties
Under I.R.C. §§3102(a) and 3402(a), an employer must withhold their employees' share of federal social security and income taxes from the employees' wages. The employer holds these "trust fund taxes" in trust for the benefit of the United States. To ensure that the taxes are remitted to the United States, I.R.C. §26 U.S.C. § 6672(a) imposes a penalty equal to the entire amount of the unpaid taxes. To be held liable for the penalty, the taxpayer must be a “responsible person” that willfully failed to collect, account for, or pay over the taxes.
The “Willfullness” of Dr. McClendon
The doctor conceded that he was a responsible person, but claimed that the penalty didn’t apply because he didn’t willfully fail to collect, account for, or pay the taxes that the clinic owed the IRS. The court disagreed. The focus was on the $100,000 loan the doctor made to his clinic to make sure the employees got paid. The doctor claimed (based on applicable Fifth Circuit caselaw) that because those funds were “encumbered” to cover payroll, he didn’t direct “unencumbered” funds away from the IRS. Therefore, he claimed, he didn’t willfully not pay the IRS and the penalty shouldn’t apply. However, the court rejected that reasoning because the doctor testified that the loaned the money so that the employees could get paid. In other words, he paid the employees instead of the IRS and the funds, the court reasoned, were not “encumbered” in any relevant sense. In addition, the court reasoned that “willful” only required a voluntary, conscious, and intentional act, not a bad motive or evil intent. The doctor also claimed that he had reasonable cause to provide a way to get his employees paid because “he acted morally and generously in using his own money to make sure [clinic] staff . . . were paid for the work they had performed. . . .". However, the court determined that the doctor’s motives were not relevant. He didn’t pay the IRS. He did pay another creditor (the employees). That’s all that mattered. So, the doctor was personally stuck with a tax penalty exceeding $4 million, plus pre-judgment and post-judgment interest until the penalty was paid. The $100,000 loan bought him much more than he bargained for. A small payment to someone other than the IRS can trigger a huge penalty. The penalty isn’t limited to the amount paid to the other creditor(s), it’s the full unpaid amount.
So why is this case a big deal for agriculture? As noted above, as farms have become more prosperous, the duties, obligations and responsibilities of a farmer are increasing. In addition, an increasing percentage of farming operations have employees. Thus, as more farmers shift the payroll compliance duties to others so that the farmer has more time to devote to conducting farming operations, this case sounds a loud warning - shifting the payroll duties does not shift the responsibility to see that trust fund withholdings have been paid to the IRS. The farmer will be held liable. The responsibility can’t be delegated. Make sure to watch payroll taxes. This is also a problem to watch out for in times of financial distress, such as what much of agriculture is going through at the present time.
The Electronic Federal Tax Payment System (EFTPS) is a secure government website that allows users to make federal tax payments electronically. That’s the system that IRS wants businesses to use to remit payroll taxes through. EFTPS is also easy to check online to ensure that payments have been made. Otherwise, there are firms that handle payroll taxes. If you use a private firm, make sure it is reputable and bonded.
Just another thing for a farmer to think about. Don’t forget the payroll taxes.
Friday, March 17, 2017
While purchased livestock that is held primarily for sale must be included in inventory (along with all items that are held for sale or for use as feed, seed, etc., that remain unsold at the end of the year), livestock that is acquired (e.g., purchased or raised) for draft, breeding or dairy purposes may be depreciated by a farmer using either the cash or accrual method of accounting, unless the livestock is included in inventory. Treas. Reg. §1.167(a)-6(b). Cash basis farmers and ranchers are allowed to currently deduct all costs of raising livestock, thus only purchased livestock are required to be capitalized and held in inventory or depreciated.
The decision to depreciate livestock (including fur-bearing livestock) or include them in inventory can be an important one for many farmers and ranchers. That’s the focus of today’s blog post.
Section 1231 Assets
I.R.C. §1231 refers to depreciable business property that has been held for more than one year, and includes buildings and equipment, timber, natural resources, unharvested crops, and livestock among other types of business assets. One benefit of I.R.C. §1231 is that gains and losses on I.R.C. §1231 property are netted against each other in the same manner as capital gains and losses except that a net I.R.C. §1231 gain is capital in nature (e.g., taxed at a preferential rate), but a net I.R.C. §1231 loss is treated as an ordinary loss. A special provision in I.R.C. §1231(b)(3) requires that cattle and horses held for draft, breeding , dairy or sporting purposes must be held for at least 24 months to qualify for I.R.C. §1231 status. Other livestock is only required to be held for at least 12 months. It does not include, for example, inventory and property held for sale in the ordinary course of business.
I.R.C. §1231 tax treatment is not available if the taxpayer includes livestock in inventory. However, a farmer might have animals listed in the closing inventory in a year that are then transferred to the depreciation schedule in the next year upon the animals reaching maturity and becoming productive. In that event, the inventory value of the animals in the first year’s closing inventory should be subtracted from the beginning inventory for the subsequent year.
Even some livestock that does not come within the category of I.R.C. §1231 is depreciable. For example, poultry held for more than one year for breeding or egg-laying purposes may be depreciated if not held primarily for resale. Treas. Regs. §§1.167(a)-3; 1.167(a)-6(b). But, livestock held for sporting purposes is not made specifically depreciable. See Treas. Reg. §1.167(a)-6(b). However, sporting assets may be depreciated as business assets.
Sheep and furbearing animals have been held to be I.R.C. §1231 assets. That at least implies that the animals would be depreciable. See Treas. Reg. §§1231-1; 1.1231-2(a)(3). One case, however, has disallowed depreciation deductions for sheep held for breeding, wool and resale purposes. Belknap v. United States, 55 F. Supp. 90 (W.D. Ky. 1944).
Depreciate or Include in Inventory – That is the Question
The key question for a farmer/rancher is whether livestock should be depreciated or included in inventory. The depreciation of livestock is beneficial to the producer for many reasons. First, depreciation is an ordinary deduction and thus reduces the farmer’s net income and self-employment income. Second, although the depreciation taken on the livestock must be recaptured under I.R.C. §1245, this recapture is not subject to self-employment tax for Schedule F and farmers operating in the partnership form. Third, the amount of gain in excess of original cost, if held for the applicable period, is taxed at favorable capital gains rates under I.R.C. §1231.
Farmer Jones purchases a cow for breeding purposes and pays $2,000 on January 1, 20X1. Over the next three years, Farmer Jones takes $1,160 of depreciation on the cow, thus reducing his farm income and self-employment income by this amount. He then sells it for $3,000 on January 1, 20X4. At that time, Farmer Jones is required to recapture the $1,160 of depreciation originally taken on the cow at ordinary income tax rates (however, it is not subject to self-employment tax) and the $1,000 gain in excess of original cost of $2,000 is subject to long-term capital gains rates since he held the cow for more than two years.
So, is this a better tax result than capitalizing the cow and holding it in inventory? The answer turns on whether a current deduction for depreciation will outweigh subsequent capital gain treatment upon sale. Also, that eventual capital gain treatment will be limited by depreciation recapture which means that ordinary income rates will apply to the portion of the gain on sale attributable to the amount of depreciation previously claimed.
What About Accural Basis Taxpayers?
In general, if an accrual basis farm taxpayer wants to achieve a lower tax rate on future gains from the qualified sale of breeding, draft, dairy or sporting livestock, livestock should generally be inventoried at the lowest possible value. If that is done, care should be taken in selecting the inventory method that is utilized. Because any particular animal’s inventory value pegs its basis for the computation of gain or loss on sale, the inventory method impacts the ordinary gain on sale. Thus, any method that assigns a relatively low value to an animal will result in a relatively greater ordinary gain upon the animal’s sale. Remember, any livestock held for sale that is not breeding, draft, dairy or sporting livestock is subject to ordinary income tax rates, regardless of the period of time held. It is only livestock held for breeding, draft, dairy or sporting purposes that qualify for long-term capital gain rates under I.R.C §1231.
Here are the available methods, and whichever one is utilized must conform to generally accepted accounting principles and must clearly reflect income.
- Cost method. This method simply values inventory at its cost, including all direct and indirect costs.
- Lower-of-cost-or market method. This method compares the market value of each animal on hand at the inventory date with its cost, and uses the lower of the two values as the inventory value for that animal.
- Farm-price method. This inventory method values inventories at market price less the direct cost of disposition. If this method is utilized, it generally must be applied to all property that the taxpayer produces in the taxpayer’s trade or business of farming – except for any livestock that are accounted for by election under the unit- livestock-price method of accounting.
- Unit-livestock-price method. Under this method of inventorying livestock, the livestock are classified into groups based on age and kind and then the livestock in each group (class) is valued by using a standard unit price for each animal in that class. Essentially, the taxpayer divides the livestock into classifications that are reasonable based on age and kind, with the unit prices for each class accounting for the normal costs of producing and raising those animals. If purchased livestock are not mature, the cost of the livestock must be increased at the end of each year in accordance with the established unit prices, except for animals acquired during the last six months of the year. This can result in a situation where the taxpayer receives a current deduction attributable to the costs of raising the livestock without any additional unit increase in the animal’s closing inventory.
When an animal is included in inventory at its unit price at maturity, its inventory value cannot be written down later to reflect a decline in its value because of, for example, a loss in value due to aging irrespective of whether the animal has not yet reached marketable age.
For taxpayers that anticipate generating significant income from the sale of draft, dairy or breeding livestock and who inventory livestock, an inventory method (such as the lower of cost or market method and the unit-livestock-price method) that maximizes capital gain on sale rather than income in the years preceding sale will likely be beneficial. However, consideration should be given to the principle that inventorying livestock will usually cause a reduction in current deductions against ordinary income. On the other hand, for livestock that are depreciated, depreciation deductions previously taken are recaptured as ordinary income upon sale of the livestock, but this income is not subject to self-employment tax and the amount of gain in excess of original cost is subject to favorable long-term capital gains treatment.
Wednesday, March 15, 2017
How a farming operation is structured influences eligibility for federal farm program payment limitations and the amount of payments that can be received. The rules can become complex in their application, but a basic point should not be missed – each “separate person” is entitled to a payment limit. But, what does that mean? How is that term defined? How does the structure of the farming operation impact separate person status?
Those are all important questions when it comes to payment limitation planning, and a recent case from Montana illustrates why proper structuring matters in the realm of payment limitation planning. That’s the focus of today’s post.
Payment Limitation Basics
Monetary limits. For payment limitation and eligibility purposes, a "person" is separately entitled to receive payments up to the applicable limit. Under the 2014 Farm Bill, the total amount of payments received, directly and indirectly, by a person or legal entity (except joint ventures or general partnerships) for Price Loss Coverage (PLC) Agricultural Risk Coverage (ARC), marketing loan gains, and loan deficiency payments (other than for peanuts), may not exceed $125,000 per crop year. A person or legal entity that receives payments for peanuts has a separate $125,000 payment limitation ($250,000 for married persons). Cotton transition payments are limited to $40,000 per year. For the livestock disaster programs, a total $125,000 annual limitation applies for payments under the Livestock Indemnity Program, the Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. A separate $125,000 annual limitation applies to payments under the Tree Assistance Program.
What (or who) is a “person”? "Persons" may be individuals, corporations, limited liability companies, and certain other business organizations (such as trusts, estates, charitable organizations, and states and their agencies), but general partnerships, joint ventures, and similar “joint operations” may not be "persons." Notice the difference. Individuals, along with entities that limit liability, can be a separate person entitled to a payment limit. But, other business structures that don’t limit liability are not a separate person for payment limitation purposes. Let me restate that a different way to drive the key point home - C corporations, S corporations and Limited Liability Companies (i.e., any type of entity that limits liability) all have one payment limitation. The Farm Service Agency (FSA) then implements the direct attribution rule down to the shareholders/members to the fourth level for each of the respective entities. Thus, the entity has a limitation, and then each member has a limitation. If benefits are sought in the name of an entity and there are four shareholders or members of the entity, for example, there is a single payment limit.
However, general partnerships, joint ventures, cooperative marketing associations, and other entities that don’t limit liability are not eligible for "person" status.
Note: The definition of “person” is contained at 7 C.F.R. §1400.3
As a general rule, for farming operations other than those that are small, general partnerships and joint ventures are more advantageous for payment limitation and eligibility purposes than corporations, limited liability companies, and limited partnerships. Why? While a corporation, limited liability company, or limited partnership will be only one "person" irrespective of the number of its shareholders or members, each of the partnership's or joint venture’s members may be a separate "person" (unless there is a “combination” of “persons” under one of the so-called “combination rules”). Therefore, more "persons" are potentially available to a farming operation conducted by an entity that doesn’t limit liability than farming is a farming operation conducted by an entity that does limit liability. But, of course, with no limitation on liability comes joint and several liability. Farmers will generally not be comfortable with that, but it can be addressed by having the general partnership farming operation consist of single-member limited liability companies (or other types of limited liability structures) in lieu of individuals.
“Separate and distinct” requirement. Each “separate person" must have a "separate and distinct" economic investment in the farming operation. That is measured by a three-part test.
* Each separate person must have a separate and distinct interest in the land or the crop involved;
* Each separate person must exercise separate responsibility for the separate interest; and
* Each separate person must maintain funds or accounts separate from that of any other individual or entity for that interest.
Note: General partnerships and joint ventures may satisfy these requirements on behalf of their members.
Farmers and farm families sometimes jointly purchase inputs or exchange equipment or services. That is permissible under the rules, but farming operations that are separate have to stay that way – separate and distinct. Thus, it is important to make sure that transactions are done at arm’s-length and a paper trail is created that clearly shows that separate farming operations are, indeed, separate and that each one meets all of the applicable requirements. Care should be taken to avoid a USDA argument that there is a commingling of funds between farming operations. Promptly paying for joint purchases is a good idea, as is making sure any equipment exchanges are equivalent. The idea is to avoid the appearance that one farming operation is responsible for what another farming operation is doing.
In addition, to be a “separate person,” that “person” must “[m]aintain funds or accounts separate from that of any other individual or entity for such interest [in the land or crop involved].” This requirement is a prohibition against commingling of funds. It is not a bar on “financing.” The rules on financing are probably a topic for another blog post. In general, financing restrictions are in the payment limitation and payment eligibility rules as part of the definitions of “capital,” “equipment,” and “land” and apply to “actively engaged in farming” determinations, not “person” determinations.
In a recent case involving a Montana farming operation, Harmon v. United States Department of Agriculture, No. 14-35228, 2016 U.S. App. LEXIS 23105 (9th Cir. Dec. 22, 2016), the plaintiff received federal farm program payments from 2005 through 2008. The USDA determined that the plaintiff was not a separate “person” from his LLC which also received farm program payments for the same years. As a result, the USDA required the plaintiff to refund to the government the payments that he had received. The plaintiff exhausted his administrative remedies with the USDA to no avail, and the trial court upheld the USDA’s determination on summary judgment.
On appeal, the appellate court affirmed. The court noted that the plaintiff was required to show that he was “actively engaged in farming” and that he was a “separate person” from the LLC because the definition of “person” applied to all of part 1400 of the Code of Federal Regulations (C.F.R.) which contains the “separate person” rules and, consequently, the USDA’s interpretation of its own regulation defining “person” for payment limitation purposes that is set forth in 7 C.F.R. §1400.3 was consistent with the regulation and not plainly erroneous. The court also determined that substantial evidence supported the conclusion that the plaintiff was not a separate person from his LLC due to many unexplained transfers or loans between the plaintiff and the LLC without accompanying documentation. That suggested a commingling of funds, as did the making of operating loans back and forth between the plaintiff and the LLC. As such, the appellate court believed it was not possible to determine the true assets and liabilities of either the plaintiff or the LLC.
The appellate court also believed that the plaintiff had not made a good faith effort to comply with the per-person payment limitations, was not a separate person from the LLC and was entitled to only one payment limit instead of two. Also, the finality rule which makes a determination by a state or county FSA final and binding 90 days from the date an application for benefits was filed did not bar the FSA from evaluating the plaintiff’s program eligibility because the determination was based on misrepresentations that the plaintiff should have known were erroneous. On the application, the plaintiff had represented that he provided all of the capital and labor on his farm and didn’t receive any operating loans from related entities. In addition, while the decision of the Director of the USDA National Appeals Division did not meet the 30-day deadline, it was not void because the statute at issue (7 U.S.C. §6998(b)(2)) contains no remedy for failure to comply.
A key problem with the Montana farming operation was its structure. The LLC was a “person” under the rules, so the individual had to meet the tests for being a “separate person” from the LLC. He couldn’t do that with the result that only a single payment limitation applied. A better approach would have been to set the farming operation up as a general partnership. The general partnership would not have qualified as a “separate person,” but the individual farmer could have as a single-member LLC. That still would have resulted in one payment limitation, but additional family members could have been added as members with each having their own single-member LLC. That structure might also help address problems with commingling of funds with the operating entity.
In any event a professional that understands the rules can help to create a structure that can result in compliance with the rules and keep the farming operation from becoming tangled in needless litigation. That’s particularly the case for medium and larger-sized farming operations where the payment limit is in play.
Monday, March 13, 2017
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “Swampbuster.” It was originally presented as only impacting truly aquatic areas and allowing drainage to continue where substantial investments had been made. The concept was met with virtually no congressional opposition, and provided that any person who in any crop year produced an agricultural commodity on converted wetlands would be ineligible for federal agricultural subsidies with regard to that commodity.
But, the Swampbuster rules have become a “quagmire” of a bureaucratic mess for many farmers and their legal counsel over the years. Today’s post takes a brief look at the issues involved in the hope that farmers and lawyers representing them can find a bit of guidance.
The original intent of Swampbuster was to deny federal farm program benefits to persons planting agricultural commodities for harvest on converted wetlands. 16 U.S.C. § 3821(a)-(b). Committee reports indicated that the Congress did not intend the Swampbuster provisions to authorize the USDA to regulate the use of private land and wanted producers to remain eligible for farm program benefits if the production of agricultural commodities occurred on converted wetlands where the impact of such conversion on wetland functional values was slight. A wetland conversion was deemed to have “commenced” when a person had obligated funds or begun actual modification of a wetland.
The legislation charged the Soil Conservation Service (SCS) with creating an official wetland inventory with a particular tract being classified as a wetland if it had (1) the presence of hydric soil; (2) wetland hydrology (soil inundation for at least seven days or saturated for at least 14 days during the growing season); and (3) the prevalence of hydrophytic plants under undisturbed conditions. In other words, to be a wetland, a tract must have hydric soils, hydrophytic vegetation and wetland hydrology. All three must be present, just having hydrophytic vegetation, for example, is not enough. See B&D Land & Livestock Co. v. Schafer, 584 F. Supp. 2d 1182 (N.D. Iowa 2008).
The final Swampbuster rules were issued in 1987 and greatly differed from the interim rules. The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion. Added were farmed wetlands, abandoned cropland, active pursuit requirements, Fish and Wildlife Service concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill). If the drainage work was not completed by December 23, 1985, a request could be made of the USDA on or before September 19, 1988, to make a commencement determination. In addition, drainage districts must satisfy several requirements under the “commenced conversion” rules. A project drainage plan setting forth planned drainage must be officially adopted. Also, the district must have begun installation of drainage measures or legally committed substantial funds toward the conversion by contracting for installation or supplies.
On-Site Wetland Identification Criteria
The USDA Natural Resource Conservation Service (USDA-NRCS) on-site wetland identification criteria are contained in 7 C.F.R. §12.31. Those rules lay out the procedures that USDA is to use to determine whether a tract contains wetlands. But, the implementation of the procedures has also led to litigation. For example, in Boucher v. United States Department of Agriculture, 149 F. Supp. 3d 1045 (S.D. Ind. 2016), the court determined that the NRCS followed regulatory procedures found in 7 C.F.R. §12.31(b)(2)(ii) for determining wetland status on the land that was being farmed by comparing the land to comparable tracts that were not being farmed. The court also noted that existing regulations do not require site visits during the growing season and “normal circumstances” of the land does not refer to normal climate conditions but instead refers to soil and hydrologic conditions normally present without regard to the removal of vegetation. The court also determined that the ten-year timeframe between the preliminary determination and the final determination did not deprive the plaintiff of due process rights. As a result, the court granted the government’s motion for summary judgment.
Likewise, in Foster v. Vilsack, 820 F.3d 330 (8th Cir. 2016), the court determined that the defendant’s method for determining hydrology by using aerial photographs taken when the tract was under normal environmental conditions was proper, given that the tract was drier than normal during the defendant’s site visit and because the plaintiffs had tilled the tract such that it was not in its normal condition at the time of the site visit. The plaintiffs’ claim that the defendant had relied on “color tone” differences in the photographs to identify the tract as a wetland was dismissed because the defendant had actually identified some of the specifically authorized wetland signatures rather than just relying on changes in color tone. The court also rejected the plaintiffs’ claim that the defendant had relied on a comparison site too distant from the tract at issue that wasn’t within the local area as the regulations required. The comparison site chosen was 40 miles away but was within the same Major Land Resource Area. As such, the comparison site satisfied the regulatory criteria contained in 7 C.F.R. §12.31(b)(2) to find a similar tract in its natural vegetative state. Accordingly, the defendant’s use of the comparison site was not arbitrary, capricious or contrary to the law. Earlier this year, the U.S. Supreme Court declined to hear the case.
The final rules defined “farmed wetlands” as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the “scope and effect” of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). Prior converted wetlands can be farmed, but they revert to protected status once abandoned. A prior converted wetland is a wetland that was totally drained to make it more suitable for farming before December 23, 1985. 16 U.S.C. §3801(a)(6). If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original drainage can be maintained.
Drainage activities on land designated as “farmed wetlands” have led to litigation. In Gunn v. United States, 118 F.3d 1233 (8th Cir. 1997), cert. den., 522 U.S. 1111 (1998), the Eighth Circuit Court of Appeals held that conversion from wetland to farmland of the land in question did not begin before 1985 even though the land had been cropped for 85 consecutive years after the county drainage district installed a tile main to drain the land for crop production in 1906. Because wetland traits occurred over time in wet years as the drainage system became incapable of draining the land, a portion of the farm was classified as “farmed wetland” and a 1992 replacement of the 1906 tile main with an open ditch was held to be an illegal improvement in the drainage beyond that which existed on December 23, 1985. The court reached this conclusion even though drainage district assessments had been paid on the land for decades.
Unfortunately, the Gunn court did not precisely address the issue of the original “scope and effect” of the 1906 drainage activities. Under USDA regulations, farmed wetland can be used as it was before December 23, 1985, and a hydrologic manipulation can be maintained to the same “scope and effect” as before December 23, 1985. The USDA is responsible for determining the scope and effect of original manipulation on all farmed wetlands. Arguably, if the 1906 drainage allowed crop production to occur on all of the land at issue at that time, then the effect of the 1906 drainage on the wetland was to convert it to crop production, and that status could be maintained by additional drainage activities after December 23, 1985. However, for farmed wetlands, the government has interpreted the “scope and effect” regulation such that the depth or scope of drainage ditches, culverts or other drainage devices be preserved at their December 23, 1985, level regardless of the effect any post-December 23, 1985, drainage work actually had on the land involved. In 1999, the U.S. Court of Appeals for the Eighth Circuit invalidated the government’s interpretation of the “scope and effect” regulation. Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999). The court held that a proper interpretation should focus on the status quo of the manipulated wetlands rather than the drainage device utilized in post-December 23, 1985, drainage activities.
Changes in the Rules
In 1990, the Congress tightened the Swampbuster rules by adding a new provision which provided that “any person who in any crop year subsequent to November 28, 1990, converts a wetland by draining, dredging, filling, leveling, or any other means for the purpose, or to have the effect, of making the production of an agricultural commodity possible on such converted wetlands shall be ineligible for USDA farm benefits. 16 U.S.C. § 3821(b)-(c). The rules were also changed to add a stronger penalty for wetland conversions. While converting a wetland before Nov. 28, 1990, resulted in only a proportional loss of benefits, conversion after that date results in the loss of all USDA benefits on all land the farmer controls until the wetland is restored or the loss is mitigated. 16 U.S.C. § 3821(c) (2008). After the 1990 Swampbuster rule change, the USDA took the position that activities that made ag production “possible” on converted wetland meant that any activity that made such land more farmable was prohibited. The USDA’s regulatory position was upheld by Clark v. United States Department of Agriculture, 537 F.3d 934 (8th Cir. 2008). but rejected by Koshman v. Vilsack, 865 F. Supp.2d 1083 (E.D. Cal. 2012).
Under the 1996 Farm Bill, a farmed wetland located in a cropped field can be drained without sacrificing farm program benefit eligibility if another wetland is created elsewhere. Thus, through “mitigation,” a farmed wetland can be moved to an out-of-the-way location. In addition, the 1996 legislation provides a good faith exemption to producers who inadvertently drain a wetland. If the wetland is restored within one year of drainage, no penalty applies. The legislation also revises the concept of “abandonment.” Cropland with a certified wetland delineation, such as “prior converted” or “farmed wetland” is to maintain that status, as long as the land is used for agricultural production. In accordance with an approved plan, a landowner may allow an area to revert to wetland status and then convert it back to its previous status without violating Swampbuster.
While the Congressional intent behind the Swampbuster rules was a good one, the actual implementation has created difficult problems for farmers and ranchers. Will a new Administration and new heads of federal agencies bring more common sense to the application of that original intent of the Congress? Only time will tell.
Thursday, March 9, 2017
Normally, land improvements constitute capital expenditures the cost of which would have to be added to the basis of the land. But, a farmer can currently deduct the cost of certain improvements and soil and water conservation expenses in the first year in which the farmer incurs the expenditures. I.R.C. §175. If the deduction is not taken in that first year, the result is that the taxpayer has elected not to deduct which is binding in subsequent years. In that case, the expenditures increase the basis of the property to which they relate. Once a method of reporting such expenses is adopted, it must be followed in subsequent years unless the IRS agrees to a change.
So, what expenditures are eligible to be currently deducted under I.R.C. §175? How is the deduction claimed? If there a possibility of recapture if the associated land is sold? These are the issues today’s post examines.
Soil and water conservation expenses that qualify under the I.R.C. §175 provision must be paid or incurred for soil or water conservation purposes with respect to land used in farming, or for the prevention of erosion on farmland. I.R.C. §175(a). Qualified expenses include various types of earth moving on farmland using in the business of farming. Expenses for leveling, conditioning, grading, terracing and contour furrowing are all eligible as are costs associated with the control and protection of diversion channels, drainage ditches, irrigation ditches, earthen dams, water courses, outlets and ponds. Even the cost of eradicating brush and the planting of windbreaks is eligible. I.R.C. §175(c)(1). Also included are drainage district assessments (and soil and water conservation district assessments) if such assessments would have been a deductible expense if the taxpayer had paid them directly. I.R.C. §175 (c)(1)(B).
Taxpayer engaged in farming. Several requirements must be met before soil and water conservation expenditures can be deducted. As noted above, the taxpayer must be engaged in the business of farming. A farm operator or landowner receiving rental income under a material participation crop share or livestock share lease satisfies the test. Treas. Reg. §1.175-3. Under that type of lease, the landlord bears the risk of production and the risk of price change. A share lease where the landlord’s report the income from it on Form 4835 also satisfies the test. However, a cash lease doesn’t meet the test. That’s a rental activity.
Land used in farming. The expenditures must pertain to land used in farming - to produce crops or sustain livestock. Specifically, the term “land used in farming” means land “used by the taxpayer or his tenant for the production of crops, fruits, or other agricultural products or for the sustenance of livestock.” I.R.C. §175(c)(2).
Improvements that are made to land that hasn’t been previously used in farming are not eligible. But, prior farming activity by a different taxpayer counts as does a different type of agricultural use. Treas. Reg. §1.175-4(a). In addition, expenses associated with assets that qualify as deductible as soil and water conservation expenses are not necessarily precluded from being depreciated by a subsequent purchaser of the real estate on which qualifying property has been placed. For example, in Rudolph Investment Corp. v. Comm’r, T.C. Memo. 1972-129, the court allowed the taxpayer to depreciate earthen dams and earthen water storage tanks located on ranchland even though the structures qualified for a current deduction under I.R.C. § 175.
NRCS plan and ineligible expenditures. The expenditures must be consistent with a conservation plan approved by the Natural Resources Conservation Service (NRCS) or, if there are no NRCS plans for the area, a state (or local) plan. I.R.C. §175(c)(3). See also 2016 IRS Pub. 225 (Ch. 5). On this point, expenditures for draining or filling of wetlands or land preparation for center-pivot irrigation are not deductible as soil and water conservation expenses. I.R.C. §(c)(3)(B). Similarly, expenses to clear land so that it can be farmed are not eligible and must be added to basis. IRS Pub. 225, Chapter 5, also points out that ineligible expenditures include those for various structures such as tanks, reservoirs, pipes, culverts, canals, dams, wells, or pumps composed of masonry, concrete, tile (including drainage tile), metal or wood. The costs associated with these items are recovered through depreciation. Similarly, costs associated with clearing land to prepare it for farming are not eligible and must be added to basis. Likewise, expenses that are currently deductible as repairs or are otherwise currently deductible under I.R.C. §162 as an ordinary and necessary business expense are not claimed under I.R.C. §175. Treas. Reg. §1.175-2(b)(2).
Deduction limit. The deduction may not exceed 25 percent of the taxpayer's “gross income derived from farming” in any taxable year. I.R.C. §175(b). The term “gross income derived from farming” includes gain from the sale of draft, dairy, breeding or sporting purpose livestock, but not gains from the sale of machinery or land. Excess amounts may be carried over to the succeeding years subject to the same 25 percent limit.
Note: It is possible that qualified expenditures could be subject to the 25 percent limitation if the farm taxpayer defers a sufficient amount of grain sales, for example, such that gross farm income is decreased.
How to Claim the Deduction
Line 12 of the 2016 Schedule F (Form 1040) is where soil and water conservation expenses can be reported. As noted above, if they are not claimed they are to be added to the land’s basis. In addition, as noted above, the decision to either currently deduct or capitalize soil and water conservation expenses is made in the first year in which the expenses are incurred and establishes a method of accounting. To change that method of accounting requires IRS approval.
If a deduction is taken for soil and water conservation expenses on farmland or ranchland and the land is disposed of within ten years of its acquisition, part or all of the deductions taken are recaptured as ordinary income up to the amount of gain on the disposition or the amount deducted multiplied by a percentage (as noted below), whichever is lower. I.R.C. §1252. The amount of recapture depends upon how long the land was held before disposition. For land held five years or less, all of the deductions are subject to recapture. For land held more than five years but less than ten, a sliding scale applies. A sale or disposition in the sixth year recaptures 80 percent, within the seventh year 60 percent, within the eighth year 40 percent, and within the ninth year 20 percent, of the deductions. If the land was held for more than nine years, there is no recapture of soil and water conservation deductions.
To restate, in the event recapture applies, the recaptured amount cannot exceed the amount of gain on the land. Also, if only a portion of the land is disposed of, the deductions attributable to the entire parcel are allocated to each part in proportion to the fair market value of each at the time of disposition. If disposition of the land is by gift, tax-free exchange or transfer at death, no gain is recognized from recapture.
The current deduction for soil and water conservation expenses can be a helpful provision for numerous farmers. When a farmer has qualifying expenses it’s a helpful tool to include in the tax planning arsenal.
Tuesday, March 7, 2017
The IRS recently issued interim guidance on a pilot program for Schedule F expenses for small business/self-employed taxpayer examinations. The program is to start on April 1, 2017 and run for one year. The focus will be on “hobby” farmers, and the program will be conducted through the IRS Brookhaven campus in Holtsville, NY. While the pilot will only consist of 50 tax returns from tax year 2015 being examined, it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F. In addition, without knowing how the returns will be selected for examination, it may be more likely to impact the relatively smaller farming operations.
Focus of the Pilot Program
The interim guidance points out that the IRS believes that compliance issues may exist with respect to the deduction of expenses on the wrong form, or expenses that actually belonged to another taxpayer, or that should be subject to the hobby loss rules of I.R.C. §183. Indeed, the IRS notes that a filter for the project will be designed to identify those taxpayers who have W-2s with large income and who also file a Schedule F “and may not have time to farm.” IRS also says the filtering for expenses will be via the same process that it uses when it examines Schedule C, and notes that deductions that relate to the taxpayer’s W-2 employment, Schedule A or a corporate return should not appear on Schedule F. In addition, the guidance informs IRS personnel that the examined returns could have start-up costs or be a hobby activity which would lead to non-deductible losses.
The interim guidance directs the IRS examiners to consult IRS Pub. 225 (Farmers’ Tax Guide) and directs its examiners to look for a taxpayer with a primary residence on a farm where the principal business is farming. The interim guidance also directs examiners to look for deductions that “appear to be excessive for the income reported.” The implication is that such expenses won’t be deemed to be ordinary and necessary business expenses. How that might impact the practice of pre-paying farm expenses remains to be seen. One of the tests for pre-paying and deducting farming expenses is that the pre-payment must not materially distort income. Is the IRS implying in the interim guidance that it views a high level of pre-paid expenses when income is relatively low to be a material distortion of income? Perhaps that’s reading too much into the guidance and giving the IRS too much credit. The guidance does instruct that deposits are not deductible pre-payments, although it does state that a deposit is deductible if it is for future supplies. That is a strange statement. A pre-payment that constitutes a deposit is not deductible in accordance with Rev. Rul. 79-229, which the guidance doesn’t mention.
The IRS also instructs its examiners to separate deductible business expenses from capital expenses and personal expenses. On the capital expense issue, there is no mention of the $2,500 safe harbor (per invoice or per item) which allows a current deduction. The guidance also instructs examiners to pick through gas, oil, fuel, repairs, etc., to determine the “business and non-business parts” of the expense. Again, no mention is made of the safe harbor.
The interim guidance indicates that custom hire expense is deductible on line 13 of Schedule F. It also notes that fuel expense is deductible if it is used for conducting business on the farm. On that issue, the IRS believes that having an on-farm storage tank and accounting for personal use of fuel is important, and that fuel bought from a gas station needs further explanation to ensure it was not used for personal purposes.
As for mortgage interest, the interim guidance notes that it is deductible if it relates to real property that is used in the taxpayer’s farming business. The guidance also states that repair and maintenance expenses on the taxpayer’s personal residence are not deductible, without mentioning the situation that is common in agriculture – an office in the home for which related repairs and maintenance would be deductible.
The interim guidance does get into an explanation of the pre-paid expense rules and this time states that the pre-payment cannot be a deposit and states that the taxpayer must be able to document the reason for the prepayment.
The interim guidance would appear to be targeted toward taxpayers that either farm or crop share some acres where the income ends up on Schedule F, but where other non-farm sources of income predominate (e.g., W-2 income, income from leases for hunting, bed and breakfast, conservation reserve program payments, organic farming, etc.). In those situations, it is likely that the Schedule F expenses will exceed the Schedule F income. That’s particularly the case when depreciation is claimed on items associated with the “farm” - a small tractor, all-terrain vehicle, pickup truck, etc. That’s the typical hobby loss scenario that IRS is apparently looking for.
Keep in mind that the IRS is only going to examine 50 returns in their pilot project, and those returns will relate to the 2015 tax year. The IRS should focus its attention on those returns with small losses, but it’s not known whether that will be the IRS approach. Also, where is the IRS going to come up with the funds to audit, even if the pilot program indicates a widespread problem? Those funds aren’t available, and aren’t likely to be forthcoming in the near future.
In any event, it’s helpful to know what the IRS is up to.
Friday, March 3, 2017
President Trump campaigned, in part, on a promise to reign-in regulatory agencies and eliminate unnecessary regulations. That’s a big deal to agriculture. A significant amount of governmental regulation of agricultural activities is conducted by and through administrative agencies that promulgate regulations and make decisions. Regulatory activity occurs outside both the legislatures and the courts, where most of conventional lawmaking occurs. Consequently, with much of administrative law, the administrative agency that writes the regulation at issue serves as judge and jury over disputed matters involving those same regulations. This raises fundamental questions of fairness. In exercising their rule-making power, agencies of government cannot go beyond the authority provided by the legislative body. At least that’s the way it’s supposed to work.
Today’s post takes a deeper look at administrative agencies and how farmers and ranchers can best deal with them.
Administrative Agency Basics
At the federal level, the Congress enacts basic enabling legislation, but leaves the particular administrative departments (such as the USDA) to implement and administer congressionally created programs. As a result, the enabling legislation tends to be vague with the administrative agencies (such as the USDA) needing to fill in the specific provisions by promulgating regulations. The procedures that administrative agencies must follow in promulgating rules and regulations, and the rights of individuals affected by administrative agency decisions are specified in the Administrative Procedures Act (APA). 5 U.S.C. §§ 500 et seq. The provisions of the APA constitute the operative law for many of the relationships between farmers and ranchers and the government.
Administrative Agency Procedure
Usually, a farmer or rancher's contact with an administrative agency is in the context of participation in an agency-administered program, or being cited for failure to comply with either a statutory or administrative rule. So, it’s helpful for farmers and ranchers to have a general understanding of how administrative agencies work and the legal effects of their decisions. In general, disputed matters involving administrative agencies must first be dealt with in accordance with the particular agency's own procedural rules before the matter can be addressed by a court of law. This is known as exhausting administrative remedies. 7 U.S.C. §6912(e). See also Johnston v. Patterson, No. 4:14-CV-210-BO, 2014 U.S. Dist. LEXIS 172224 (E.D. N.C. Dec. 12, 2014). About the only exception to the rule of exhaustion that I have seen is if a facial challenge is made to the regulation itself. See Gold Dollar Warehouse, Inc. v. Glickman, 211 F.3d 93 (4th Cir. 2000). Thus, participating carefully in administrative proceedings can be vitally important to a farmer or rancher, especially in terms of properly preserving a record for subsequent court review.
Going through the administrative process is critical because, typically, an appeal to a court of law is made only on the basis of the record generated in the administrative proceeding. Courts are limited in the extent to which they can substitute their judgment for that of an administrative agency regarding the facts of the dispute. Thus, it is critical to preserve all disputed factual and legal issues in the record of the administrative proceeding so that they can later be considered by a court. The exhaustion of administrative remedies, as a general rule, also requires that legal issues must be raised during the administrative process so as to be preserved for judicial review. If they are raised in the administrative process, then they will likely be precluded. Also, exhaustion is required as to each legal issue. See, e.g., Ballanger v. Johanns, 495 F.3d 866 (8th Cir. 2007).
What’s the Standard For Reviewing Agency Action?
Courts generally consider only whether the administrative agency acted rationally and within its statutory authority. Consequently, a particular farmer or rancher bears the burden of insuring that the record is adequate for the appeal of the issues involved before the matter leaves the administrative process. Otherwise, an appeal of an administrative agency's decision must be based solely on arguments that the agency acted arbitrarily, capriciously, beyond legal authority or that it abused its discretion.
In general, when dealing with administrative appeals from a federal agency such as the USDA, the court generally defers to the agency’s interpretation of its regulations as contained in the agency’s interpretive manuals. Prevailing in court on this type of a claim can be quite difficult. However, in Christensen v. Harris County, 529 U.S. 576 (2000), the U.S. Supreme Court ruled that statutory interpretations made by governmental agencies in pronouncements that do not have the force of law, such as opinion letters, policy statements, agency manuals, and enforcement guidelines, are not entitled to such great deference. This is a significant case for the agricultural sector because the USDA often makes interpretations of the laws they administer in formats that do not have the force of law. Similarly, in Meister v. United States Department of Agriculture, 623 F.3d 363 (6th Cir. 2010), the court noted than an agency is not entitled to deference simply because it is a governmental agency. The case involved a claim that the U.S. Forest Service had failed to comply with its own regulations and a federal statute in developing its 2006 management plan for national forests in northern Michigan. The trial court granted the government’s motion for summary judgment, but the appellate court reversed. The appellate court noted that it was insufficient for the government to only identify the lands on which a particular activity (such as snowmobiling) could occur. Instead, the government had to identify the supply of lands on which participants in particular activities would experience a quality recreational experience. As a result, the issuance of the agency’s plan was arbitrary because the estimates of snowmobile and cross-country visitors to the forests were entirely arbitrary and there was no coordination with Michigan's recreational planning, and the agency did not minimize conflicts between off-road vehicle use and other uses and interests of the forests. The court specifically noted that agency deference was not automatic. Instead, the agency must apply the relevant statutory and regulatory authority.
On the deference issue, a change might be in the wind. In 1997, the U.S. Supreme Court again reiterated the principle of agency deference. Auer v. Robbins, 519 U.S. 452 (1997). However, the Court, in 2013 criticized the Court’s 1997 decision and suggested that it might be time to reconsider principles of agency deference. Decker v. Northwest Environmental Defense Center, 133 S. Ct. 1326 (2013).
The Equal Access to Justice Act (EAJA) (5 U.S.C. §§504 (2008); 28 U.S.C. §2412(d)(2)(A)) provides that a party who prevails administratively against government action can recover fees and expenses if the administrative officer determines that the government’s position was not substantially justified. However, the USDA’s longstanding position is that the EAJA does not apply to administrative hearings before the USDA’s National Appeals Division (NAD) because NAD proceedings are not adversarial adjudications that are held “under” the APA. But, the United States Court of Appeals for the Eighth Circuit rejected the USDA’s position in 1997. Lane v. United States Department of Agriculture, 120 F.3d 106 (8th Cir. 1997). The Ninth Circuit ruled similarly in 2007. Aageson Grain and Cattle, et al. v. United States Department of Agriculture, 500 F.3d 1038 (9th Cir. 2007). The Seventh Circuit ruled likewise in 2008. Five Points Road Venture, et al. v. Johanns, 542 F.3d 1121 (7th Cir. 2008).
Dealing with administrative agencies is a reality for the typical farmer or rancher. Perhaps the change in Administration with last fall’s election will provide some common-sense reform to the impact they have on the business activity of farmers and ranchers. Time will tell.
Wednesday, March 1, 2017
An individual engaged in a farming (or fishing) business can elect to spread whatever portion of current taxable income attributable to any farming business (termed “elected farm income”) evenly over the three prior taxable years by using Schedule J. I.R.C. §1301. Thus, if rates were lower in the prior years, the taxpayer will get the benefit of applying the lower rates to current taxable income from farming. The current year's income tax liability is calculated by determining the current year's tax (without the amount of elected farm income) plus the increases in income tax for each of the three prior taxable years by taking into account the allocable share of elected farm income for each of those years. Any adjustment for any taxable year is taken into account for income averaging purposes in subsequent tax years.
Income averaging can be a great tool for farm clients in certain situations? But what are those situations, and how best can the election be utilized? Farm income averaging planning – that’s the focus of today’s post – after reviewing the basics of the provision.
Basics of Averaging
Who is eligible? Only individuals with farm (or fishing) income are eligible to utilize income averaging. Estates and trusts are not eligible and C corporations are not considered to be individuals. For entities taxed as partnerships, it is the individual partners or members, that can be eligible to elect income averaging. For Subchapter S corporations engaged in farming, the S corporation is not eligible to make an income averaging election, but the S corporation individual shareholder is. Likewise, income attributable to a farming business carried on by a partnership can be averaged without regard to the partner’s level of participation in the partnership or the size of the ownership interest.
Engaged in a “farming business.” An individual electing income averaging must be “engaged in a farming business” in the year for which the election is made. But, the individual doesn’t need to necessarily have been engaged in a farming business in the three prior carryback years. A “farming business” means a trade or business involving the cultivation of the land or the raising and harvesting of any agricultural or horticultural commodities, but does not include the processing of commodities or products “beyond those activities which are normally incident to the growing, raising or harvesting of such products.”
An individual's relationship to the “farming business” is critical in determining eligibility. Clearly eligible for income averaging are operators of farming businesses that bear the risks of production and the risks of price change and provide substantial involvement in management. That means that a landlord is engaged in a rental activity and not in a farming business if the rental is a fixed rent (cash rent). Whether the landlord materially participates in the tenant’s farming business is irrelevant for income averaging purposes. But, non-materially participating landlords are only eligible for income averaging if the landlord’s share of a tenant’s production is set in a written rental agreement before the tenant begins significant activities on the land.
What about a recently retired farmer? Individuals who have ceased farming operations with the only activity in the year in question being the sale of inventory and the sale of machinery are not engaged in a “farming business” in that year. However, gains or losses from property regularly used in a farming business after cessation of the farming business are treated as attributable to a farming business if the property is sold within a reasonable time after cessation of the farming business. If the sale or other disposition of such assets occurs within one year of the cessation of farming, it is presumed to be within a reasonable time. After that, it is a facts and circumstance test.
Are gains eligible? Gains from the “sale or other disposition of property (other than land) regularly used by the taxpayer in such a farming business for a substantial period” are eligible for averaging. I.R.C. § 1301(b)(1)(B). Clearly, gains from the sale or exchange of land do not qualify. Although not completely clear, it would appear that gain from land sales is ineligible for averaging whether that gain is taxed as capital gain, ordinary income, recaptured depreciation or “unrecaptured § 1250 gain” and where that gain is attributable to the soil.
The IRS position is that gains from assets considered to be part of the land (buildings, fences and tile lines, for example) are eligible for income averaging.
Phase-outs, rates and limitations. Income averaging doesn’t impact the taxable income or tax of any of the three base years. That means that it is not a “carryback” of current income to the base year. Instead, it’s just a reference to the base year’s marginal income tax rate for the purpose of applying that rate to a portion of current year taxable income. What that means is that income averaging does not change the phase-outs or percentage limitations of the base year tax returns. Treas. Reg. §1.1301-1(d)(1). Also, when tax rates go up, all else staying the same, an income averaging election can benefit top bracket filers. In that situation, the election will always reduce the tax rate. While an increase in rates isn’t going to happen in the near future, when they increased starting in 2013, top bracket filers benefited from income averaging for 2013, 2014 and 2015.
Capital gain rate reduction. The averaging election can be made on both ordinary and capital gains, but clarification by the IRS indicates that an equal portion of each type of income must be carried to each prior year. From a tax planning standpoint, an income averaging election can be made on ordinary income and, with proper planning, the effective rate on non-farm capital gains can be reduced. Likewise, when the top capital gain rate increased 33 percent to a 20 percent rate beginning in 2013, the averaging election had the impact of reducing the rate to 15 percent. It also could, perhaps, eliminate it. That could be a big deal for a farmer that sells breeding stock or other assets that trigger capital gain.
Alternative minimum tax. The income averaging election has no direct impact on how the alternative minimum tax (AMT) is calculated. The taxpayer can’t “average” the AMT calculation. But, look to make the averaging election in a year in which the farmer triggers AMT. A tax benefit can be derived. Also, see whether an increase in taxable income might decrease the AMT. In that event, the marginal tax rate for top bracket farmers will drop. Likewise, look for situations where AMT income exceeds the phase-out of the AMT exemption and the tentative minimum tax exceeds the regular income tax before averaging both before and after adding incremental income. If you have that situation, the AMT will decline. Also, because there is no AMT floor on the use of averaging, the election can be quite beneficial in a year when a farmer has an income spike (maybe from a machinery sale or because a large amount of carryover grain is sold (especially at high prices). In addition, watch for planning opportunities when the farmer has substantial nonbusiness expenses that exceed nonbusiness income in the base years.
Other tax items. There are numerous other tax items that can potentially be impacted by an averaging election. Here’s a listing of a few of the more prevalent ones:
- An income averaging election doesn’t impact self-employment tax. But, it can generate big self-employment tax savings if it drops income beneath the social security base.
- As for the “kiddie tax,” making the election on the parents’ return will cause the child’s tax on investment income to be applied by using the parents’ rate after shifting the elected farm income. But, in the base years, the kiddie tax is not affected by the election. Reg. §1.1301-1(f)(5).
- For losses and carrybacks, any net operating loss carryovers or net capital loss carryovers to an election year are applied to the election year income before the elected farm income is subtracted. Think that one through. The election could create a tax advantage.
- An individual is not prohibited from making an income averaging election solely because the individual’s filing status is not the same as in the base years. Reg. § 1.1301-1(f)(2). However, the IRS has not provided guidance on how the remaining bracket amounts are to be divided between the spouses if both spouses have elected income averaging in a year following divorce.
- In addition, negative figures can be utilized. That’s good news for many farmers that are presently experiencing tough economic times. However, it appears that negative elected farm income figures in the year of election cannot be used to reduce tax liability as calculated with reference to the three carryback years.
- An income averaging election can be made on a late or amended return if the period of limitations on filing a claim for credit or refund has not expired. Also, a previous election can be changed or revoked if the period of limitations has not expired. This feature provides great flexibility in utilizing the election.
Farm income averaging can provide a significant tax savings for farm (and fishing) clients in certain situations. Watch for the retiring farmer that has carryover grain sales and/or income from a machinery auction. Also, it may be worthwhile to try to cause a farm client’s farm income to spike periodically (every three to four years) to avoid self-employment tax, while simultaneously lowering income tax costs by an election. Also, look to utilize the election on behalf of maximum tax bracket taxpayers. Finally, keep an eye on future tax legislation. Once it is known what the new rates and brackets will be, then a reevaluation can be done of the potential impact of farm income averaging for farm clients.