Friday, April 28, 2017
The title of today’s post may seem odd. But you might be surprised to know that the issue does come up from time to time. I vividly remember an estate planning conference I had with a married couple when I was in full-time practice. When I was one on one with the husband, he commented to me that he wanted to cut his wife out of everything. He was serious, and it presented some interesting representation issues. After the initial shock of the question, I was able to make a few points that seemingly changed his mind.
But, can a spouse be disinherited? While generally the answer is “no,” there are some things that can be done (at least in some states) that can seriously diminish what a spouse receives upon death. It’s important to have a basic understanding of how this can happen, and a recent court opinion illustrates the point.
First things first – spousal rights largely depend on state law. With that in mind, when a person executes a will, they have the ability to say who gets their property upon their death – with a major exception. That exception is designed to protect a surviving spouse. The surviving spouse can’t be intentionally disinherited, unless they have signed a prenuptial or postnuptial agreement (in states where those are recognized).
In some states, the extent to which the surviving spouse is protected depends on the length of the marriage, or whether the couple had children born of the marriage, or whether the deceased spouse had “probatable” assets. Further complicating matters, some states are “community property” states. In these states, the surviving spouse automatically gets one-half of the couple’s “community property” (basically, property acquired during marriage while domiciled in a community property state). Other states follow the Uniform Probate Code (UPC). In these states, the surviving spouse can automatically take a portion of the deceased spouse’s probate estate, non-probate property and property that is titled in the name of either spouse. Yet other states follow only part of the UPC and allow the surviving spouse to make an election to take part of the deceased spouse’s probate estate and a portion of the non-probate assets. Still other states don’t follow the UPC and limit a disinherited spouse to take only a part of the deceased spouse’s probate estate. So, if there aren’t any probate assets (basically, assets that don’t have a beneficiary designation or survivorship feature) the surviving spouse is at risk of receiving little to nothing. In these states, for example, the use of a revocable living trust (coupled with a “pourover” will) can be used to hold what would otherwise be probate assets to avoid probate and a claim of the surviving spouse.
Of course, there are nuances in each state’s law, but the above comments paint a picture of how a surviving spouse can be left a limited to non-existent inheritance.
A recent court opinion from Iowa highlights how a spouse can be, at least partially, disinherited. In In re Estate of Gantner III, No. 16-1028, 2017 Iowa Sup. LEXIS 40 (Iowa Sup. Ct. Apr. 21, 2017), the decedent died, leaving a surviving spouse and two daughters. The marriage was a second marriage for both spouses and they had only been married a few months when the husband, an investment advisor, died accidentally. His will provided for the distribution of his personal property and established a trust for the benefit of his daughters. In addition, 90 percent of the residue of the estate was to be distributed to the daughters. In accordance with her rights under state law, the surviving spouse filed for an elective share of the estate and requested a spousal support allowance of $4,000 per month. The daughters resisted the surviving spouse’s application for spousal support, claiming that the decedent’s retirement accounts (two IRAs and a SEP IRA) were not subject to the spousal allowance because they were not part of the decedent’s probate estate. The IRAs were traditional, pre-tax, self-employed IRA plans and executed spousal consent forms were provided to the court. However, the issue that the surviving spouse had consented to the beneficiary designations was never brought up as a defense to the statutory claim for a spousal allowance. The focus was solely on a provision in state law.
The probate court determined that the decedent’s probate estate would not have had enough assets to pay a spousal allowance without the retirement accounts included. The surviving spouse claimed that the retirement accounts should have been included in the probate estate for purposes of spousal support based on Iowa Code §633D8.1 that provides that “a transfer at death of a security registered in beneficiary form is not effective against the estate of the deceased sole owner…to the extent…needed to pay…statutory allowances to the surviving spouse.” The surviving spouse argued that because the funds in the accounts were likely mutual funds or index funds, that the accounts should be “securities” within the statutory meaning. The daughters disagreed on the basis that the Uniform Iowa Securities Act excludes any interest in a pension or welfare plan subject to ERISA. The probate court ruled for the daughters on the basis that the retirement accounts were not available for spousal support because they were not probate assets and became the personal property of the daughters at the time of their father’s death. The probate court also noted that the Iowa legislature would have to take action to make beneficiary accounts available to satisfy a spousal allowance.
On appeal, the Iowa Supreme Court affirmed. The court noted that the accounts were traditional IRAs governed by I.R.C. §408 that pass outside of the probate estate under Iowa law and were not covered by Iowa Code §633D as a transfer-on-death security. The retirement accounts were not “security” accounts merely because they contained securities. Rather, it is a custodial account that does not actually transfer on death to anyone other than a spouse.
The point that the IRAs were traditional IRAs is a key one. Had they been “qualified plans” (known as a “401k” plan), I.R.C. §417(a)(2) in conjunction with I.R.C. §401 requires the spouse’s consent to not be named as a beneficiary. While the spouse had executed the necessary consent forms to the decedent’s traditional IRAs (which the court didn’t focus on, instead focusing on state law), had they been qualified plans, then the federal rules would have controlled and provided greater protection for the surviving spouse.
Some state legislatures have taken action in recent years to protect spousal inheritance rights upon death. In some state, for instance, no longer is it possible to use a revocable trust to effectively disinherit a spouse. Other states, have modified the rules on transfer on death accounts or payable on death accounts. In any event, knowing and understanding spousal inheritance rights is something worth knowing about. There are many situations that can arise which could lead to the rules becoming very important to a surviving spouse or, as in the case of the husband that asked the question those many years ago, a spouse wanting to leave the surviving spouse little to nothing.
Wednesday, April 26, 2017
The range fires in Kansas, Oklahoma and Texas earlier this year have generated numerous questions. I have addressed several of those in earlier posts. Another one is on the table for discussion today and concerns associated liability issues. In particular, whether a landowner is liable for smoke damage to others and whether there is any obligation to inform people that might be affected by the smoke.
Range Fire or Controlled Burns?
It is important to distinguish between a true range fire and a controlled burn. For a range fire that starts by some external event that the landowner has no control over or involvement in, there simply is no liability to others. This is the situation for the recent range fires in the Southern Plains. It’s just one of those situations that unfortunately occurs and landowners try their best to contain it and deal with it. The outpouring of support from farmers and ranchers across the country was heartening to see.
Many areas of Kansas and elsewhere engage in controlled burns of pasture. For controlled burns, each state has rules and regulations what govern the procedures to be followed. Those rules may include a duty to notify adjoining landowners and local authorities before starting a burn. It is important to understand the rules and follow them closely to avoid fines and other penalties that could apply.
Smoke Drift As a Trespass?
For a controlled burn, can smoke drift onto another’s property constitute a trespass and make the person conducting the burn liable for any resulting damages? Trespass is the unlawful or unauthorized entry upon another person's land that interferes with that person's exclusive possession or ownership of the land. The tort of trespass is conceptually related to the tort of nuisance, but a nuisance is an invasion of an individual's interest in use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The law governing trespass to land is particularly important to farmers and ranchers because real estate plays a significant role in the economic life of the typical farmer or rancher.
A trespass consists of two basic elements: (1) intent and (2) force. Most jurisdictions do not impose absolute liability for trespass. Instead, proof of intentional invasion, reckless or negligent conduct, or inherently or abnormally dangerous activity is required. In these jurisdictions, proof of intent to commit a trespass is not necessary. Rather, the plaintiff must show that the trespasser either intended the act that resulted in the unlawful invasion or acted so negligently or in such a dangerous manner that willfulness can be assumed as a matter of law. A minority of jurisdictions still follow the common law approach holding an individual liable for any interference with the possession of land, even if that interference was completely unintentional. In these jurisdictions, it is immaterial whether the act was done accidently, in good faith, or by mistake.
Trespass also involves an element of force. Liability for trespass may result from any willful act, whether the intrusion is the immediate or inevitable consequence of a willful act or of an act that amounts to willfulness.
At its most basic level, a trespass is the intrusion on to another person's land without the owner's consent. However, many other types of physical invasions that cause injury to an owner's possessory rights abound in agriculture. These types of trespass include dynamite blasting, flooding with water or residue from oil and gas drilling operations, erection of an encroaching fence, unauthorized grazing of cattle, or raising of crops and cutting timber on another's land without authorization, among other things. In general, the privilege of an owner or possessor of land to utilize the land and exploit its potential natural resources is only a qualified privilege. The owner or possessor must exercise reasonable care in conducting operations on the land so as to avoid injury to the possessory rights of neighboring landowners. That can include controlled burn activities and the resulting smoke drift. For example, in Ream v. Keen, 112 Or. App. 197, 828 P.2d 1038 (1992), smoke from field burning drifted to an adjoining home and the neighbor sued for soot removal costs and emotional and physical damages. The trespass claim was submitted to a jury and the appellate court ultimately determined that the elements of an intentional trespass had been established and sent the case back to the trial court for a determination of damages.
As in any trespass case, the outcome turns on the facts of each case. Each case is different.
Is A Controlled Burn an Unnatural Land Use?
“Unnatural” land uses are typically governed by a rule of strict liability. That means that intent doesn’t matter. If damage occurs to others, there is liability. The strict liability approach for “non-natural” land use activities was applied in an 1868 English case. Rylands v. Fletcher. L.R. 3 H.L. 330 (1868). In Rylands, the defendants hired an independent contractor to construct a reservoir on their property. When the reservoir was filled up, water broke from it and flowed into abandoned mine shafts on the property, and then flooded adjacent mine shafts owned by the plaintiffs. The defendants themselves were not aware of the abandoned shafts, and were therefore not negligent (although the contractor probably was). After the lowest court denied liability, the case came before the Exchequer Chamber, in effect an intermediate appeals court. The court reversed, holding that there was liability because “...the person who for his own purposes brings on his lands and collects and keeps there anything likely to do mischief if it escapes, must keep it in at his peril, and if he does not do so, is prima facie answerable for all the damage which is the natural occurrence of its escape.” The case then went to the House of Lords, the final appellate tribunal. The holding of the Exchequer Chamber was affirmed, but was significantly limited. Liability existed because, the court said, the defendants put their land to a “non-natural use for the purpose of introducing [onto it] that which in its natural condition was not in or upon it”, i.e., a large quantity of water. If, on the other hand, the court said, the water had entered during a “natural use” of the land, and had then flowed off onto the plaintiff's land, there would have been no liability.
Initially, American courts frequently misconstrued the Ryland's decision and purported to reject it. They focused on the Exchequer Chamber version, which would have imposed liability for escaping forces even where the land is put to a natural use. Eventually, however, the vast majority of American courts accepted at least the practical result of Rylands, even if not the case by name.
Today, the rule has been extended to include most activities that are extremely dangerous. However, in Koger v. Ferrin, 926 P.2d 680 (Kan. Ct. Ap. 1996), the court refused to apply a strict liability rule in a situation involving the spread of a fire that was not intentionally started. In an important passage, the court stated the following:
“In Kansas, farmers and ranchers have a right to set controlled fires on their property for agricultural purposes and will not be liable for damages resulting if the fire is set and managed with ordinary care and prudence, depending on the conditions present [citation omitted]. There is no compelling argument for imposing strict liability on a property owner for failing to prevent the spread of a fire that did not originate with that owner or operator. Because the essential facts of this case are undisputed, as a matter of law, the doctrine of strict liability is not applicable under the facts presented.”
Liability for smoke damage from fires depends on the facts and circumstances surrounding the fire. For controlled burns, carefully following any applicable rules and regulations will go a long way to eliminating liability for any resulting damages. Range fires typically don’t lead to personal liability issues.
Monday, April 24, 2017
Farmers and ranchers buy and sell commodity futures and options to hedge against fluctuating prices. They also buy and sell commodity futures and options to speculate with fluctuating prices. They also enter into cash forward grain contracts and hedge-to-arrive contracts. The tax issues associated with commodity trading are important to understand, and are the focus of today’s post.
Hedging or Speculation
A hedging transaction is defined as a transaction that a taxpayer enters into in the normal course of the taxpayer’s trade or business, primarily to reduce (as opposed to simply managing) the risk of price changes or currency fluctuations with respect to ordinary property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowing or ordinary obligations. I.R.C. §1221; Treas. Reg. §1.1221-2(b). To receive tax treatment as a hedge, the transaction must be identified by the taxpayer as a hedging transaction before the close of the day the hedge is entered into. I.R.C. §1221(a)(7); Treas. Reg. §1.1221-2(f)(1). The item being hedged must be identified no more than 35 days after the hedging transaction. Treas. Reg. §1.1221-2(f)(2)(ii). If the transaction is not timely identified as a hedge, the straddle rules and mark-to-market rules may apply. I.R.C. §§1092; 263(g); I.R.C. §1256.
A taxpayer uses a hedge to lock in a position in a particular commodity. Once locked in, if the physical commodity increases in value, the taxpayer’s value of the futures position should go down – one should offset the other with the net result that the hedge maintains the taxpayer’s position.
Speculation involves a commodity transaction entered into other than in the context of the taxpayer’s trade or business. Speculation can be illustrated by the farmer who harvests corn, sells the corn, and buys futures in the marketplace in anticipation of prices rising and believing this strategy is better than storing the commodity. This is speculation and is subject to the mark-to-market rules of I.R.C. §1256. The mark-to-market rules require taxpayers to report on Form 6781 gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the mark-to-market rule. These rules close out speculative transactions as of December 31. They are marked to market by treating each contract held by the taxpayer as if it were sold for fair market value on the last business day of the tax year, thereby requiring profit or loss to be reported on the taxpayer’s income tax return. The net gain or loss is allocated 40 percent to short-term capital gain (or loss) and 60 percent to long-term capital gain (or loss).
Tax difference. Gain and loss from transactions that are hedges generate ordinary income and loss and are not subject to the loss deferral rules and the “mark-to-market” rules that apply to speculative transactions. I.R.C. §1221 and Treas. Reg. §1.1221-2. Because a hedge is entered into in the normal course of the taxpayer’s business (such as to lock-in a position in a particular commodity), any resulting gain is subject to self-employment tax.
However, if the transaction involves speculation, resulting gains and losses are treated as capital gains and losses. Capital gains can offset capital losses, but capital losses deductible
against ordinary income are capped at $3,000 per year. In addition, corporations are not eligible for the $3,000 deduction against ordinary income. Also, speculative transactions are subject to the loss deferral and “mark-to-market” rules. Speculative transactions do not trigger self-employment tax.
Farmers and ranchers will often buy options. When a put option is purchased by the producer of a commodity, the producer acquires the right to sell the commodity at a future point in time. If the sale occurs just before the crop is planted or while the crop is growing, the transaction is a hedge. If the right to sell is triggered after the crop is sold, the transaction is speculative.
A farmer or rancher may also buy a call option. A call option gives the producer the right to buy the commodity at some future point in time. Transactions involving the purchase of a call option for the purchase of a commodity by a crop producer are speculative regardless of when the option is exercised. However, a livestock farmer may enter into a call option for feed, or a crop farmer may enter into a call option for crop inputs. The question of whether a transaction is a hedge or is speculation turns on whether it was entered into in the normal course of the taxpayer’s business to reduce risk.
Any income, deduction, gain or loss from a hedging transaction is matched with the income, deduction, gain or loss on the item being hedged. Also, in some situations, the hedge timing rules apply irrespective of whether the transaction has been identified as a hedge. Rev. Rul. 2003-127, 2003-2 C.B. 1245. In essence, the tax rules for hedging transactions address both character and timing, and are designed to match the character and timing of a hedging transaction with the character and timing of the item being hedged. The timing Farmers participating in true hedging programs likely have multiple transactions for a single crop and may combine option purchases and sales to minimize the cost of these programs or to create both a ceiling and a floor for prices. Properly identifying and reporting these many transactions is a challenge for the taxpayer and tax preparer and IRS Pub. 550 can be helpful.
Just as important as the matching principle with commodity transactions is what constitutes “property.” I.R.C. §1001 governs the computation of gain or loss on the sale or exchange of property, with gain being the excess of the amount realized over the adjusted basis of the property, and the loss is the excess of the adjusted basis of the property over the amount realized. Thus, for gain or loss to be computed on a transaction, the taxpayer must know the identity and amount of property that will be delivered. That isn’t known until the contract is settled.
In Estate of McKelvey v. Comr., 148 T.C. No. 13 (2017), the decedent had entered into contracts to sell corporate stock to Bank of America and Morgan Stanley & Co., International. The contracts were structured as variable prepaid forward contracts (VPFC) that required the banks to pay a forward price (discounted to present value) to the decedent on the date the contracts were executed, rather than the date of contract maturity. Accordingly, the decedent received a cash prepayment from Bank of America of approximately $51 million on September 14, 2007. On September 27, 2017, the decedent received a cash prepayment from Morgan Stanley & Co. of slightly over $142 million. The prepayments obligated the decedent to deliver to the banks stock shares pledged as collateral at the time of contract formation, and certain other stock shares that weren’t pledged as collateral or an equal amount of cash. The actual number of shares or their cash equivalent is determined via a formula that accounts for stock market changes.
Under the contracts as originally executed in September of 2007, the decedent was to deliver to the banks every day for 10 consecutive business days in September of 2008. Each day, one-tenth of the total number of shares agreed to be transferred was to be delivered as determined by adjusting the number of shares by the ratio of an agreed floor price over the stock closing price for that particular day, or a cash equivalent to the stock. However, in July of 2008, the banks agreed to extend the settlement dates to early 2010. To get the extension, the decedent paid Morgan Stanley & Co. slightly over $8 million on July 15, 2008, for delivery over 10 consecutive days in early January of 2010, and paid Bank of America approximately $3.5 million on July 24, 2008, for delivery over 10 consecutive days in early February of 2010.
For tax purposes, the decedent treated the original transactions as “open” transactions in accordance with Rev. Rul. 2003-7, 2003-1 C.B. 363 and did not report any gain or loss for 2007 related to the contracts. In addition, the decedent did not report any gain or loss related to the contract extensions that were executed in 2008 on the basis that the extensions also involved “open” transactions. The decedent died in late 2008, and on July 15, 2009, the decedent’s estate transferred shares of stock to settle the Morgan Stanley & Co. contracts. The estate filed a Form 1040 for the decedent’s taxable year 2008, and the IRS issued a deficiency notice for over $41 million claiming that when the decedent executed the extensions in 2008, he triggered a realized capital gain of slightly over $200 million comprised of a short-term capital gain of $88 million and $112 of long-term capital gain from the constructive sale of shares pledged under the contracts. The IRS claimed that the decedent had no tax basis in the stock pledged as collateral.
The court disagreed with the IRS on the basis that the “open transaction” doctrine applied because of the impossibility of computing gain or loss with any reasonable accuracy at the time the contracts were entered into. In addition, the court rejected the argument of the IRS that the extensions of the original contracts closed the contracts which triggered gain or loss at the time the extensions were executed. The court specifically noted that, in accordance with Rev. Rul. 2003-7, VPFCs are open transactions at the time of execution and don’t trigger gain or loss until the time of delivery because the taxpayer doesn’t know the identity or amount of property to be delivered until the future settlement date arrives and delivery is made. Until delivery, the only thing that the decedent had was an obligation to deliver; this was not property that could be exchanged under I.R.C. §1001. The court also noted that the open transaction doctrine applied because the identity and adjusted basis of the property sold, disposed of or exchanged was not known until settlement occurred. The court also stated that an option is a “familiar” type of open transaction from which we can distill applicable principles.”
Many commodity transactions in which farmers engage are “open” transactions, with the producer holding merely a contractual obligation at the time of contract execution. An option, for example, is a type of “open transaction.” See, e.g., Rev. Rul. 78-182, 1978-1 C.B. 256. Forward grain contracting, hedge-to-arrive contracts, and other types of commodity transactions may also delay tax consequences until the contract requirements are fulfilled. The Tax Court’s recent decision helps confirm that point.
Thursday, April 20, 2017
Even though the federal estate and gift tax exclusion is high enough to discourage many people from gifting solely for tax purposes, I still receive numerous gift tax questions. So, gifting is not usually utilized as a strategy for minimizing potential estate tax at death. However, many people accumulate significant amounts of property, both tangible and intangible, as well as cash during life. Among the common estate planning goals of many clients is a desire to preserve that accumulated wealth during life, as well as transfer ownership interests in family businesses to other family members before death as a supplement to property transfers occurring at death.
Today’s post examines the basic rules surrounding the gifting of property during life and some common gift planning strategies.
Present Interest Annual Exclusion
The present interest annual exclusion is a key component of the federal gift tax. For gifts made in 2017, the exclusion is $14,000 per donee. That means that a donor can make cumulative gifts of up to $14,000 (in cash or an equivalent amount of property) to as many donees as desired without triggering any gift tax, and without any need to file Form 709 – the federal gift tax return. Because the exclusion “renews” each year and is not limited by the number of potential donees, but only the amount of the donor’s funds and interest in making gifts, the exclusion can be a key estate planning tool. Used wisely, the exclusion can facilitate the passage of significant value to others (typically family members) pre-death to aid in the succession of a family business or a reduction in the potential size of the donor’s taxable estate, or both.
But, to qualify for the exclusion, the gift must be a gift of a present interest – the exclusion does not apply to future interests. A present interest is an “unrestricted right to immediate use, possession, or enjoyment or property or the income from the property. Treas. Reg. §25.2502-3(b). A remainder interest, for example, would be a future interest.
There’s a special rule that comes into play for gifts made by spouses. They can elect “split gift” treatment regardless of which spouse actually owns the gifted property, if certain conditions are satisfied and the spouses consent to gift splitting treatment. They are simply treated as owning the property equally. This allows gifts of up to $28,000 per donee annually. So, as an example, let’s say that Mom and Dad have 4 children and 5 (unmarried) grandchildren. Also assume that each child has a spouse. That makes 13 persons that Mom and Dad could make annual exclusion gifts to without triggering the need to file a federal gift tax return. That would be 13 present interest annual exclusion gifts of $14,000 each for Mom and Dad - $182,000 each, annually. In addition, if those gifts are of interests in a closely held business, discounting those interests for lack of marketability and minority interest could leverage those present interest gifts and increase the total amount that can be given gift-tax free by another 30 percent or so.
There is also a special rule that allows for the direct payment of certain educational and medical expenses. Under the rule, these transfers are not even deemed to be gifts. Thus, the limitation of the present interest annual exclusion does not apply to those gifts.
“Coupled Estate and Gift Tax Systems”
The estate and gift tax systems are “unified.” The unified credit $2,141,800 (for 2017) offsets lifetime taxable gifts of $5.49 million or a taxable estate of $5.49 million. The unification or “coupling” of the estate and gift tax systems create tremendous opportunities for higher net worth individuals and families to leverage the $5.49 million exemption equivalent of the unified credit through lifetime gifting. Present interest annual exclusion gifts do not count against the lifetime $5.49 million limitation.
Valuation of Gifts
It’s also necessary to know the value of the property at the time of the gift. The donor needs this information to determine whether the gift exceeds the $14,000 annual exclusion amount and, if so, the amount to report on Form 709 that will be required to be filed. The recipient of the gift may also need this information to determine whether a deduction is available if the property is later sold at a loss. Gifts are valued for gift tax purposes at their fair market value as of the time of the gift. I.R.C. §2512. Fair market value is defined as “the price at which the property would change hands between a [hypothetical] willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Treas. Reg. 20.2031-1(b). As noted above, discounts from fair market value can be recognized for interests in closely-held entities that are minority interests and/or lack marketability, as well as fractional interests in real estate.
Generation-Skipping Transfer Tax (GSTT) Implications.
The GSTT is imposed on both outright gifts and transfers in trust to or for the benefit of related persons that are more than a generation younger than the donor, or unrelated persons who are more than 37.5 years younger than the donor. The GSTT is imposed only if the transfer avoids incurring a gift or estate tax at each generation level. For 2017, each individual has a $5.49 million exemption from the GSTT. With respect to split gifts made during a calendar year, each spouse is treated as the transferor for GSTT purposes of one-half of all gifts eligible for gift-splitting. Thus, each spouse can allocate their GSTT exemption to one-half of each gift that is split.
A gift of income-producing property does not trigger income in the hands of the donee to the extent the gifts are true gifts. But, income tax cannot be avoided, for example, on money or other property received in exchange for services.
The recipient of a gift of income-producing property must report any income that the property produces after the gifted property is received. For example, a gift of stock would require the recipient of the stock to report any dividends paid on the stock after the gift. Gifts of income-producing property can also be used to shift the income from the property to other family members that are in a lower tax bracket.
Sometimes a gift of income producing property is made in the form of interests in a business entity as part of an overall family estate and succession plan. If the entity owns only non-income producing property (such as vacant real estate) another potential problem arises in that the gifted property may not qualify for the present interest annual exclusion if it is determined to not be a gift of a present interest.
Income Tax Basis and Holding Period
Now, there’s a potentially major drawback to gifting. If the gift consists of property other than cash, the basis and holding period of the property in the hands of the donee is the same as it was in the hands of the donor. I.R.C. §1015. It’s important for the recipient to know when the donor acquired the property, the cost of the property, and any other information that would affect the property’s basis. Ideally, the recipient of the gift should also receive records that will provide adequate proof of these facts. So, while gifts of property during the donor’s lifetime will remove the gifted property from the donor’s estate computation, the gift also removes the ability to obtain a stepped-up basis on that property. Measuring estate tax savings against the tax implications of reduced basis step-up is an important part of the overall planning process. With the coupled estate and gift tax exclusion at $5.49 million for 2017, the basic plan for many people would be to hold the property until death to achieve a basis step-up. The tax savings for the heirs that might later sell the property will often outweigh that estate tax cost of having the property included in the estate.
The change in the rules governing the transfer tax system a few years ago has significantly changed gifting strategies. While there still remain significant income tax incentives to gifting, the transfer tax system rules indicate to many people that it may be better to not gift property and thereby cause it to be included in the estate at death where the exclusion will prevent it from being subject to federal estate tax. By causing the property to be include in the estate will result in a basis step-up equal to the fair market value of the property as of the date of death.
When considering gifting assets or doing significant estate planning, make sure to consult professionals for assistance.
Tuesday, April 18, 2017
Private property and the ability to exclude others is very important to farmers and ranchers. Land is typically the largest asset in terms of value that an ag producer owns and much farm and ranch machinery and equipment is often outdoors frequently during planting and harvesting. Not to mention buildings and livestock. So, trespassing is a big issue for rural landowners.
One issue that has popped-up recently in South Dakota involves public access to farmland that has become flooded. What are the rules associated with the recreational use of water? That’s the focus of today’s post.
In the United States, the individual states own the beds of navigable streams or lakes that flow or exist within their borders, and hold them in trust for their citizens. Under this public ownership concept, states may license use of the beds or lease rights to minerals found there. The right of the public to recreate over the bed can be asserted either because there is a federal navigational servitude or because the state has an expanded definition of navigability which allows more public uses than exist under federal law.
Under state law, the public's right to use rivers or lakes for recreational purposes is typically limited to those waters where the state owns the bed. For non-navigable streams, the title to the bed is held by the adjacent upland owner. Consequently, ownership of the bed is related to the concept of navigability. In general, navigability for title purposes is determined by the “natural and ordinary condition” of the water.
Although a federal test for bed title controlled the rights that states received upon joining the Union, state title tests are still important. When the states received title to the beds, they had the power to keep or dispose of them. Before the Supreme Court decisions which required federal law to be used in determining bed ownership, there were many state court decisions. These tests are still in use today and many conflict with federal law. When they do, federal law controls for title purposes (under the definition of “navigability”), but state law has been incorporated into this to determine what rights the state retains and what rights were granted to adjacent landowners. For example, some states keep title to watercourse beds only where there is a title influence. Other states follow a rule of “navigability in fact” similar to the federal rule. In these jurisdictions, the state retains title to watercourse beds only if the watercourse is navigable in fact. The remaining states use other approaches.
In early 2014, the New Mexico attorney general issued a non-binding opinion taking the position that a private landowner cannot prevent persons from fishing in a public stream that flows across a landowner’s property if the stream is accessible without trespassing across privately owned adjacent lands. Att’y. Gen. Op. 14-04 (Apr. 1, 2014). That opinion was based on New Mexico being a prior appropriation state and, as a result, unappropriated water in streams belongs to the public and is subject to appropriation for beneficial use irrespective of whether the adjacent landowner owns the streambed. Thus, the public has an easement to use stream water for fishing purposes if they can access the stream without trespassing on private property.
There are several other ways states have power over the water within their boundaries. Under its police power, a state may regulate its waters, whether or not they are navigable under the federal test, in order to protect the public's health, safety, and general welfare. Some western states claim ownership of all the water in the state, and as the owner, they claim the power to regulate. Other states limit their control to those waters considered navigable under bed ownership tests. As a result, state laws on public use of watercourses are a complex mix of cases and legislation.
The South Dakota Situation
Under South Dakota law, “the owner of land in fee has the right to the surface and everything permanently situated beneath or above it.” S.D.C.L. §43-16-1. In addition, South Dakota law provides that (with some specifically delineated exceptions), “…no person may fish, hunt or trap upon any private land without permission from the owner or lessee of the land….”. S.D.C.L. §41-9-1. Numerous states have similar statutory provisions. South Dakota also claims to own all wildlife in the state, including wildlife on private land. But, hunters cannot hunt that wildlife without the landowner’s permission unless the landowner is participating with the South Dakota Department of Game, Fish and Parks (GFP) in the “walk-in” program. Under that program, and landowner can give permission to the public to hunt on the landowner’s property in exchange for a payment from the GFP. Many other states also claim to own the wildlife found in the state and offer some sort of “walk-in” program.
South Dakota law, just like the laws of many other states, also bars “road hunting” outside of the public right-of-way. Thus, by barring hunting over private land from a public roadway, the state is recognizing landowners have “air rights” over their private property.
But, what about fishing? In a March decision, the South Dakota Supreme Court ruled that all water in the state is held in the public trust for “beneficial use.” That doesn’t seem unreasonable – other state high courts have reached the same conclusion. But, the Court held that the “beneficial use” rule applies to flooded private land (non-meandered lakes). This became an issue in South Dakota due to excess rainfall in 1993 which caused the formation of large lakes on private land in the northeastern part of the state. Fishermen flocked to the expanded lakes and the SD GFP didn’t stop them. The matter boiled over into litigation resulting in the Court’s recent decision.
The South Dakota Case
In Duerre v. Hepler, No. 27885, 2017 S.D. LEXIS 29 (S.D. Sup. Ct. Mar. 15, 2017), landowners sued the SD GFP for declaratory and injunctive relief concerning the public’s right to use the waters and ice overlying the landowners’ private property for recreational purposes. As noted above, in 1993, excessive rainfall submerged portions of the landowners’ property. In accordance with instructions from the United States Surveyor General’s Office, commissioned surveyors surveyed bodies of water in SD in the late 1800s. Pursuant to those survey instructions, if a body of water was 40 acres or less or shallow or likely to dry up or be greatly reduced by evaporation, drainage or other causes, surveyors were not to draw meander lines around the body of water but include it as land available for settlement. The meander lines delineated the water body for the purpose of measuring the property that abuts the water. When originally surveyed, the lands presently in question were small sized sloughs that were not meandered. Thus, the landowners owned the lakebeds under them. The 1993 flooding resulted in the sloughs expanding in size to over 1,000 acres each. The public started using the sloughs in 2001 and established villages of ice shacks, etc. In the spring and fall, boats would launch in to the waters via county roads. After the landowners complained to the GFP about trash, noise and related issues, the GFP determined that the public could use the waters if they entered them without trespassing. That’s sounds exactly like the New Mexico Attorney General opinion in 2014.
In 2014, the landowners sued. The trial court certified a defendant class to include those individuals who used or intended to use the floodwaters for recreational purposes, appointing the Secretary of the GFP as the class representative. On cross motions for summary judgment, the trial court entered declaratory and injunctive relief against the defendants. The trial court held that the public had no right of entry onto the water or ice without a landowner’s permission, and entered a permanent injunction in favor of the landowners.
On appeal, the South Dakota Supreme Court upheld the trial court’s decision to certify the class and include non-residents users in the class. The Court also upheld the trial court’s determination that the landowners had established the elements necessary for class certification and that the GFP Secretary was the appropriate class representative. The Court also upheld the trial court’s grant of declaratory relief to the landowners, noting that prior caselaw had left the matter up to the legislature and the legislature had not yet enacted legislation dealing with the issue. The legislature had neither declared that the public must obtain permission from private landowners, nor declared that the public’s right to use waters of the State includes the right to use waters for recreational purposes.
The Court remanded the order of declaratory relief and modified it to direct the legislature to determine whether the public can enter or use any of the water or ice located on the landowners’ property for any recreational use. As for the injunctive relief, the Court modified the trial court’s order to state that the GFP was barred from facilitating public access to enter or use the bodies of water or ice on the landowners’ property for any recreational purpose.
In short, the SD Supreme Court found that neither the GFP nor the landowners have a superior property right, but that the issue is up to the legislature to determine if recreation is a “beneficial use.” The issue is not just an important one for landowners in South Dakota. State rules for determining access rights to private property are important in every state. It certainly seems like a reasonable solution could be reached in South Dakota to protect private property rights while simultaneously providing reasonable access for fishermen. Time will tell.
Friday, April 14, 2017
With many things, it is true that there is a right way and a wrong way to do things. The same maxim holds true in business entity structuring. There is a right way to structure and a wrong way to structure the entity when it comes to many legal and tax issues, including self-employment tax liability. A recent Tax Court case illustrates that last point – proper structuring makes a difference on the self-employment tax liability issue.
So, how can self-employment tax be minimized when the desired structure is a limited liability company (LLC)? That’s today’s focus.
LLCs and Self-Employment Tax
Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations (that were barred by the Congress in the late 1990s from being finalized), an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
The Castigliola case. In Castigliola, et al. v. Comr, T.C. Memo. 2017-62, a group of lawyers structured their law practice as member-managed Professional LLC (PLLC). On the advice of a CPA, they tied each of their guaranteed payments to what reasonable compensation would be for a comparable attorney in the locale with similar experience. They paid self-employment tax on those amounts. However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed payment. Self-employment tax was not paid on the excess amounts. The IRS disagreed with that characterization, asserting self-employment tax on all amounts allocated.
The Tax Court agreed with the IRS. Based on the Uniform Limited Partnership Act of 1916, the Revised Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated), the court determined that a limited partner is defined by limited liability and the inability to control the business. The members couldn’t satisfy the second test. Because of the member-managed structure, each member had management power of the PLLC business. In addition, because there was no written operating agreement, the court had no other evidence of a limitation on a member’s management authority. In addition, the evidence showed that the members actually did participate in management by determining their respective distributive shares, borrowing money, making employment-related decisions, supervising non-partner attorneys of the firm and signing checks. The court also noted that to be a limited partnership, there must be at least one general partner and a limited partner, but the facts revealed that all members conducted themselves as general partners with identical rights and responsibilities. In addition, before becoming a PLLC, the law firm was a general partnership. After the change to the PLLC status, their management structure didn’t change.
The court did not mention the proposed regulations, but even if they had been taken into account the outcome of the case would have been the same. Member-managed LLCs are subject to self-employment tax because all members have management authority. It’s that simple. In addition, as noted below, there is an exception in the proposed regulations that would have come into play.
Note: As a side-note, the IRS had claimed that the attorney trust funds were taxable to the PLLC. The court, however, disagreed because the lawyers were not entitled to the funds.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses, such as the one involved in Castigliola. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership (such as the law firm at issue in the case), structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. But, the husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment for his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of the other spouse from passive to active income that will not be subject to the 3.8 percent surtax.
Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
The manager-managed LLC provides a better result than the result produced by the member-managed LLC for LLCs that are not service partnerships. For those that are, such as the PLLC in Castigliola, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to S.E. tax, but the balance drawn from the entity can be received self-employment tax free. But, for farming operations with land rental income, the manager-managed LLC can provide a better overall tax result than the use of an S corporation because of the ability to eliminate the net investment income tax.
Of course, the self-employment tax and the net investment income tax are only two pieces of the puzzle to an overall business plan. Other non-tax considerations may carry more weight in a particular situation. But for some, this strategy can be quite beneficial.
The decision in Castigliola would appear to further bolster the manager-managed approach – an individual that is a “mere member” appears to now have an even stronger argument for limited partner treatment. In addition, the court didn’t impose penalties on the PLLC because of reliance on an experienced professional for their filing position. I am not so sure about that one and believe that the judge was simply being nice, perhaps because the professional tax advisor died before the trial. But, the outcome they were seeking was easy to obtain if they had just structured the entity properly and had taken some time to carefully draft an operating agreement.
Wednesday, April 12, 2017
Any depreciable business asset is only depreciable if it has been placed in service during the tax year. “Placed in service” means that the asset is in a state of readiness for use in the taxpayer’s trade or business. See, e.g., Brown v. Comr., T.C. Sum. Op. 2009-71. In the year that an asset is place in service, all or part of the income tax basis can be deducted currently. A key point is that it is not actually necessary that the asset be used in the taxpayer’s trade or business for the taxpayer to begin claiming depreciation attributable to that asset.
The Code and regulations seem abundantly clear on what “placed in service” means. A court decision involving a retail building that was decided in early 2015 bore that out. But, IRS has now muddied the water by disagreeing with that court’s decision which, in turn, means that they are disagreeing with their own regulation on the issue and even their own audit technique guide on the matter.
Today’s post takes a look at what “placed in service” means and the confusing IRS position.
Code and Regulations
As noted above, property that is “placed in service” means that it is placed in a state of readiness or availability for use in the taxpayer’s trade or business, regardless of the time of year that the asset is placed in service. Treas. Reg. §1.167(a)-10(b). That means that the asset must be ready for the taxpayer to use by the taxpayer by the end of the tax year if the taxpayer so desires. It doesn’t mean that the taxpayer must have begun using the asset in the taxpayer’s trade or business by the end of the tax year. But, an item of property is not deemed to be placed in service if it is simply manufactured and is sitting at the dealership, or if an order has been placed but the property has not yet been built. So, simply signing a purchase contract or taking delivery of a depreciable materials (such as for the construction of a pole barn, etc.) to be used in the taxpayer’s business does not mean that those assets are depreciable – they aren’t yet ready for use in the taxpayer’s business. The asset must be ready for use in the taxpayer’s business whether or not they have actually been used by the taxpayer in the business by the end of the tax year. For a building in which the taxpayer’s retail business is conducted, for example, the store doesn’t have to be open for business in order for the building by the end of the tax year for the building to be deemed to be placed in service for depreciation purposes for that tax year. Treas. Reg. §1.167(a)-11(e)(1)(i). The building is considered to be placed in service on the date that its construction is considered to be substantially complete or in the state or readiness and availability regardless of whether depreciable items in the building meet the placed in service test. Id.
The Stine Case
In Stine, LLC v. United States, No. 2:13-03224, 2015 U.S. Dist. LEXIS 9850 (W.D. La. Jan. 27, 2015), non-acq., 2017-02 (Apr. 10, 2017), the taxpayer operated a retail business that sold home building materials and supplies. The taxpayer built two new retail stores. As of December 31, 2008, the buildings were substantially complete and partially occupied and the taxpayer had obtained certificates of completion and occupancy and customers could enter the stores. However, the stores were not open for business as of the end of 2008. The taxpayer claimed the 50 percent GoZone depreciation allowance for 2008 on the two buildings which created a tax loss for 2008 and allowed the taxpayer to carry back the losses to the 2003-2005 tax years and receive a refund. The IRS disallowed the depreciation deduction on the basis that the taxpayer had not placed the buildings in service and assessed a deficiency of over $2.1 million for tax years 2003-2008. The taxpayer paid the deficiency and sued for a refund. The IRS argued that allowing the depreciation would offend the "matching principle" because the taxpayer's revenue from the buildings would not match the depreciation deductions for a particular tax year. The court held that this argument was "totally without merit."
On the placed in service issue, the IRS maintained that the two buildings were not “open for business” as of the end of the tax year so no depreciation could be claimed for that year. The court disagreed, noting the government’s own regulation that defied that argument. The court noted that Treas. Reg. §1.167(a)-11(e)(1) says that placed in service means that the asset is in a condition of readiness and availability for its assigned function. With respect to a building, the court noted that this meant that the building must be in a state of readiness and availability without regard to whether equipment or machinery housed in the building has been placed in service. The court held that there was no requirement that the taxpayer's business must have begun by year-end. Cases that the IRS cited involving equipment (in one case an airplane) being placed in service were not applicable, the court determined. The court also noted that the IRS's own Audit Technique Guide for Rehabilitation Tax Credits stated that "[A] 'Certificate of Occupancy' is one means of verifying the 'Placed in Service' date for the entire building (or part thereof)". The court noted that the IRS had failed to cite even a single authority for the proposition that "placed in service" means "open for business," and that during oral arguments IRS had admitted that no authority existed. Thus, the court granted summary judgment for the taxpayer and also specified that the taxpayer could pursue attorney fees against the government if desired.
The IRS reaction. The court’s decision in Stine was based precisely on the regulation. It’s common sense, also. For retail businesses that are constructing stores, once the product is received to be placed into the display shelves at the constructed building, the building will be considered to have been placed in service. That’s what the regulation seems pretty clear about. The court sure believed so.
The IRS did not file an appeal with the U.S. Court of Appeals for the Fifth Circuit. That’s not surprising, considering how badly the IRS lost the case. Recently, however, the IRS issued a non-acquiescence to the court’s decision. A.O.D. 2017-02. That means that the IRS disagrees with the court’s decision and will continue to audit the issue outside of the Western District of Louisiana. Unfortunately, the IRS didn’t give any reason(s) why it disagreed with its own regulation and audit technique guide on the matter. That’s understandable – they have none.
An asset is placed in service for depreciation purposes when it is ready and available for use in the taxpayer’s trade or business. The Stine case makes that clear. It’s an issue that comes up in agriculture also. Just think back to the end of the year promotional ads that have appeared on TV and in farm magazines in recent years stating that a contract could be signed or delivery be taken before year end for a business asset to be depreciable. That’s not correct. While the asset need not be “used” by the taxpayer to be placed in service, it still has to be ready and available for use. Merely signing a contract or taking delivery of parts and materials that have to be assembled is not enough.
Monday, April 10, 2017
The Endangered Species Act (ESA) establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531 et seq (2002). The U.S. Fish and Wildlife Service (USFWS), within the Department of the Interior, is the lead administrative agency for most threatened or endangered species.
The ESA has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the Act extend to individual members of the species when they are on private land. Approximately 90 percent of endangered species have some habitat on private land, with almost 70 percent of the endangered or threatened species having over 60 percent of their total habitat on nonfederal lands. A recent decision of the U.S. Court of Appeals for the Tenth Circuit reiterates that the ESA applies to activities on private land. That’s the focus of today’s post.
The Impact of Species “Listing”
Once a species has been listed as endangered or threatened, the ESA prohibits various activities involving the listed species unless an exemption or permit is granted. For example, with respect to endangered species of fish, wildlife and plants, the ESA makes it unlawful for any person to import or export such species, deliver, receive, carry, transport or ship in interstate or foreign commerce by any means whatsoever, and sell or offer for sale in interstate or foreign commerce any such species. The ESA, with regard to endangered species of fish or wildlife, but not species of plants, makes it unlawful for any person subject to the jurisdiction of the United States to “take” any such species. 16 U.S.C. §§ 1538(a)(1)(B), (C) (2008). The ESA defines the term “take” to mean harass, harm, pursue, hunt, shoot, wound, kill, trap, capture, or collect, or to attempt to engage in any such conduct. The prohibition against “taking” an endangered species applies to actions occurring on private land as well as state or federal public land, and financial penalties apply for violating the prohibition.
1982 amendments to the ESA establish an incidental take permit process that allows a person or entity to obtain a permit to lawfully take an endangered species “if such taking is incidental to, and not the purpose of, the carrying out of an otherwise lawful activity.” 16 U.S.C. §1539(a)(1)(B). A person may seek an incidental take permit from the USFWS by filing an application that includes a Habitat Conservation Plan (HCP) which includes a description of the impacts that will likely result from the taking, proposed steps to minimize and mitigate those impacts, and alternatives to the taking that the applicant considered and the reasons why those alternatives were not selected. If the permit is issued, the FWS will monitor the project for compliance with the HCP and the effects of the permitted action and the effectiveness of the conservation program. The FWS may suspend or revoke all or part of an incidental take permit if the permit holder fails to comply with the conditions of the permit or the laws and regulations governing the activity.
Impact on Private Land Use Activities
The denial of an incidental take permit involving habitat modification of an underground cave bug of no known human commercial value and only found in two Texas counties has been upheld against a Commerce Clause challenge. GDF Realty Investments, LTD, et al. v. Norton, 326 F.3d 622 (5th Cir. 2004), reh’g en banc denied, 362 F.3d 286 (5th Cir. 2004), cert. denied, 545 U.S. 1114 (2005). The landowner claimed the federal government had no jurisdiction due to the lack of connection with interstate commerce. The court upheld the denial of the incidental take permit on the basis that the bug could be aggregated with all other endangered species to show a sufficient connection with interstate commerce. Likewise, in Rancho Viejo, LLC v. Norton, 323 F.3d 1062 (D.C. Cir. 2003), reh’g en banc denied, 334 F.3d 1158 (D.C. Cir. 2003), cert. denied, 540 U.S. 1218 (2004), a different court held that the ESA extended to the Southwestern Arroyo Toad even though the Arroyo Toad only resided in southern California and never has been an article of commerce. In 2009, a commercial wind farm was enjoined from further development until receipt of an incidental take permit due to the project’s impact on the endangered Indiana bat. The court held that it was a “virtual certainty” that Indiana bats would be “harmed, wounded or killed” by the wind farm in violation of the ESA during times that they were not hibernating. Animal Welfare Institute, et al. v. Beech Ridge Energy LLC, et al., 675 F. Supp. 2d 540 (D. Md. 2009).
An important issue for farmers and ranchers is whether habitat modifications caused by routine farming or ranching activities are included within the definition of the term “take.” In 1975, the Department of Interior issued a regulation defining “harm” as “an act or omission which actually injures or kills wildlife, including acts which annoy it to such an extent as to significantly disrupt essential behavior patterns, which include, but are not limited to, breeding, feeding or sheltering; significant environmental modification or degradation which has such effects is included within the meaning of ‘harm’.” 50 C.F.R. § 17.3; 40 Fed. Reg. 44412, 44416. The regulation was amended in 1981 to emphasize that actual death or injury to the listed species is necessary, but the inclusion of “habitat modification” in the definition of “harm” led to a series of legal challenges.
The regulation was upheld by the Ninth Circuit Court of Appeals in 1988 in a case involving an endangered bird species whose critical habitat was on state-owned land in Hawaii. Palila v. Hawaii Dept. of Land & Natural Resources, 639 F.2d 495 (9th Cir. 1981). The court held that the grazing of goats and sheep threatened to destroy the endangered birds' woodland habitat and resulted in harm and a “taking” of the endangered bird. The court ordered the Hawaii Department of Land and Natural Resources to remove the goats and sheep from the birds' critical habitat. In subsequent litigation, the plaintiffs sought the removal of an additional variety of sheep from the birds' critical habitat. The defendant argued that, under the ESA, “harm” included only the actual and immediate destruction of the birds' food source, not the potential for harm which could drive the bird to extinction. However, the Ninth Circuit held that “harm” is not limited to immediate, direct physical injury to the species, but also includes habitat modification which may subsequently result in injury or death of individuals of the endangered species. Palila v. Hawaii Dept. of Land & Natural Resources, 852 F.2d 1106 (9th Cir. 1988).
Recent case. In People for the Ethical Treatment of Property Owners v. Unites States Fish and Wildlife Service, No. 14-4151, 2017 U.S. App. LEXIS 5440 (10th Cir. Mar. 29, 2017). the U.S. Court of Appeals for the Tenth Circuit again illustrated the impact of the ESA on private land activities in a case involving protected prairie dogs. In the case, the plaintiffs were landowners in Utah whose experienced problems with the prevalence of the Utah prairie dog damaging their tracts. The Utah prairie dog is a threatened species under the ESA and has approximately 70 percent of its population on private land. The Utah prairie dog is found only in Utah, and its population has increased about 12 times over since 1973.
As a threatened species, the USFWS issued a special rule regulating the “taking” of the Utah prairie dog. Under the rule, “taking” was limited to agricultural land, property within one-half mile of conservation land and areas where the species creates serious human safety hazards or disturb the sanctity of significant cultural or burial sites. Incidental taking is allowed if it occurs as part of standard agricultural practices. The plaintiffs challenged the rule as applied to private land as not authorized under either the Commerce Clause or the Necessary and Proper Clause of the U.S. Constitution and sought declaratory and injunctive relief.
The trial court granted the plaintiffs motion for summary judgment on the basis that the Commerce Clause does not authorize the Congress to enact legislation authorizing the regulation of the taking of a purely intrastate species without a substantial effect on interstate commerce and the Necessary and Proper Clause did not authorize the regulation of taking of the species because the regulation is not essential to the ESA’s economic scheme. The government appealed.
On review, the appellate court reversed. The appellate court determined that the “substantial effect” on interstate commerce was to be determined under the rational basis standard. Under that standard, the appellate court held that the Congress has the power to regulate purely local activities that are part of an economic class of activities that have a substantial effect on interstate commerce. Thus, because (in this court’s view) the Commerce Clause authorized the regulation of noncommercial purely intrastate activity that is an essential part of a broader regulatory scheme, the “take” regulation was constitutional. The appellate court noted that approximately 68 percent of ESA-protected species have habitats that do not cross state borders, as such the court reasoned that the ESA could be severely undercut if the ESA only allowed protection to those species whose habitats were in multiple states.
The ESA and the underlying regulations have a significant impact on private landowners and associated agricultural activities. With new leadership in the White House and regulatory agencies it remains to be seen whether that will amount to any change in how the rules are applied on private land.
Thursday, April 6, 2017
Yesterday the U.S. House Committee on Agriculture Heard Testimony concerning the impact of the tax code on the agricultural industry. I teach farm income tax at the law school, and a significant focus of the course for the students is on those areas of tax law where the rules are different for agricultural producers and agricultural businesses than they are for other taxpayers. The stated (and largely correct) reason for the different treatment of agriculture is that there are unique risks that the sector faces.
One of the speakers at the hearing focused on the uniqueness of farm income tax. I found that interesting and today’s post will summarize the testimony of that speaker – Chris Hesse. Chris is a principal of CliftonLarsonAllen. I am only focusing on the portions of his testimony that dealt with tax issues unique to agricultural producers and businesses. It’s important for legislators to understand these unique provisions and how they apply to agricultural producers.
Installment method. Farm businesses can report income on the installment method. That means that income is recognized when payment is received instead of when the sale is made. This rule can apply to the sales of raised crops and livestock, for example. Nonfarm businesses cannot report the income from the sale of products manufactured or held for sale to customers using the installment method. A seller of ag equipment (e.g., an implement dealer) is not a “farmer” and can’t use the installment method.
Commodity Credit Corporation (CCC) loans. The CCC is the USDA’s financing institution with programs administered by the Farm Service Agency (FSA). Among other things, the CCC makes commodity and farm storage facility loans to farmers where the farmers’ crops are pledged as collateral. These loans are part of the price and income support system of the federal farm programs. Farmers have an option for treating the loan on the return – either as a loan or as income in the year that the loan proceeds are received.
Crop insurance. Farmers can defer the receipt of crop insurance proceeds that are paid for physical damage or destruction to crops. Deferred planting payments are also deferrable. But, if the policy pays based on anything other than physical damage or destruction to covered crops, the payments are not deferrable
Livestock sales on account of weather-related conditions. There are two basic deferral rules that can apply when excess livestock are sold on account of weather-related conditions. I recently blogged on these two rules in light of the wildfires in Kansas, Oklahoma and Texas that has impacted cattle ranchers in those areas. One rule provides for a one-year deferral and the other rule provides the ability to replace the excess livestock with replacement animals and deferral of the gain until the replacement animals are disposed of.
Hedging. As Chris pointed out in his testimony, farmers may reduce price risk for both the sale of crops and livestock and for the purchase of inputs. Puts, calls, and the commodity futures markets are available to hedge prices for the inputs and sales. The hedging opportunities provide ordinary income or loss treatment upon using techniques to lock-in prices. Without this provision, a loss on a commodity futures contract would be capital gain, the deductibility of which is limited to capital gains plus $3,000.
Cancelled debt income. The default treatment for the discharge of indebtedness is as taxable income. However, exclusions are available. One of those is unique to farmers and involves the discharge of qualified farm indebtedness. My blog post of March 29, 2017, dealt with this rule.
Raising livestock. Farmers may deduct the costs of raising livestock, even though dairy cattle, for example, otherwise have a pre-productive period of more than two years. Consequently, when cattle are culled from the breeding or dairy herd, the farmer recognizes I.R.C. §1231 gain, usually taxed as capital gain.
Raising crops. Farmers may deduct the costs of raising crops in the year paid for a cash method farmer, except for those crops that have a more than two-year pre-productive period. But, an election is available for the crops with a more than two-year pre-productive period which allows a current deduction for the costs of establishing the crop. If election is made, depreciation on all farm assets must be computed using slower methods over longer cost recovery periods. The cost of raising the crops is deductible in the year paid for the cash method farmer.
I.R.C. §199. The Domestic Production Activities Deduction (DPAD) of I.R.C. §199 reduces the overall tax rate from growing and production activities for farmers that pay W-2 wages. It’s a nine percent deduction from net farm income (but it doesn’t reduce self-employment income). This provision is uniquely applied to agriculture in the context of cooperatives, farm landlords, crop insurance payments, Farm Service Agency subsidies, custom feeding operations, hedging transactions and the storage of ag commodities.
Fertilizer and soil conditioning expenditures. Farmers can elect to deduct fertilizer and soil conditioner expenses in the year purchased.
Farm supplies. Farm supplies are deductible in the year that they are paid for, rather than in the year of their use.
Charitable donation of conservation easement. Farmers get an enhanced limitation for the donation of a conservation easement. Instead of a 50 percent of adjusted gross limitation for non-farm taxpayers, a farmer or rancher may claim a charitable deduction up to 100 percent of adjusted gross income. If the charitable deduction is greater than the limitation, the excess charitable deduction may be carried forward for up to 15 years.
Charitable contribution of food. Farmers may deduct up to 50 percent of the value of apparently wholesome food given for the benefit of the needy. This provision provides the same incentive to grower/packer/shippers who own cash basis inventory, as provided to the local grocery store that has excess food inventory nearing its expiration date.
Other Provisions Unique to Agriculture
Estimated tax. Form 1040 farmers need not pay estimated taxes if the tax return is filed by March 1. Farmers who don’t file by March 1 can pay one estimated tax payment on January 15. This flexibility helps farmers by not having to pay income tax on expected income that doesn’t arise to the risks mentioned above.
Farm income averaging. Farmers can average their income over a three-year period. This helps deal with fluctuating commodity prices, and is useful upon retirement.
Net operating losses. Farmers have the option of using a net operating loss carryback period of five years, rather than the two-year provision applicable to non-farmers.
Optional self-employment tax. Farmers benefit from the optional self-employment tax, to earn credits toward the Social Security system even though suffering a loss in a current year. Non-farm taxpayers may elect optional self-employment tax for only five years. Farmers do not have a limit.
Farm supplies. Farmers may deduct farm supplies in the year paid, rather than the year consumed (within limits).
Chapter 12 bankruptcy. Farm bankruptcy (Chapter 12) contains a special rule that allows taxes owed to a governmental entity to be changed from priority to non-priority status. This wasn’t in Chris’ testimony, but it’s a crucial provision particularly in this time of financial distress in agriculture. A current problem, however, is that the debt test for Chapter 12 needs to be raised. Numerous farming operations now have aggregate debt levels high enough that they are precluded from filing Chapter 12. For those, the tax provision is of no use.
CRP rents for a farmer receiving Social Security. A special tax rule allows active farmers who receive Conservation Reserve Program (CRP) payments to not pay self-employment tax on those payments if the farmer is also receiving Social Security benefits. This was also not a part of Chris’ testimony.
It was apparent at the hearing that interest deductibility for interest associated with farmland purchases is a key tax provision that should be retained. There had been some discussion during the summer of 2016 that its removal was a possibility. At least that was mentioned as a possibility in the “Blueprint” made public by the House Ways and Means Committee. That doesn’t seem to be the case now. Also, the hearing pointed out that the current tax-deferred exchange rules are necessary to retain.
On the federal estate tax, while the exemptions are high enough to exempt out the vast majority of farmers, the point was made that a significant reason of its inapplicability to farmers is that they engage in costly and time-consuming planning to avoid the tax. That’s what is called a “dead weight loss.” That point is never mentioned by the proponents of keeping the federal estate tax in place who claim they have no evidence of a farm or ranch ever having been sold to pay the tax. The retention of basis “step-up” at death is of particular importance to farm and ranch families.
Another panelist gave testimony that focused on proposals that could incentive farmers that are retiring from farming to transfer their assets before death. I haven’t seen much interest in the Congress over the past few years to enact the proposals suggested, but it’s still good to have the discussion and put the issues back out in the open.
It’s always nice when those in D.C. get to hear from those in the trenches that have to deal with the rules the Congress enacts. Hopefully the hearing was beneficial for the legislators.
Tuesday, April 4, 2017
A nuisance is an invasion of an individual's interest in the use and enjoyment of land rather than an interference with the exclusive possession or ownership of the land. The concept has become increasingly important in recent years due to land use conflicts posed by large-scale, industrialized confinement livestock operations. But, that’s not the only activity that has generated nuisance litigation. “Renewable” energy also has started to produce its own subset of nuisance cases. In these cases, the claim might involve allegations of noise, vibration, flicker, and damage to local aesthetics, among other annoyances.
But, can a nuisance claim be based solely on a claim of harm to aesthetics? If so, that could spell trouble for sources of renewable energy. The issue has been addressed by court on numerous occasions, but came up most recently in Vermont involving the installation of solar panels in a rural area – a so-called solar farm.
The issue of aesthetics (visual blight) and nuisance is the focus of today’s post.
Nuisance – In General
Nuisance law prohibits land uses that unreasonably and substantially interfere with another individual's quiet use and enjoyment of property. The doctrine is based on two interrelated concepts: (1) landowners have the right to use and enjoy property free of unreasonable interferences by others; and (2) landowners must use property so as not to injure adjacent owners.
Nuisance law is rooted in the common law and two primary issues are at stake in any agricultural nuisance dispute - whether the use alleged to be a nuisance is reasonable for the area and whether the use alleged to be a nuisance substantially interferes with the use and enjoyment of neighboring land. Each case is highly fact-dependent with the court considering multiple factors.
A private nuisance is a civil wrong that is based on a disturbance of rights in land. A private nuisance may consist of an interference with the physical condition of the land itself, as by vibration or blasting which damages a house, the destruction of crops, flooding, the raising of the water table, or the pollution of a stream or underground water supply. A private nuisance may also consist of a disturbance of the comfort or convenience of the occupant as by unpleasant odors, smoke, dust or gas, loud noises, excessive light, high temperatures, or even repeated telephone calls. The remedy for a private nuisance lies in the hands of the individual whose rights have been disturbed. A public nuisance, on the other hand, is an interference with the rights of the community at large. A public nuisance may include anything from the obstruction of a highway to a public gaming house or indecent exposure. The normal remedy is in the hands of the state.
Nuisance and Renewable Energy Production Activities
Odors from large-scale livestock confinement operations are not the only activities on rural property that give rise to nuisance actions. While such activities tend to predominate nuisance actions, especially in the Midwest, the development of large-scale wind turbine operations is also generating a great deal of conflict among rural landowners. While nuisance litigation involving large-scale “wind farms” is in its early stages, a significant opinion from the West Virginia Supreme Court in 2007 illustrates the land-use conflict issues that wind-farms can present. In Burch, et al. v. Nedpower Mount Storm, LLC and Shell Windenergy, Inc., 220 W. Va. 443, 647 S.E.2d 879 (2007), the West Virginia Supreme Court ruled that a proposed wind farm consisting of approximately 200 wind turbines in close proximity to residential property could constitute a nuisance. Seven homeowners living within a two-mile radius from the location of where the turbines were to be erected sought a permanent injunction against the construction and operation of the wind farm on the grounds that they would be negatively impacted by turbine noise, the eyesore of the flicker effect of the light atop the turbines, potential danger from broken blades, blades throwing ice, collapsing towers and a reduction in their property values. The court held that even though the state had approved the wind farm, the common-law doctrine of nuisance still applied. While the court found that the wind-farm was not a nuisance per se, the court noted that the wind-farm could become a nuisance. As such the plaintiffs’ allegations were sufficient to state a claim permitting the court to enjoin the creation of the wind farm. The court remanded the case to the trial court for a trial. At trial, the defendant was given an opportunity to establish that the operation of the wind farm did not unreasonably interfere with the plaintiffs’ use and enjoyment of their property. That’s how most of the cases positioned like this would turn out. Courts thend not to permit a claim for “anticipatory nuisance.” A party is entitled to show that they can conduct their activity without creating a nuisance.
In another case involving nuisance-related aspects of large-scale wind farms, the Kansas Supreme Court upheld a county ordinance banning commercial wind farms in the county. Zimmerman v. Board of County Commissioners, 218 P.3d 400 (Kan. 2009). The court determined that the county had properly followed state statutory procedures in adopting the ordinance, and that the ordinance was reasonable based on the county’s consideration of aesthetics, ecology, flora and fauna of the Flint Hills. The Court cited the numerous adverse effects of commercial wind farms including damage to the local ecology and the prairie chicken habitat (including breeding grounds, nesting and feeding areas and flight patterns) and the unsightly nature of large wind turbines. The Court also noted that commercial wind farms have a negative impact on property values, and that agricultural and nature-based tourism would also suffer.
Aesthetic Injury Only?
But what if the only complained-of problem is aesthetic? Is that enough to make out a claim for nuisance? The issue came up recently in a court case from Vermont that involved solar panels. In Myrick v. Peck Electric Co., et al., No. 16-167, 2017 Vt. LEXIS 4 (Vt. Sup. Ct. Jan. 13, 2017), the plaintiff was a landowner that sued the defendant, two solar energy companies, when the plaintiff’s neighbors leased property to the defendants for the purpose of constructing commercial solar arrays (panels). The plaintiff claimed that the solar arrays constituted a private nuisance by negatively affecting the surrounding area’s rural aesthetic which also caused local property values to decline. The trial court granted summary judgment to the defendants. On appeal, the Vermont Supreme Court affirmed. The Court noted that Vermont law has held, dating back to the late 1800s, that private nuisance actions based on aesthetic disapproval alone are barred. The Court rejected the plaintiff’s argument that the historic Vermont position should change based on changed society. The Court also rejected the notion that Vermont private nuisance law was broad enough to apply to aesthetic harm, stating that, “An unattractive sight, without more, is not a substantial interference as a matter of law because the mere appearance of the property of another does not affect a citizen’s ability to use and enjoy his or her neighboring land.” Emotional distress is not an interference with the use or enjoyment of land, the court stated. But, if the solar panels casted reflections, for example, that could be an interference with the use and enjoyment of one’s property. Aesthetic values, the court noted, are inherently subjective and the court wasn’t going to set an aesthetic standard. The Court also noted that the plaintiffs had conceded at oral argument that they were not pursuing a claim that diminution in value, by itself, was sufficient to constitute a nuisance. However, the Court went on to state that a nuisance claim based solely on loss in value invites speculation that the Court would not engage in.
The decision from Vermont follows the majority rule among jurisdictions in the United States. Of course, there are some exceptions. For example, a few courts have held that proof of general damages (diminished quality of life) may be sufficient evidence to support a monetary award. See, e.g., Stephens, et al. v. Pillen, 12 Neb. App. 600 (2004). But, in general, aesthetic injury, by itself, is not enough to make a claim for nuisance. However, if it is coupled with claims of substantial interference with use and enjoyment of property, a nuisance claim might successfully be made. Renewable energy generation tends to require a large amount of land for its operation, but unsightliness, by itself, probably won’t be enough to make it a nuisance.