Tuesday, May 30, 2017

Ag Goods Sold At Auction – When Is A Contract Formed?


A basic rule of contract formation is that an offer for specific goods must be made and the offer must be accepted.   The Uniform Commercial Code (UCC) as adopted by a particular state also helps define when an offer is accepted and a enforceable contract is formed.  

In the context of an auction, what’s an offer and when does acceptance occur?  That’s the focus of today’s post.

General Rules

An auction sale contract is enforced, as is true of any other contract, according to its terms. In general, the owner of property sold at auction has the right to prescribe, within reasonable limits, the manner, conditions and terms of sale.  That means a buyer, for example, will be bound by a written sale brochure provision stating that announcements made day of sale would control terms of sale.

Many agricultural goods are sold at auction.  In an auction sale, the auctioneer is the seller’s agent.  The auctioneer is selected by the seller, is remunerated by the seller, is to act in the seller’s interest and, to a degree, is subservient to the seller’s wishes.  Until the auctioneer signals that the sale has been consummated, the auctioneer is exclusively the seller’s agent and functions in a principal-agent relationship.  The auctioneer’s authority and liability depend upon the nature and extent of the agency conferred on the auctioneer by the seller.  If the auctioneer exceeds the scope of authority, the auctioneer does not bind the owner of the property. 

As an agent of the seller, the auctioneer must exercise ordinary care and skill in the performance of duties undertaken.  An auctioneer may be held accountable to the seller for any secret profits received by the auctioneer as a result of the sale which are not disclosed to the seller.  But, there is no auctioneer liability if the auctioneer never becomes a party to a contract with the bidder.  See e.g., In re Wilson Freight Co., 30 B.R. 971 (Bankr. S.D. N.Y. 1983). 

Offer and Acceptance

The fundamental rule at common law and under the UCC is that a bid at an auction constitutes an offer to buy.  Other than for judicial sales, a contract is formed when the auctioneer signals acceptance by the fall of the auctioneer’s hammer or by some other act. If a bid is made while the hammer is falling in acceptance of a prior bid, the auctioneer has the discretion to reopen the bidding or declare the goods sold.  A bidder may retract a bid until the auctioneer’s announcement of completion of the sale.  UCC § 2-328(3).  But a bidder’s retraction does not revive any previous bid.  UCC § 2-328(3).

Auctions may be held either “with reserve” or “without reserve.”  UCC § 2-328(4).  These terms relate to the seller’s right to withdraw the goods if dissatisfied with the bids received.  In an auction conducted “with reserve,” the seller or the auctioneer has the right to reject all bids if desired.  In an auction conducted “without reserve,” the seller does not have the right to withdraw goods and the goods must be sold to the highest bidder even if only one bid is made.  An article or lot cannot be withdrawn unless no bid is made within a reasonable time. 

“With Reserve” Auction

Under the UCC, all auctions are presumed to be “with reserve” unless it is expressly announced to the contrary.  For auctions conducted without reserve, the seller is committed to the sale once a bid has been entered, regardless of the level of bidding or the seller’s notion of the property’s true value.  In a without reserve auction, the seller is the offeror, the bidder is the offeree and a contract is formed when a bid is made, subject only to a higher bid being made.  For auctions conducted with reserve, a bid is an offer, and a contract is formed when the seller accepts the bid.  Acceptance in a with-reserve auction is usually denoted by the fall of the auctioneer’s hammer, but UCC § 2-328(2) states that a sale may be completed “in any other customary manner.”  This permits a seller to reject the highest bid even after the auctioneer’s hammer falls or the auctioneer otherwise ends the auction.  See, e.g., Bradshaw v. Thomson, 454 F.2d 75 (6th Cir. 1972); Johnson v. Herman, No. CX-98-946, 1998 Minn. App. LEXIS 1390 (Minn. Ct. App. Dec. 22, 1998).

Seller Bidding on Own Goods?

At an auction, a seller may bid on the seller’s own goods only if the right to do so is reserved in advance.  Except at a forced sale, if the auctioneer knowingly receives a bid on the seller’s behalf or the seller makes a bid, and notice has not been given that liberty for such bidding is reserved, the buyer may at the buyer’s option void the sale entirely or take the goods at the price of the last good-faith bid before the completion of the sale.  UCC § 2-328(4).  However, the seller must have an obligation to sell to the highest bidder before the bidder has a right to take the goods at the price of the last good-faith bid.

In some instances, the consequences of a seller not giving notice of an intention to bid can go beyond the bidder’s remedies of avoiding the contract or taking the goods at the price of the last good-faith bid.  If the seller acts with a malicious intent to inflate the bids and injure other bidders, punitive damages may be awarded.  See, e.g., Nevada National Leasing Co. v. Hereford, 36 Cal. 3d 146, 680 P.2d 1077 (1984).

What About Real Estate Auctions?

While Article 2 of the UCC does not apply to real estate sold at auction, some courts have applied by analogy the various rules of Article 2 to real estate auctions. For example, Well v. Schoeneweis, 101 Ill. App. 3d 254, 427 N.E.2d 1343 (1981) involved an action for specific performance of a sale of farmland brought by the highest bidder at a public auction against the seller. The court, while noting that Article 2 did not apply to real estate auctions, stated that the rules for real and personal property were identical and that the lower court did not err in relying on Article 2 for arriving at its judgment.  Similarly, in Pitchfork Ranch Co. v. Bar TL,615 P.2d 541 (Wyo. 1980)  the court noted that even though Article 2 did not apply to real estate sales, its auction sale provisions were useful.


As noted earlier, many agricultural goods are sold at auction.  It is helpful to know the basic contract rules that apply in an auction context.  So, enjoy the next farm auction you attend or conduct, and don’t get surprised by an unexpected rule application.

May 30, 2017 in Contracts | Permalink | Comments (0)

Friday, May 26, 2017

Minority Shareholder Oppression Case Raises Several Tax Questions


Minority shareholders in a small, closely-held corporation are in a precarious position.  They have no control over management of the corporation, and, for example, can’t force dividends to be paid or force a corporate liquidation.  Clearly, corporate directors (including those acting as directors) owe a fiduciary duty to the corporation with respect to their actions as directors, and those fiduciary duties apply in the context of directors’ ability to manage the closely-held business within their discretion.  However, while corporate directors can generally use their business judgment to operate the business as they deem appropriate, they must manage the business in a manner that is consistent with honesty and good faith toward all of the shareholders – the minority included. 

A recent opinion of the Nebraska Court of Appeals involved an allegation of “oppression” of a minority shareholder is a closely-held farming corporation.  While the minority shareholder was not able to establish that oppression had occurred, testimony was offered in the case by the corporation’s tax professional that merits a closer look.

Nebraska Case

In Jones v. McDonald Farms, Inc., 24 Neb. App. 649 (2017), the defendant was incorporated as an S corporation in 1976 by a married couple. The couple had four children – two sons and two daughters. The sons began farming with their parents in the mid-1970s. Upon incorporation, the parents were the majority shareholders and the sons held the minority interests. One of the sons became corporate president when the father resigned in 1989 and the other son became the vice-president. The mother died in 2010 and her corporate stock shares passed equally to all four children. In 2012, the father gifted his stock equally to the sons and, after the gift, the sons each owned 42.875 percent of the corporate stock and the daughters each owned 7.125 percent.

The father died in early 2014 at a time when the corporate assets included 1,100 acres of irrigated farmland and dry cropland. The corporation, since 1991, leased its land to two other corporations, one owned by one son and his wife, and the other corporation owned by the other son and his wife. The land leases were 50/50 crop share leases with each son’s corporation performing all of the farming duties under the leases. In 1993, the corporation converted to a C corporation with corporate employees being paid in-kind commodity wages. For tax planning purposes, corporate net income was kept near $50,000 annually to take advantage of the 15 percent tax rate by timing the purchase of crop inputs, replacing assets and paying in-kind wages. The father and sons did not receive any cash wages, but did receive an amount of commodity wages tied to crop prices and yields – all with an eye to keeping the corporate net income low. Hence, the amount of commodity wages varied widely from year-to-year. The corporation’s CPA testified that he believed the high commodity wages in the later years was appropriate because of the amount of accrued unpaid wages since 1976. The CPA also testified that the corporation was not legally obligated to pay any wages, but that it was merely optional for the corporation to do so.

The corporation’s articles of incorporation required a shareholder to offer their shares to the corporation for purchase at book value before selling, giving or transferring them to anyone else. Shortly after her father died, the plaintiff, one of the daughters, offered to sell her shares to the corporation for $240,650 – the fair market value of the shares based on a December 2010 valuation done for purposes of the mother’s estate. The corporation, in return, offered to buy the shares for $47,503.90, the book value as of December 2011 less $6,000 due to a corporate loss sustained by the plaintiff’s failure to return a form to the local Farm Service Agency office.

The plaintiff sued in early 2013 seeking an accounting, damages for breach of fiduciary duty and conflicting interests, judicial dissolution of the corporation based on oppressive conduct, misapplication and waste of corporate assets and illegal conduct. The trial court denied all of the plaintiff’s claims, finding specifically that the payment of commodity wages and purchase of expensive farm equipment were not unreasonable or inappropriate.

On appeal, the appellate court affirmed. The appellate court, noting that while NE law does provide a remedy to minority shareholders for oppressive conduct, the court stated that the remedy of dissolution and liquidation is so drastic that it can only be invoked with “extreme caution.” The court noted that the plaintiff was essentially challenging the corporation’s tax strategy, and asserting that the corporation should be maximizing its income and paying dividends and the failure to do so constitutes oppressive conduct particularly because, as the plaintiff noted, the corporation had over $13 million in assets and no debt.

The appellate court disagreed with the plaintiff, and made the following specific findings:

  • A corporation is not required to pay dividends under state law, and the corporation had a long history of never paying dividends.
  • The high level of commodity wages in the later years was not oppressive because it made up for years the shareholders worked without compensation.
  • The plaintiff did not have a reasonable expectation of sharing in corporate profits because the plaintiff acquired her stock interest entirely by gift or devise and never committed capital to the corporation.
  • Since incorporation in 1976, no minority shareholder had ever been paid profits.
  • The payment of commodity wages was not illegal deferred compensation.
  • The corporation’s offer to pay book value for the plaintiff’s shares was consistent with the corporate articles of incorporation, and the plaintiff did not challenge the method by which book value was calculated.
  • The stock transfer restriction was upheld as enforceable contract.

Tax Planning Concerns

Commodity wages.  As the facts of the case indicated, the corporation leased its land to two other corporations, with each of the lessee corporations owned by a son that was a shareholder of the landlord corporation.  As noted, those sons were receiving commodity wages from the landlord corporation.  Unless the landlord corporation was materially participating in the lease, the income derived under the lease (whether in cash or crop-share) is a rent receivable.  Thus, the payment of commodity wages would trigger income to the corporation and payroll taxes to the sons at the time of the transfer of the commodity as a wage.  The commodities are rent and not inventory that the corporation raised.  While the corporation could pay commodity wages from its inventory (e.g., a crop that the corporation raises), it can’t pay commodity wages with a crop share that is classified as a rent receivable.  The outcome is different, however, if the corporation is materially participating under the lease in the production of the commodities.  In addition, that material participation must be achieved via the corporation’s employees. 

That last point is important.  Since material participation must be satisfied by the corporate employees, reasonable compensation must be paid for those services.  That compensation will either need to take the form of a landlord’s share of the rent or a portion of the crop that the corporation raised (via material participation under the lease). 

As for wages, an appropriate amount must be paid for services rendered.  If services are not rendered, no wages should be paid.  The point is that wages are not optional.  Dividends are optional.  However, the facts of the case indicated that the father (while living) and sons had numerous years where they did not receive any wages, with those unpaid wages being made up in later years in the form of high commodity wages.  That’s an interesting (and highly relevant) fact from a tax standpoint.  There are innumerable court cases addressing unreasonably high compensation (paid in order to lower C corporation income). As a landlord corporation under a crop share arrangement, the corporation provides the land and the tenant provides the services. Landlord services would be minimal.  Indeed, in the NE case, the court noted that each son’s corporation performed the farming duties – not the landlord corporation.  But, it was the landlord corporation that paid the commodity wages.  That could cause the IRS to assert that the compensation was unreasonably high.  Alternatively, if the landlord corporation were materially participating under the lease, a question could arise as to whether the 50-50 crop share arrangement sufficiently compensated the corporation for the material services that were rendered.   

Another concern with having unpaid wages is the lack of documentation. With documentation, though, the corporation would have a deferred compensation plan, subject to onerous taxes unless payment requirements are strictly satisfied.

Why were wages paid in-kind instead of in cash?  For agricultural labor, only cash wages are subject to Social Security tax.  Wages paid in-kind to agricultural labor are not subject to FICA tax, FUTA (Federal Unemployment Tax Act) tax, or income tax withholding, but they are subject to income tax.  I.R.C. §§3121(a)(8); 3306(b)(11).  In 1994, an IRS Task Force produced guidelines that set forth several factors as relevant in determining when a particular in-kind payment qualifies for the exemption.  To the IRS, the payment of at least some cash wages is important.  That’s another area of concern with the wage arrangement of the corporation in the NE case.

A drawback of paying wages-in kind is that they don’t generate W-2 wages for purposes of the domestic production activities deduction of I.R.C. §199.  They are also not considered wages for purposes of determining the amount of earnings in retirement.

Other tax issues.  Another question concerns the value of the corporate assets.  The court noted that the corporation had $13 million in assets.  Depending on the mix of corporate assets (land and non-real estate assets), the corporation might have triggered the personal holding company (PHC) tax.  I.R.C. §541.    If a C corporation has too much investment income, the PHC tax will apply.  When more than a single entity is utilized, the landholding C corporation will receive the bulk, if not all, of its income from leasing the land to the production entity or entities.  If the lease is not structured properly, the income under the lease can be construed as passive investment income which may trigger application of the personal holding company tax.  The personal holding company tax is levied at a 20 percent rate on undistributed personal holding company income, and serves as a “penalty tax” in addition to the corporation's income tax that is normally owed.    

To be a personal holding company, two tests must be met.  The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year.  Most farming and ranching operations automatically meet this test, and it was satisfied in the NE case.  The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted gross income (gross receipts reduced by production costs) comes from passive investment sources.  Rental income is included in adjusted ordinary gross income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and dividends for the taxable year equal or exceed the amount (if any) by which the corporation's non-rent personal holding company income for that year exceeds 10 percent of its ordinary gross income.  In other words, if the mixture of rental income and other passive income sources exceed 10 percent and the rental income exceeds 50 percent, the personal holding company tax could be triggered.  Thus, farming and ranching corporations engaged predominantly in rental activity may escape application of the personal holding company tax.  But if the corporation's non-rent personal holding company income (dividends, interest, royalties and annuities) is substantial, the corporation must make taxable dividend distributions to avoid imposition of the personal holding company tax.  Thus, for corporations owning agricultural land that is cash rented out and the corporation's only passive income source is cash rent, there is no personal holding company tax problem.  There is not enough detail provided by the NE court to make this determination.

Another possible complication is the accumulated earnings (AE) tax.  I.R.C. §531. The AE tax applies only to amounts unreasonably accumulated during the taxable year.  Thus, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax.  All corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax except for service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) where the amount is $150,000.  The accumulated earnings tax rate for tax years after 2012 is 20 percent. However, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax.  The tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business.   In the NE case, the corporation was deliberately leaving $50,000 of taxable income to be taxed.  If the corporation has a lot of investment assets, the IRS could seemingly make a strong argument that the corporation is subject to the AE tax. In a recent IRS Chief Counsel’s Advice (CCA), the IRS noted that the corporation could be held responsible for the AE tax without any investment assets. I blogged on the CCA and its implications in early January.  http://lawprofessors.typepad.com/agriculturallaw/2017/01/c-corporation-penalty-taxes-time-to-dust-off-and-review.html


There are other comments that could be made about the legal issues involving minority shareholder oppression, but today’s post is long enough already.  While the corporation and its majority shareholders prevailed in the NE case, care should always be taken by tax professionals when they provide testimony in cases that aren’t purely tax-related.  Some things, in that context, probably shouldn’t be commented on. 

May 26, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, May 24, 2017

Self-Employment Tax On Farming Activity Of Trusts


I.R.C. §1402(a) defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member.”

That seems fairly clear – the business activity must be carried on by and “individual.”  If that’s the case, that provides some planning opportunities for farm and ranch businesses (and other businesses too).  That’s what today’s post takes a look at, based on a piece that I wrote for the University of Illinois Tax Workbook in recent years.  That’s a workbook that is used at tax seminars in many states each fall and is a great resource for your tax library.

Business of a Trust Not Subject to Self-Employment Tax

The regulations provide that a trade or business must be carried on by an individual, either personally or through agents or employees. The regulations further provide “accordingly, income derived from a trade or business carried on by an estate or trust is not included in determining the net earnings from self-employment of the individual beneficiaries of such estate or trust.” Treas. Reg. §1.1402(a)-2(b).

As a result of this statutory and regulatory language, income derived from a business maintained by a trust (or an estate) is not included in determining net earnings from self-employment of the individual beneficiaries.  Thus, in situations where a trade or business is carried on by an estate or trust rather than an individual, the income derived from the entity is not includable in determining the self-employment earnings of an individual beneficiary (or executor) unless there is a basis for disregarding the entity for purposes of the Code. 

What type of a situation would serve as a basis for disregarding the entity (estate or a trust)?  One example would be where the grantor of the trust is also the trust beneficiary.  For example, in Huval v. Comr., T.C. Memo. 1985-568, a surviving spouse operated an oil and gas lease in her capacity as executrix of her husband’s estate, rather than in her individual capacity. That meant that the leasing business was conducted by the estate, and the Tax Court held that the lease income was not net earnings from self-employment for the surviving spouse.

What is a Trust?

A “trust” is subject to trust taxation, which means that self-employment tax savings can be achieved.  Treas. Reg. §301.7701-4(a) addresses the definition of trusts for purposes of the Code, noting that trusts generally refer to arrangements created by either will or inter vivos declaration for the purpose of either protecting or conserving property for beneficiaries.  Where the beneficiaries of the trust are the persons who created the trust, the trust will be recognized under the Code if it was created for the purpose of protecting or conserving trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them.  But, a trust that is treated as a grantor trust under the provisions of I.R.C. §§671-679 is treated as owned directly by the grantor. That’s because the grantor retains the control to direct the trust income or assets.  Consequently, trust taxation does not apply, and self-employment tax savings will not be achieved.

A “business trust” is not subject to trust taxation, and won’t result in saving self-employment tax.  Treas. Reg. §301.7701-4(b) addresses business trusts, describing them as arrangements where legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Code because they are not arrangements to protect or conserve property for beneficiaries. These trusts are described as being created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships under the Code.

Let’s take a look at an example.  Assume that Bob was a farmer at the time of his death.  When he died, his farm assets were placed in a trust created under the terms of his will.  Bob’s surviving widow, Brenda, was named as the sole trustee of the trust and the sole beneficiary of a QTIP trust and a credit-shelter bypass trust.  Both of these trusts became irrevocable upon Bob’s death.  Brenda participated in the operations and the management of the farming activity.  Brenda reported the income and the distributions from the trusts on her Form 1040 Schedule E where it was not subject to self-employment tax. 

This is the factual setting that the IRS was faced with in Tech. Adv. Memo. 200305001 (Jul. 24, 2002).  The IRS determined that the QTIP trust and the credit shelter bypass trust were trusts with a separate existence.  Thus, the pass-through income from the trusts was not deemed to be net earnings from self-employment to Brenda.  The trusts were not found to be business trusts whose separate existence would be ignored under the Code.  However, the IRS noted that there could be an issue of whether the wife, as trustee, received adequate payments for the services she performed for these two trusts, and suggested that a determination be made by the IRS Examination Division as to whether the payments that the wife received were reasonable and of sufficient amount for the services that she provided to these trusts.

Let’s change the facts slightly.  Assume that Jack died, and an irrevocable, testamentary trust went into effect as a result.  His surviving widow, Mary and their son, Doug, were the trustees and beneficiaries of the trust.  The trust paid a fee to Doug for managing the farming operation, and paid a fee to Mary for maintaining the farming records.  Doug and his mother reported the fees as self-employment income, but did not report the income received as beneficiaries of the trust as subject to self-employment tax. 

These facts were involved in Tech Adv. Memo. 200305002 (Jul. 24, 2002).  There, there IRS treated the trust as a separate entity with the result that the earnings were not subject to self-employment tax.  The trust was to be separately respected under the Code.   But, again, the IRS noted that there could be an issue of whether the wife received adequate payments for her services, and whether the son received reasonable and sufficient payments for his management activities.


These IRS Memos suggest that a trust can insulate the beneficiaries from SE income on an actively conducted farming operation, but only if two conditions are met:

  • The trust is created to preserve the property for another party or in a testamentary manner that suggests it is not merely an attempt to move business operations into a trust entity (i.e., it is not a business trust);
  • The trustees or other individuals rendering management or other services to the trust are reasonably compensated for their services in a manner that is subject to either FICA or self-employment With respect to the second issue, a testamentary trust can serve in much the same manner as an S corporation, where the issue at hand is the reasonableness of fees or compensation to those owners of the entity that also receive Schedule K-1 income exempt from self-employment tax.

As an additional thought, an individual receiving a distribution from a trust as a beneficiary who is also paid for trade or business services that the individual provides to the trust should be able to document that their compensation is reasonable based on what would have to be paid to a third party for the services. 


An active business conducted through a trust can achieve self-employment tax savings.  But, proper structuring is critical.  As is the case with other estate or business planning techniques, whether to use a trust to achieve self-employment tax savings is to be considered in light of a host of planning considerations, both tax and non-tax. 

May 24, 2017 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Monday, May 22, 2017

Employer-Provided Meals and Lodging


Meals and lodging furnished in-kind to an employee (including the employee’s spouse and children) for the convenience of the employer on the employer’s business premises are excluded from the employee’s gross income.  I.R.C. §119.  They are also deductible by the employer (as a non-cash fringe benefit) if they are provided in-kind.  I.R.C. §162.   

The IRS, at least in certain parts of the country, appears to have an audit program that examines farm and ranch corporations on the meals and lodging issue.  In light of that, today’s post takes a look at the basic rules and what might cause concern for the IRS.

Employer-Provided Lodging

In general. For the value of lodging to be excluded, the employer must furnish the lodging to the employee and the employee must be required to accept the lodging on the premises as a condition of employment and for the convenience of the employerI.R.C. §119(a)(2).  The term “lodging” includes such items as heat, electricity, gas, water and sewer service unless the employee contracts for the utilities directly from the supplier.  Rev. Rul. 68-579, 1968-2 C.B. 61.  The term also includes household furnishings and telephone services.  See, e.g., Turner v. Comr., 68 T.C. 48 (1977); Hatt v. Comr., T.C. Memo. 1969-229.  However, if the employee is required to pay for the utilities without reimbursement from the employer, the utilities are not furnished by the employer and are not excludible from income.  Turner v. Comr., 68 T.C. 48 (1977).  Also, the lodging must be provided “in-kind.”  Cash allowances for lodging (and meals) are includible in gross income to the extent the allowance constitutes compensation.

As a condition of employment. The employee must accept the employer-provided lodging as a condition of employment. That can only occur if the employee’s acceptance of the lodging is necessary for the employee to property perform their job duties. Thus, it makes no difference if the employee is required to accept the employer-provided lodging.  The key is whether the employer provided lodging is necessary for the performance of the employee’s duties.  Thus, the standard is an objective one and it is immaterial, for example, that corporate documents (such as a board resolution) require the employee to live in corporate-provided lodging. See, e.g., Peterson v. Comr., T.C. Memo. 1966-196; Winchell v. United States, 564 F. Supp. 131 (D. Neb. 1983).

Convenience of the employer.  With respect to employer-provided lodging, the “convenience of the employer test” is basically the same as the requirement that the lodging be provided as a condition of employment.   Thus, if the lodging meets the test as being provided as a condition of employment it will also be deemed to be provided for the convenience of the employer.  For example, in MaschMeyer’s Nursery, Inc. v. Comr., T.C. Memo. 1996-78, the petitioner, an agricultural nursery, provided its sole shareholder a residence at the nursery.  The petitioner claimed that the shareholder’s presence was necessary on a full-time basis as a security measure for the equipment, oversee employees and handle shipments that came in after normal business hours.  The Tax Court held that the provision of the lodging met the requirements of I.R.C. §119.

On the business premises. To be excluded from income, meals must be furnished “on the business premises” of the employer. §119(a)(1).  For lodging, the employees must be required to accept the “lodging on the business premises of his employer.”  Thus, both meals and lodging must be provided on the business premises.  The regulations specify that “business premises of the employer” generally means the place of employment of the employee.  Treas. Reg. §1.119-1(c). It doesn’t necessarily matter if the lodging is not physically contiguous to the actual business premises if the employee conducts significant business activities in the residence. See, e.g., Faneuil v. United States, 585 F.2d 1060 (Fed. Cl. 1978)In addition, it is immaterial whether the meals and lodging are provided on premises that the corporation leases rather than owns.  On this point, the regulations state, “For example, meals and lodging furnished in the employer’s home to a domestic servant would constitute meals and lodging furnished on the business premises of the employer. Similarly, meals furnished to cowhands while herding their employer’s cattle on leased land is regarded as being furnished on the business premises of the employer.”  Regs. §1.119-1(c)(1).

As noted above, whether the employer actually owns the property where the lodging (and meals) is provided is irrelevant.  The key is that the lodging (and meals) is provided on the business premises, and ownership has no bearing on that determination.

For additional caselaw on the “business premises” issue, see the following:

In most of the farm and ranch cases decided to date, whether the meals and lodging were provided “on the business premises” has not been an issue, but there are a few cases where it has been an issue.  The following cases illustrate the application in farm/ranch settings:

  • Peterson v. , T.C. Memo. 1966-196.
  • Grant Farms, Inc. v. Comr., T.C. Memo 1985-174

Exclusion of Employer-Provided Meals

On the business premises.  To be excluded from an employee’s income, the meals must be furnished on the employer’s business premises.  The “business premises” is the employee’s place of employment where the employee performs a significant portion of his duties or the employer conducts a significant portion of its business.  Treas. Reg. §1.119-1(c)(1); Rev. Rul. 71-411, 1971-2 CB 103.  Thus, the meals cannot be furnished at someplace that is merely near the place of employment or where significant duties are performed, but is a convenient place to provide the meals.

For the employer’s convenience.  The meals must also be provided for the convenience of the employer. If they are not, the value of the meals is subject to FICA and FUTA taxes.  Rev. Rul. 81-222,1981-2 C.B. 205.  The key is that the meals (or lodging) must not be intended as compensation.  On this point, an employment contract that fixes the terms of employment isn’t controlling, by itself.   The same is true for a state statute.  In essence, why an employer provides meals and lodging to employees is based on objective facts and not on stated intentions. There must be some reasonable connection between providing employees with meals and lodging and the business interests of the employer. 


Example:  FarmCo operates on property that it leases from its shareholders/officers. Farmco requires the corporate officers to be on the farm premises at all times to monitor activities and deal with issues as they come up.  Farmco reimburses the shareholders’ grocery expenses. In addition, the shareholders’ residence was on the farm and groceries were cooked in the shareholders’ home. 


This type of arrangement is problematic because IRS can make a decent argument that it appears to be for the employees’ convenience rather than that of the employer.  Also, it’s a problem if other employees aren’t similarly treated and the reimbursement isn’t necessary to unexpected corporate issues.  Also, a question can be raised as to whether the lease covers the residence on the property.  See, e.g., Dobbe v. Comr., T.C. Memo. 2000-330.    If it does, it’s best to have a written lease detailing the amount of rent the corporation is to pay and detailing the corporation’s access right to the residence.

Allowances?  Cash meal allowances or reimbursements are includible in gross income to the extent the allowance constitutes compensation.  Likewise, meal allowances provided on a routine basis for overtime work are not “occasional meal money” for purposes of the de minimis rules, and are treated as wages for FICA, and withholding purposes (and presumably for FUTA as well). 

What are “meals”?  As to what can count as “meals,” the U.S. Court of Appeals for the Third Circuit, in a case involving employer-provided housing that met the test for excludability (discussed later), held that the cost of groceries (including such things as napkins, toilet tissue and soap) were excludible from the employees’ income.  Jacob v. United States, 493 F.2d 1294 (3d Cir. 1974).  The court reached this conclusion because the employee was required to live on the business premises as a condition of employment. 

However, the U.S. Tax Court (and, on appeal, the Ninth Circuit) has reached a different conclusion.  See Tougher v. Comr., 51 T.C. 737 (1969).  Tougher involved an employee (taxpayer) of the Federal Aviation Agency (FAA) that was stationed on a remote island in the Pacific with only a handful of people and very few places to eat. As a result, the taxpayer bought groceries from the FAA commissary and used them to prepare meals at his home. The Tax Court determined that the groceries did not meet the definition of “meals” under I.R.C. §119.  The Tax Court’s decision was affirmed on appeal.  As a result, the IRS does not follow the Third Circuit’s opinion outside of the Third Circuit, and takes the position in those jurisdictions that the value of such items is wages for FICA purposes. 

The Tax Court got another chance to deal with the “groceries as meals” issue in a 1973 case.  In Harrison v. Comr., T.C. Memo. 19810-211, two farm families incorporated a farming operation.  They lived on the farm and were also corporate employees.  The corporation purchased groceries that the farm wives used to prepare meals for all of the family members and hired help.  The Tax Court, finding that the groceries counted as “meals” for purposes of I.R.C. §119, determined that the wives had a duty as employees of the corporation to buy the groceries and prepare meals that were then provided to all of the corporate employees.  Construed in that light, the groceries were “meals.”

As an additional note, meals provided without lodging can also qualify under I.R.C. §119 if they are consumed on the business premises.  Thus, meals provided to farm employees in the field during harvesting and planting would be covered.  But, if the employees take a break and drive to town to eat meals, the cost would not be deductible.

Treatment of meals as a fringe benefit.  If more than one-half of the employees to whom meals are provided on an employer’s premises are provided for the convenience of the employer, then all of the meals are treated as furnished for the employer’s convenience.  I.R.C. §119(b)(4).  If that test is met, the value of all meals is excludible from the employee’s income and is deductible by the employer.

Employee option.  If employees have the option of not purchasing meals provided by the employer at a cost, the IRS has taken the position that the excess of fair market value over the price of the meals is taxable income to the employees.  Priv. Ltr. Rul. 7740010 (Jun. 30. 1977).

What About Partnerships? 

Generally, a partner is treated as a self-employed owner of the business rather than an employee. So, by its terms, I.R.C. 119 does not apply.  However, it can apply when a partner transacts with the partnership in a non-partner capacity. I.R.C. §707(a).  The regulations say that this could occur in “the rendering of services by the partnership to the partner or by the partner to the partnership.  Treas. Reg. §1.707-1(a).  A key case supporting the application of I.R.C. §119 in the context of a partnership is Armstrong v. Phinney, 394 F.2d 661 (5th Cir. 1968).  See also Papineau v. Comr., 16 T.C. 130 (1951), non-acq., 1952-2 C.B. 5; but see, Comr. v. Doak, 234 F.2d 704 (4th Cir. 1956); Moran v. Comr., 236 F.2d 595 (8th Cir. 1956); Comr. v. Robinson, 273 F.2d 503 (3d Cir. 1959), cert. den., 363 U.S. 810 (1960).  In a case involving a ranch partnership, the managing partner had to include amounts received from the partnership for meal reimbursements in gross income.  Wilson v. United States, 376 F.2d 280 (Ct. Cl. 1967).  

Relatedly, an S corporation is not a “corporation” for purposes of I.R.C. §119.  Dilts v. Comr., 845 F. Supp. 1505 (D. Wyo. 1994).


Employer-provided meals and lodging is an important fringe benefit that corporations can provide for their employees.  But, it is important to properly structure such arrangements within the confines of the guidelines set forth by the IRS and the courts.

May 22, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Thursday, May 18, 2017

Insights Into Handling IRS Disputes


Last month, U.S. Tax Court Judge Elizabeth Paris spent at day at Washburn Law School at my invitation.  I have known Judge Paris for over 20 years, and it was a delight to see her again and spend the day with her.  She had five events during the day, including an open session for the students and a continuing education event for lawyers and other tax professionals.  During these two sessions, Judge Paris provided great insight into client representation in tax matters, and handling a tax case through the process all the way through to the Tax Court.

Today, I would like to share the insights of Judge Paris based on my notes of her discussions.  I believe that those of you who represent clients in tax matters will find this very helpful.  Even if you don’t represent clients in tax matters, I trust that you will find this information useful.

Tax Law

Judge Paris made the point that many areas of the tax law are neither black or white, but many different shades of grey.  The complexity of the Code and regulations fosters this, and the outcome of cases that end up before the Tax Court are often heavily fact-dependent.  In addition, the IRS not infrequently takes a position on an issue that is questionable or is contrary to existing caselaw.  That is a frustrating aspect of tax practice.  No taxpayer wants to have correspondence from the IRS, and a goal of many practitioners is to ensure that a position taken on a return will not generate any interest from the IRS.  But, when a taxpayer does get a Notice from the IRS that asserts a deficiency, Judge Paris pointed out that procedure is very important. 

Audits and Responding to An IRS Notice

Most IRS audits are not in-person.  Instead, they are commonly done via correspondence.  Often, the initial contact will involve the IRS seeking additional information from the taxpayer to clarify something on the return.  Alternatively, if the taxpayer agrees with the additional tax asserted, the option exists to sign the form and mail it back.  If the amount in issue is small, it may be best to pay the additional amount and get the matter closed instead of risking opening up other areas on the return for inspection.  On the other hand, if the taxpayer doesn’t respond to the IRS correspondence, the next item received might be an Examination Report.  This is commonly known as a “30-day” letter.  The taxpayer has 30 days to respond with a “protest” letter that explains the taxpayer’s position.  The IRS may agree and close the matter, but usually it rejects the taxpayer’s explanation and transfers the matter to the IRS Office of Appeals. 

Unfortunately, it is not uncommon for the reasons given for the IRS rejection to not match-up with the reasons the taxpayer provided.  That’s where things, hopefully, can get straightened out at Appeals.  When I was in full-time practice, my experience with the IRS Appeals Office (out of Omaha at that time) was good.  You actually got to sit down with a person well-versed in tax law that had lots of experience in handling complicated tax matters – even agricultural tax matters.  Unfortunately, the IRS has put in place a new procedure that eliminates the possibility of a face-to-face meeting with an IRS Appeals Officer.  There is no longer a right to an in-person appeal.  Instead, what the taxpayer (and their representative) is left with is dealing with an “appeals tax specialist.”  From conversations that I have had with practitioners, what I hear is that these persons lack the training and experience of the persons I dealt with years ago in Omaha. 

If the matter is not resolved at Appeals (or the taxpayer doesn’t respond to the 30-day letter) the IRS will issue a Notice of Deficiency.  This is also known as a “statutory notice of deficiency” or SNOD.  It may also be referred to as a “90-day letter.”   It’s a legal notice informing the taxpayer that receives it that the IRS has determined there to be a deficiency associated with the tax return.  The IRS must issue the SNOD before it can assess additional income, estate, gift or certain excise taxes unless the taxpayer agrees to the additional assessment.  I.R.C. §§6212; 6213.  The SNOD is a legal determination, and it is presumed to be correct.  It will show how the deficiency was computed and will inform the taxpayer of the right to petition the Tax Court to dispute what the IRS is proposing as an adjustment to the tax liability in the SNOD.  The taxpayer has 90 days to respond, and that response is filing a petition in the U.S. Tax Court or paying the additional tax asserted and filing a refund suit in the federal district court.

U.S. Tax Court

As Judge Paris pointed out, a case before the Tax Court could be tried under simplified procedures if the taxpayer chooses to not be represented by counsel and the amount in controversy is less than $50,000.  For these cases, the Tax Court will issue an “S” opinion which cannot be appealed to the applicable U.S. Circuit Court of Appeals and cannot be cited as precedence by other taxpayers.  In other cases (those not qualifying for “S” status), the Tax Court will issue either a Memorandum opinion or a “Full” opinion if the case involves an issue that the court has not squarely addressed before. 

Judge Paris noted that while the Tax Court building itself is in Washington, D.C., and that is where the law clerks are located, the judges (19 of them) travel around the country to federal courthouses to conduct trials.  She discussed where cases can be heard and the application of state law to many of the Tax Court’s decisions.  She also pointed out that the Tax Court’s procedural and evidentiary rules are streamlined.  There is no jury.  The case is tried directly to the judges.  The taxpayer can call witnesses, and often many issues are stipulated to with the IRS before they are presented to the court. 

When the Tax Court issues an opinion, that opinion (unless it is an “S” opinion) can be appealed to the Circuit Court of Appeals where the case arose from.  One of the questions that Judge Paris received involved the IRS practice of issuing an “Action on Decision” indicating that it will not follow the Tax Court’s decision (in those cases where the Tax Court has ruled against the IRS) in subsequent cases.  This is known as a “non-acquiescence.”  For those of us that deal with ag tax cases, this is the technique that the IRS utilized in the Morehouse CRP litigation where it won in the Tax Court and then lost in the Eighth Circuit Court of Appeals.  The IRS “non-acquiesced” to the Eighth Circuit’s opinion.  IRS can also issue a “non-acquiescence” to a Tax Court opinion and continue to litigate the matter to a different Circuit in hopes of a different result.  While Judge Paris acknowledged the frustration to taxpayers and tax practitioners of an administrative agency such as the IRS taking such a position, she noted that it is within the IRS’ province to do so. 

Judge Paris also noted that an alternative to going the Tax Court route is for the taxpayer to pay the asserted deficiency and file a refund suit in the federal district court.  But, she noted that many cases may not merit that approach because of the amount involved. 


The “jurist in residence” day at Washburn Law School for Judge Paris was a great day for the students and the faculty.  It’s not every day that we get to “rub shoulders” with a sitting U.S. Tax Court Judge.  Judge Paris also made presentations in two different classes during her day at the law school, giving the students direct access to her.  It helps put a practical application to the concepts that the students are learning in class and will make them better lawyers once they finish law school.  After all, that’s what it’s all about.

May 18, 2017 in Income Tax | Permalink | Comments (0)

Tuesday, May 16, 2017

Summer Farm Tax/Farm Estate and Business Planning Conference


This coming July 13-14 the Washburn University School of Law in conjunction with the Kansas State University, Department of Agricultural Economics and the Wyoming Society of CPAs are co-sponsoring a two-day CLE/CPE conference on agricultural tax and estate and business planning at Sheridan College in Sheridan, Wyoming.  The event will also be streamed live over the internet.  If you represent agricultural clients in the handling of tax work or the preparation of estate and business plans, this conference will be tailor-made for you.  The presenters will be myself and Paul Neiffer of CliftonLarsonAllen.  Paul and I have worked together for several years and it will be a joy to do join forces again in Sheridan.

Day 1 – Farm and Ranch Tax Day

Thursday, July 13, will be devoted to agricultural tax-related topics.  We will start the day with an overview of recent developments in ag taxation.  While it appears doubtful at this time that there will be any significant tax legislation to discuss in July, there have been many key court developments and IRS rulings impacting agriculture that will be covered.  We will also have sessions on this day concerning farm income averaging, financial distress and income tax deferral opportunities for ag clients.  During the afternoon session, we will take a deep look at the continued IRS attack on the cash method of accounting, including analysis of the recently decided Agro-Jal Farms case from California and the Estate of Backemeyer case from Nebraska.  We will also provide an update on the capitalization/repair regulations, and go over in some detail various tax planning strategies for farmers and ranchers.  To round out the day will be coverage of numerous miscellaneous ag tax topics.

Day 2 – Farm and Ranch Estate and Business Planning

On Friday, July 14, we will focus on estate and business planning issues for farm and ranch clients.  Any legislative developments will be covered along with their impact on the planning process, as will recent case and rulings.  We will also cover the use of charitable trusts, and the present planning landscape in light of higher exemptions and portability.  Also addressed on Friday will be FSA planning and tax issues associated with the sale of a decedent’s residence.  The afternoon session will focus on how the business structure can impact self-employment tax liability, long-term care planning strategies, profits interests and portability planning.


As noted above the two-day session will be webcast.  Glen McBeth, Instructional Technology at Washburn Law School, will be handling the webcasting.  You will be able to see and hear both myself and Paul and interact with us if you wish. 

Saturday Event

There are plenty of things to see and do in the Sheridan area if you are attending the conference in person.  Sheridan is just east of the Bighorn Mountains and there are plenty of things to see and do.  The 87th Annual PRCA Sheridan Rodeo will be on while we are there.  It starts on July 12 and goes through the 15th.  Paul and I are planning a fishing event for Saturday the 15th.  If, you would like to join us, please let us know so that we can plan accordingly. 


We certainly hope that you will join us in Sheridan.  If you can’t join in person, you can join via the web.  Either way, the conference will be a great opportunity for you to pick up concepts that you can use with your clients.

You can learn more about the conference and register here:  http://washburnlaw.edu/employers/cle/farmandranchincometax.html

May 16, 2017 in Business Planning, Estate Planning, Income Tax | Permalink | Comments (0)

Friday, May 12, 2017

Like-Kind Exchanges, Reverse Exchanges, and the Safe Harbor


Generally, an exchange of property for other property is treated as a sale with gain or loss being recognized on the transaction.  I.R.C. §§61(a)(3); 1001.  However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment.  I.R.C. §1031.  Federal and state income tax is not avoided, it is simply deferred until the replacement property is sold (except that gain is immediately recognized to the extent of any boot or unlike property received in the exchange). The rationale is that the replacement property is viewed as causing no material change in the taxpayer’s economic position.  It’s just a continuation of the original property. 

Like-kind exchanges are popular in agriculture for various reasons.  Those reasons can include the facilitation of an estate or business plan, Medicaid asset preservation planning, or simply for tax deferral reasons.  Sometimes an exchange is straightforward as a direct, two-party exchange.  Other times it is a “deferred” exchange or a “reverse” exchange.  When an exchange is other than a direct, two-party exchange, special rules must be followed.  Several years ago, the IRS established a “safe harbor” for such exchanges, but recently the U.S. Tax Court said that a transaction that wasn’t within the confines of the safe harbor still qualified for tax deferral.

The implications of the Tax Court decision on deferred or like-kind exchanges is our focus today. 

Like-Kind Exchange Details

With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class.  Also, property is of a like-kind to property that is of the same nature or character.  Like-kind property does not necessarily have to be of the same grade or quality.  In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis.  Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.

With respect to real estate, a much broader definition of like-kind applies.  Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment.  Even water rights, if they are not limited in duration, can be like-kind to a fee interest in land.  See, e.g., Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).  Thus, agricultural real estate may be traded for residential real estate.  See also Treas. Reg. §1.1031(a)-(1)(c).  However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise.  Many farm depreciable buildings and structures are I.R.C. §1245 property.  For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate.  If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property.  IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange. 

Deferred exchanges.  An exchange may qualify for the like-kind exchange treatment even if the replacement property is received after the relinquished property has been given up.  I.R.C. §1031(a)(3) and Treas. Reg. §1.1031(k)-1.  This is known as a deferred exchange, and a qualified intermediary (Q.I.) is to be used to facilitate the exchange.  The Q.I. is a party unrelated to the taxpayer that, pursuant to a written agreement with the taxpayer, holds the proceeds from the sale of the relinquished property in trust or an escrow account.  The Q.I. takes title to the property that is sold (the relinquished property) and receives the sales proceeds.  This is done to ensure that the taxpayer is not in constructive receipt of the sale proceeds.

After the relinquished property is transferred, replacement property must be identified within 45 days after the date of the transfer of the relinquished property, and the replacement property must be received before the earlier of 180 days or the due date of the income tax return, including extensions, for the tax year in which the relinquished property is transferred.  Treas. Reg. §1.1031(k)-1(b). 

Reverse exchanges.  With a reverse exchange, the taxpayer receives the replacement property before the transfer of the relinquished property.  Often, a reverse exchange is facilitated by a “parking” transaction or a “build-to-suit” transaction where the replacement property is “parked” with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed.

Safe Harbor.  While the Code doesn’t address reverse exchanges and regulations haven’t been developed to provide guidance, the IRS did issue a safe harbor in 2000 for such transactions.  Rev. Proc. 2000-37, 2000-2, C.B. 308.  Under the safe harbor, the Q.I. must hold the property for the taxpayer’s benefit and be treated as the beneficial owner for federal tax purposes.  In addition, for the safe harbor to apply, the IRS said that the 45-day and 180-day requirements must be met.  The IRS made no comment on the tax treatment of “parking” transactions that don’t satisfy the safe harbor.  But, a major difference between the safe harbor and the Treasury Regulations governing deferred exchanges is that, under the safe harbor, the Q.I. must take title and beneficial ownership of the replacement property.  In a deferred exchange, the Q.I. only need “facilitate” the exchange.  That doesn’t require taking legal title.  Later, in 2004, the IRS tightened the safe harbor so that it didn’t apply to taxpayers who acquire replacement property that the taxpayer or a related party owned before the exchange.  Rev. Proc. 2004-51, 2004-2, C.B. 294. 

Clearly, with Rev. Proc. 2004-51, the IRS didn’t want taxpayers to use reverse exchanges to reinvest proceeds from the sale of one property into improvements to other real estate that the taxpayer had previously owned.  For example, assume that a farmer owns a tract of land that is not in close proximity to his primary farming operation and has become inconvenient to operate.  Thus, the farmer wants to sell the tract and use the proceeds to build a livestock facility on other land that he owns that is adjacent to his farming operation.  In an attempt to structure the transaction in a manner to qualify as a tax-deferred exchange, the farmer transfers title to the land where the livestock facility will be built to a Q.I.  The farmer provides the financing and the Q.I. has the livestock facility built.  The farmer then transfers the tract that he desires to dispose of to the Q.I. and the Q.I. sells it and uses the sale proceeds to retire the debt on the livestock facility.   Because the farmer owned the land on which the livestock facility was built before the exchange occurred, Rev. Proc. 2004-51 would operate to bar the transaction from tax-deferred treatment. 

2016 Case

In Estate of Bartell v. Comr., 147 T.C. No. 5 (2016), a taxpayer (a drugstore chain) sought a new drugstore while it was still operating an existing drugstore that it owned.  The taxpayer identified the location where the new store was to be built, and assigned its rights to the purchase contract in the property to a Q.I. in April of 2000.  The taxpayer then entered into a second agreement with the Q.I. that provided that the Q.I. would buy the property, with the taxpayer having the right to buy the property from the Q.I. for a stated period and price. The taxpayer, in June of 2001, leased the tract from the Q.I. until it disposed of the existing drugstore in September of 2001.  The taxpayer then used the proceeds of the existing drugstore to buy the new store from the intermediary, with the transaction closing in December of 2001.  Because the new store was acquired before the existing store was disposed of, it met the definition of a reverse exchange.  However, the safe harbor did not apply because the exchange was undertaken before the safe harbor became effective.  If the safe harbor had applied, the transaction would not have been within it because the Q.I. held title for much longer than 180 days.  Despite that, the IRS nixed the tax deferral of the exchange because it viewed the taxpayer as having, in substance, already acquired the replacement property.  In other words, it was the taxpayer rather than the Q.I. that held the burdens and benefits of ownership before the transfer which negated income tax deferral.  An exchange with oneself is not permissible.    As a result, eliminated was the deferral of about $2.8 million of gain realized on the transaction in 2001.

The Tax Court noted that existing caselaw did not require the Q.I. to acquire the benefits and burdens of ownership as long as the Q.I. took title to the replacement property before the exchange.  The Tax Court noted that it was important that the third-party facilitator was used from the outset.  While the safe harbor didn’t apply to the transaction, the Tax Court noted that 45 and 180-day periods begin to run on “the date on which the taxpayer transfers the property relinquished in the exchange,” and that the taxpayer satisfied them.  The Tax Court also noted that caselaw does not impose any specific time limits, and supported a taxpayer’s pre-exchange control and financing of the construction of improvements on the replacement property during the time a Q.I. holds title to it.  The taxpayer’s temporary possession of the replacement property via the lease, the court reasoned, should produce the same result.      


What impact does the court’s decision have on the safe harbor?  For starters, even though the safe harbor didn’t apply in the case, the court’s decision certainly illustrates that the safe harbor only applies with respect to reverse exchanges.  Another point is that because the facts of the case involved pre-2004 years, the Tax Court did not need to address Rev. Proc. 2004-51 and how the IRS tightened the screws on the safe harbor at that time.  That means that Estate of Bartell probably shouldn’t be relied too heavily upon and a reverse exchange transaction should be structured to come within the safe harbor, as modified by Rev. Proc. 2004-51.  But, the safe harbor is just that – a safe harbor. 

May 12, 2017 in Income Tax, Real Property | Permalink | Comments (0)

Wednesday, May 10, 2017

The Necessity Defense To Criminal Liability

In general, the law only punishes those individuals who have the capacity to make a moral choice of whether to engage in the prohibited behavior.  Consequently, insane persons who commit crimes are generally believed to lack the moral fault necessary for punishment.  Similarly, persons below a certain age are deemed to lack the full capacity for criminal liability and are typically liable only as juvenile delinquents.  Likewise, those who commit crimes while voluntarily intoxicated are liable for their behavior, though sometimes at a lesser level.

Sometimes, however, conduct that would otherwise constitute a crime is not because it is deemed necessary.  That’s an issue that sometimes arises in agriculture.

Necessity - Defined

The Model Penal Code (MPC) states that conduct that is believed to be necessary to avoid a harm or evil to oneself or to another is justifiable, provided that the harm or evil sought to be avoided is greater than that sought to be prevented by the law defining the offense charged, and the law does not provide another exception or defense.  Under a necessity defense, for example, property may be destroyed to prevent the spread of a fire or a speed limit may be violated in pursuing a suspected criminal.

In 1884, in a case brought before the Queen's Bench in England, the court completely rejected the necessity defense.  R. v. Dudley & Stephens, 15 Cox Crim. Cas. 624 (QB 1884). The defendants, while adrift on a lifeboat about 1,000 miles from land, killed a weak and sick boy, and fed upon his body to avoid their own death by starvation.  The Queen's Bench found that this act constituted willful murder and sentenced the defendants to death, the only penalty then available for murder.  Later, the Crown commuted the sentence to six-months imprisonment.  In the United States, however, the approach of the English court has been rejected.

Wyoming Case

In a prominent Wyoming Supreme Court decision in 1962 (Cross v. State, 370 P.2d 371 (Wyo. 1962)), the court found the defendant not guilty of illegally shooting game animals in defense of his property due to the constitutional guarantee that one cannot be deprived of property without due process of law.  Under the facts of the case, a rancher was charged on six counts for various acts associated with shooting two moose in violation of Wyoming law.  He plead not guilty, but the jury found him guilty on all of the charges.  The problem stemmed from a large herd of wild game in a nearby refuge that followed natural water courses and creek bottoms in the winter time in search of food that caused them to ultimately gather on the defendant’s ranch.  The wild game, including a large herd of moose, did serious and substantial damage to the defendant’s ranch by consuming pasture and other forage that was for the defendant’s livestock.  The wild game also prevented the production of hay and other natural grasses on the defendant’s ranch, as well as destroying fences.  Overall, the defendant’s ranching operations were substantially interrupted. 

Because of these problems, the defendant sought help from the Wyoming State Game and Fish Department, and ultimately ended up in litigation designed to induce the Department to enforce sufficient controls to protect his ranch and residents in the area.  The Department and the defendant took various measures to keep the moose away, but to no avail.  The two moose at issue were in feeding in the defendant’s meadow and he tried to “spook” them away.  One of them ran into his fence and got entangled in the wire.  When the moose tried to free itself, it instead tore down a considerable amount of good fence.  The defendant shot the moose to protect his property from further destruction.

After being charged, the defendant plead that he was justified in protecting his private property.  While the trial court disagreed with the defendant, the Wyoming Supreme Court reversed and dismissed the complaint.  The state claimed that the defendant had violated the state’s game law.  However, the Wyoming Supreme Court noted that the power of the state cannot conflict with constitutional provisions.  Framed that way, the issue was whether the state could bar the defendant from protecting his property from the depredations of wild animals.  The court determined that the defendant should not be penalized because the killing of the moose was reasonable necessary (based on the facts) for the protection of his private property.  The court did emphasize that before force can be taken to protect one’s property from wild animals that are protected by law, a person must use every available before killing the animals.  Then, the property owner can use only such force as is reasonably necessary and suitable to protect the private property and that force must be what a reasonably prudent person would use under the circumstances. 

Defending Property – Generally

In certain parts of the United States damage to crops, poultry and livestock by wildlife is a significant concern.  All states have criminal statutes that prohibit the taking of protected wildlife out of season and without a license.  However, a broader question is whether such a statute violates a state Constitutional provision vesting state citizens with certain inalienable rights – including the right to protect one’s property. For instance, the Iowa Constitution provides that, "All men and women are, by nature, free and equal, and have certain inalienable rights among which are those of enjoying and defending life and liberty, acquiring, possessing and protecting property, and pursuing and obtaining safety and happiness.”  Iowa Const. art. I, §1.

The Constitutional defense of property provisions most often make a difference in cases where the defendant claims a right to kill wild animals to protect property.  Courts considering these cases have read the right to protect property as a judicially enforceable constitutional right that trumps state statutes and regulations.  The longest line of such cases comes from Pennsylvania, where, from 1917 to 2000, the courts held that the constitutional right to protect property entitles landowners and their agents to kill wild animals that are threatening the landowner's crops, and that it is unconstitutional for state game laws barring the killing of wild animals to be applied in such situations.  Courts from Iowa, Kentucky, Montana, New Hampshire, and Ohio have taken the same view.  Courts from Alabama, South Carolina, Washington, and Wyoming have taken this view even though the respective state constitutions do not have an express provision for the protection of property. 

In a 1997 Ohio case, State v. Troyer, No. 97CA0015, 1997 Ohio App. LEXIS 5207 (Ohio Ct. App. Nov. 19, 1997), the defendant’s primary source of income was from the raising of exotic and domestic birds on his farm.  To combat the threat from great horned owls preying on his birds, the defendant erected traps at various locations on the farm near where his birds were located.  He was charged and convicted of violating a state statute which provided that “…hawks or owls causing damage to domestic animals or fowl may be killed by the owner of the domestic animal or fowl while such damage is occurring.”  The State claimed that the defendant was attempting to take or kill an owl at a time when damage to his property was not occurring.  The defendant claimed that waiting until an owl had actually caught one of his birds in its beak would be too late to prevent damage to his property.  On appeal, his conviction was reversed on the basis that the statute unconstitutionally abridged the defendant’s right to protect his property.  The court noted that the statute should be construed in such a manner to allow the defendant to use such force as is reasonably necessary to protect his property from predatory owls.

Under the MPC, the necessity defense is limited to those situations where the harm or evil sought to be avoided is greater than that sought to be prevented by the law defining the offense charged, and a legislative purpose to exclude the justification claimed does not plainly appear.  MPC §3.02


It is certainly frustrating for farmers, ranchers and rural landowners to have property damaged or destroyed by wildlife.  If the wildlife are protected game under state law, it’s important to know your rights before taking action to remedy the situation. 

May 10, 2017 in Criminal Liabilities | Permalink | Comments (0)

Monday, May 8, 2017

Special Use Valuation and Cash Leasing


Most assets are valued at fair market value as of the date of the decedent’s death.  The IRS defines fair market value as the price at which a willing buyer and a willing seller would exchange the property, neither being under any compulsion to buy or sell and each having full knowledge of all relevant facts.  Treas. Reg. § 20.2031-1(b).  For stored grain, for example, fair market value is what the elevator would pay.  For feed on hand at death, selling price is an appropriate measure of fair market value.

A major exception to the general valuation rule is special use valuation. I.R.C. §2032A.  The provision contains many complex rules, and the proper type of lease arrangement is a significant issue for many estates seeking to qualify to make a special use valuation election or avoid having to refund the taxes saved by the valuing farm or ranch real estate at the lower use value amount. 

Cash leases and special use valuation is today’s topic. 

Special Use Valuation 

The only major exception to the willing buyer/willing seller test is special use valuation of land used in a farming or ranching business. I.R.C. § 2032A.  Special use valuation allows the executor of an estate to make an election on the estate’s return to elect to value real property devoted to farming or ranching (or other closely-held businesses) at its special use or “use” value rather than its fair market value.  This valuation provision, however, cannot reduce the gross estate by more than $1,120,000 (for 2017).  Consequently, special use valuation has the potential to be an enormous federal estate tax saver for agricultural estates and can easily trim more than $100,000 off the federal estate tax bill with the right set of facts.  Theoretically, the maximum saving could be $448,000 (40 percent of $1,120,000) in 2017, but savings of that magnitude are unusual. 

The idea behind the provision is to make it easier for a family farming or ranching business to continue in operation without losing some of the land and other assets to pay the federal estate tax bill.  That was a particular concern when the exemption from federal estate tax was much lower than it is today, but with the increase in land values in recent years (with some pullback in recent months) special use is still important.  It also is useful for farming operations that are experiencing upward price pressure on land values due to the potential for commercial/residential development, but where the family wants to continue farming. 

A special use valuation election requires a lot of work for the practitioner.  Not only does a great deal of data have to be acquired in determining the special use value of the decedent’s land, a decision has to be made on how much of the land to make the election on, and each pre-death requirement must be satisfied so that the election can be made.  In addition, there are numerous post-death requirements that must be satisfied for 10 years after the date of death.  Those rules are in place to ensure that the provision is limited in use to those that are truly farmers, and to make sure that the land continues to be farmed by the decedent’s family for at least 10 year after the decedent dies.

Cash leasing.  There are special rules that apply to leases.  This is a big issue for estates where the special use valuation election is being considered to be utilized or has been made.  In the pre-death qualification period, cash renting to a member of the family or family-owned entity is permissible. Treas. Reg. §20.2032A-3.  However, the land must not be cash rented to anyone else. In the post-death period the rule is different. 

Specifically, there can be no cash renting in the post-death period, with three exceptions:  (1)  a surviving spouse can cash rent to members of the surviving spouse’s family (I.R.C. §2032A(c)(7)(E)); (2)  cash renting is permissible during a two-year grace period which extends for two years after the date of death; and (3) a lineal descendant of the decedent can rent the land on a “net cash basis” to a member of the lineal descendant’s family.  If the post-death bar on cash leasing (outside of the exceptions) is violated, then the tax saved by making the election must be paid back, with interest.  This is known as “recapture.”

So, if the land isn’t leased to a family member pre-death, can the estate make the special use election?  What type of lease qualifies post-death? If the decedent was an active farmer at the time of death, then there is no problem.  If the decedent was a landlord, the rules require the decedent to have borne the risk of production and risk of price change for a set period of time before death if the lease isn’t to a family member.  That means a crop-share/livestock share lease that subjects the landlord’s share to self-employment tax.  Post-death, each qualified heir must have an equity interest in the operation. I.R.C. § 2032A(c)(6)(A).  Failure of a qualified heir to meet the qualified use test causes recapture with respect to that heir’s interest.  As noted above, that means cash renting in the recapture period outside of the two-year grace period triggers recapture, except for cash leases by surviving spouses to members of the surviving spouse’s family, and, cash leases by a lineal descendant of the decedent to a member of the lineal descendant’s family.

Other Rules

Special use valuation is a complex provision with many requirements that must be satisfied before death, and numerous requirements that the heirs must satisfy for 10-years post-death.  Only those estates comprised of a significant amount of farm land and farm real and personal property that has been owned and operated as a farm for a set amount of time before death is will qualify to make the election.  In addition, the elected land must pass in a prescribed manner to qualified heirs.  Not every person that is typically thought of as a family member counts for purposes of I.R.C. §2032A. 


Special use valuation is a useful tool for some farm and ranch estates where the intent is to continue the farming or ranching business after the death of a family member.  But, if a lease is involved, it must be the right type of lease.  Cash leasing can cause problems.  However, surviving spouses have a special rule that applies to them when it comes to cash leasing land.  They can cash rent to a member or their family.  But, check the rules to make sure that the tenant is actually a member of the family as defined by the statute. 

To restate, special use valuation is a very complex part of the Code.  Today’s post has given only a cursory review of a piece of the statute. 

May 8, 2017 in Estate Planning | Permalink | Comments (0)

Thursday, May 4, 2017

Discounting IRAs for Income Tax Liability?


On a daily basis, I field many questions from practitioners, farmers, ranchers, agribusiness professional and others.  Some areas of tax and ag law seem to generate more questions than others and, of course, the facts behind each question often dictate the correct answer.  But, sometimes a question comes in that I have never had before.  I recently got a new one – when valuing an individual retirement account (IRA), is the potential federal income tax liability to the beneficiaries to be considered? 

Valuation discounting and IRAs, that’s today’s topic.

Discounting Basics

Valuation discounts have been in the news recently.  Last fall the IRS issued new I.R.C. §2704 proposed regulations that could seriously impact the ability to generate valuation discounts for the transfer of family-owned entities.  While it doesn’t look likely now that the proposed regulations will be finalized, if they do become finalized in their present form, they would largely eliminate the ability to derive valuation discounts through various estate planning techniques.

Over the past few decades, valuation discounting through the use of family-owned business entities has become a popular estate and gift tax planning technique.  If structured properly, the courts have routinely validated discounts ranging from 10 to 45 percent.  Valuation discounting has proven to be a very effective strategy for transferring wealth to subsequent generations.  It is a particularly useful technique with respect to the transfer of small family businesses and farming/ranching operations.  Similar, but lower, valuation discounts can also be achieved with respect to the transfer of fractional interests in real estate. 

The basic concept behind discounting is grounded in the IRS standard for determining value of a transferred interest – the willing-buyer, willing-seller test.  In other words, the fair market value of property is the price it would changes hands at between a hypothetical willing-buyer and a willing-seller, with neither party being under any compulsion to buy or sell.  Under this standard, it is immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller.  Thus, there is no attribution of ownership between family members that would change a minority interest into a majority interest.

Discounting Possibilities

Family limited partnership (FLP).  The principal objective of an FLP is to carry on a closely-held business where management and control are important.  FLPs have non-tax advantages, but a significant tax advantage is the transfer of present value as well as future appreciation with reduced transfer tax.  See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235.  Commonly in the ag setting, the parents contribute most of the partnership assets in exchange for general and limited partnership interests.  However, as the use of FLPs expanded, so did the focus of the IRS on methods to avoid or reduce the discounts.  In general, FLPs have withstood IRS attack and produce significant transfer tax savings.  But, there are numerous traps for the unwary.  Formation shortly before death can result in the FLP being disregarded for valuation purposes.  See, e.g., Priv. Ltr. Rul. 9719006 (Jan. 14, 1997); Priv. Ltr Rul. 9725002 (Mar. 3, 1997).  Indeed, if the only purpose behind the formation of a family limited partnership is to depress asset values, with nothing of substance changed as a result of the formation, the restrictions imposed by the partnership agreement are likely to be disregarded.  See, e.g., F.S.A. 200049003 (Sept. 1, 2000).  There also should be a business purpose for the FLP’s formation.  See, e.g., Estate of Bongard v. Comr., 124 T.C. 95 (2005).

Corporate liquidation and built-in gain.  Until 1998, the IRS disallowed discounts when valuing interests in C corporations to reflect built-in capital gains tax.  But, the courts then began focusing on the level of the discount until, in 2007, a federal appellate court ruled that in determining the estate tax value of holding company stock, the company’s value is to be reduced by the entire built-in capital gain as of the date of death.  Estate of Jelke III v. Comr., 507 F.3d 1317 (11th Cir. 2007).  Later, the Tax Court allowed a dollar-for-dollar discount for built-in gain.  Estate of Litchfield v. Comr., T.C. Memo. 2009-21; Estate of Jensen v. Comr., T.C. Memo. 2010-82.  That makes sense.  When a buyer purchases C corporate stock, the value of the stock to the buyer is what it takes to get cash in a liquidation.  One of the “things” it takes is the payment of deferred income tax.  The discount reflects that.

Restricted Management Account.  An alternative to the FLP is the restricted management account (RMA).  An RMA is an investment account where the investor gives up control of certain assets to an investment manager for a certain period of time and the manager exclusively manages the account assets.  During the term of the account (as set forth in a written agreement), the investor cannot make withdrawals, and transfer to family members are limited.  Based on these restrictions, the argument has been that the value of the assets in the RMA should be discounted for transfer tax purposes.  But, in 2008, IRS said that the restrictions in an RMA agreement do not result in anything other than valuation of the account assets at fair market value.  Rev. Rul. 2008-35, 2008-2 C.B. 116.

Discounts for IRAs?

Back to the question at hand – can a discount from fair market value be taken for the potential income tax liability to the beneficiaries of an IRA when the assets in the account are distributed to them?  The issue was presented to the Tax Court in Estate of Khan v. Comr., 125 T.C. 227 (2005).  The decedent died owning two IRAs.  One IRA was valued at $1.4 million at the time of death and the other one slightly over $1.2 million.  The executor reduced the estate tax value of the accounts by 21 percent and 22.5 percent respectively to reflect the anticipated income tax liability on distribution to the beneficiaries.  But, the court rejected the discounts because the inherent tax liability cannot be passed on to a hypothetical buyer.  On this point, the Tax Court followed the lead of the Fifth Circuit in Smith v. United States, 391 F.3d 621 (5th Cir 2004), aff’g., 300 F. Supp. 2d 474 (S.D. Tex. 2004) in noting that I.R.C. §691(c) provides for a deduction for estate tax that is attributable to income in respect of a decedent (IRD), which IRAs are.  That eliminates the potential income tax inherent in assets that are also subject to estate tax, and serves as a statutory substitute for the valuation discount. In other words, a hypothetical buyer would not take into consideration the income tax liability of a beneficiary on the IRD because the hypothetical buyer is not the beneficiary and would not be paying the income tax on the gain inherent in the IRA.  Thus, any additional reduction in estate tax for potential income tax would not be appropriate.  A marketability discount is also not appropriate because there aren’t any restrictions barring the IRA assets from being distributed to beneficiaries upon the account owner’s death.  See, e.g., Priv. Ltr. Rul. 200247001 (Nov. 22, 2002). 


While valuation discounts are still viable for minority interests and lack of marketability in closely-held entities, valuation discounts are not available for assets that are IRD.  That means that IRAs and similar items of IRD will be valued at fair market value for transfer tax purposes.  With an IRA, the IRA doesn’t have a tax liability.  The beneficiary does.

May 4, 2017 in Estate Planning, Income Tax | Permalink | Comments (0)

Tuesday, May 2, 2017

Specific Property Devised in Will (or Trust) That Doesn’t Exist At Death – What Happens?


The distribution of property in accordance with a decedent’s will or trust can be a straightforward matter, or it can prove to be a trying event for the family. But, what if, for example, a parent dies and specifies in a will or trust that a particular family member is to get a specific item of property and it doesn’t exist at the time of death?  Perhaps the specifically devised property has already been gifted to the beneficiary in satisfaction of the specific devise.  Or, maybe the specifically devised asset has been disposed of pre-death and the will or trust still contains the specific devise language.   

When either of these events happens, the legal doctrine of ademption is invoked.  The pre-death gift situation is called an ademption-by-satisfaction, and the pre-death disposal situation is called “ademption -by extinction.”  Ademption has the possibility of occurring anytime there is language in a will or trust that devised specifically identified property.  It can even occur as the result of a rather straightforward tax-deferred exchange transaction, and frustrate the intentions of a testator’s estate plan.

Ademption - the topic of today’s blogpost.

Ademption – What Is It?

Ademption is a legal rule that governs the disposition of a bequest of specific property that is no longer in the decedent’s estate at the time of the decedent’s death. In general, for devises of specific items of property, called specific gifts, the property is adeemed, and the gift fails. For example, if a parent leaves a specific tractor to an identified beneficiary, but the parent didn’t own the tractor at the time of death, then the gift is said to have been adeemed and the beneficiary would either receive no gift at all or a portion of the gift.  This is the likely result with specific bequests of tangible personal property and real estate.

Some gifts, however, are never adeemed. An example would be a gift of cash. If there is not enough cash in the testator’s estate to satisfy the gift, then other assets in the residuary estate are sold to raise the necessary cash. Some gifts are in a gray area, where the testator’s specific intent must be determined. Also, ademption may be waived if the property leaves the estate after the testator has been declared incompetent and a guardian has been appointed, or an agent acting under a power of attorney disposes of the property.  See, e.g., In re Estate of Anton,731 N.W.2d 19 (Iowa 2007).  Generally stock splits and stock mutations in the context of a business reorganization don’t trigger the doctrine – that’s just an exchange of specifically devised shares of stock for new stock, or the creation of more shares.  However, the specific language in the dispositive instrument at death is key. 

For real estate sales, the doctrine can apply even if the property hasn’t sold before the testator dies, but a contract for sale has been entered into before death.  For instance, assume that a testator executes a will (or trust) that devises a property (for instance, a specific home) to an individual.  Before death, the testator enters into a contract to sell the home to a buyer, but then dies before the closing.  The devise of the home may be adeemed and the buyer will be entitled to specific performance of the contract.  The rationale would likely be that once the contract is executed, equitable conversion occurred – the testator owned a contract right to the proceeds of sale and not the home.  This result can be avoided if the will or trust says that the proceeds of sale follow the specifically devised property. 

Tax-Deferred Exchange

While an exchange of stock in a company as a result of a reorganization is not an ademption, what about an I.R.C. §1031 exchange of real estate.  That’s a rather common transaction in agriculture.  Does that trigger ademption when a specifically devised tract is traded for another tract?  Indeed, it can if the tract is specifically identified and is not in the decedent’s estate at death. 

In In re Steinberg Family Living Trust, No. 16-0380, 2017 Iowa Sup. LEXIS 44 (Iowa Sup. Ct. Apr. 28, 2017), a married couple created a trust and named themselves and one of their sons as co-trustees. Upon the last of the parents to die, the two sons were to be the co-trustees.  Dad died in 2011 and the Mom died in 2013. The trust became irrevocable upon the Mom’s death and the sons became co-trustees. The trust provided that one son was to receive a specific 40-acre Iowa tract, and the other son would receive a specific 80-acre Iowa tract and have the first right to buy or rent the other 40-acre Iowa tract.  Both tracts were identified by their legal description. The balance of the trust assets was to be split equally between the sons.

Sounds like a fine estate plan.  The idea is to give each son a specific tract so they don’t have to deal with co-ownership issues after the last of the parents to die (and the seemingly inevitable forced-sale scenario), and give one son the first right to buy or rent the other son’s tract.  But, here’s the rub – in 2008, the trust did a tax-deferred exchange of the 80-acre Iowa tract for the 80-acre Minnesota property.  Thus, when the trust became irrevocable upon Mom’s death, the trust held the 80-acre Minnesota tract and the 40-acre Iowa tract (and other non-real estate assets). The son with the purchase option gave notice to buy the Iowa tract, and the other son then filed a declaratory judgment action claiming that the option only gave his brother the right to rent the property from him while he continued to own it.  He also claimed that the Minnesota tract should be split between the two brothers, because the specific bequest of the 80-acre Iowa tract to his brother had been adeemed by the like-kind exchange. Of course, the other son claimed that the 80-acre Minnesota tract should be devised to him directly because it merely replaced the Iowa tract in a tax-deferred exchange transaction.

The trial court held that the gift of the 80-acre Iowa tract had been adeemed and, consequently, it was subject to the trust provision requiring it to be owned equally by the two sons. The trial court also held that the option only gave the one brother the first right to rent the Iowa tract from his brother for the price specified in the trust for as long as the other brother owned it.

On further review, the Iowa Supreme Court affirmed on the ademption issue, not recognizing any exception from ademption under Iowa law for property received in a like-kind exchange. The court refused to adopt §2-606(a)(5) of the Uniform Partnership Act which states, “a specific devisee has a right to specifically devised property in the testator’s estate at the testator’s death and to any real property or tangible personal property owned by the testator at death which the testator acquired as a replacement for specifically devised real property or tangible personal property.” The court opined that it was up to the legislature to specifically adopt the UPC provision, as it has done with other selected UPC provisions. Thus, the court affirmed the trial court’s decision and the brothers ended up owning the replacement property equally.


While the Iowa Supreme Court stated that its rule of interpretation for trusts was that “the testator’s intent is paramount,” that’s a stretch as applied in this instance.  The result the court reached on the ademption issue most likely violated the precept by resulting in a co-owned tract of farmland which the trust provisions appear to have been trying to avoid. The court vacated the trial court’s ruling on the option provision and remanded the issue for consideration of extrinsic evidence as to its meaning. 

Lessons?   What looks to be purely a tax transaction can have extraneous implications in the law.  Chances are that a non-lawyer tax practitioner has never heard of “ademption.”   The client may want to do a like-kind exchange, for example, but if a tract is specifically identified in an estate plan and then it is exchanged, that can throw off the entire plan.  While, it’s not the tax practitioner’s responsibility to worry about non-tax matters, perhaps knowing that the possibility of ademption exists can result in a question being asked to make sure the client checks with their attorney about the impact of the exchange on an existing estate plan.  In the Iowa case, the exchange occurred about five years before Mom died.  There was plenty of time to modify the trust language to avoid the impact of ademption.  But, that doesn’t mean that strictly applying the rule of ademption was consistent with the decedent’s intent.  It’s probably more likely that they never even thought of such a thing as ademption and its impact on the estate plan.

So, whenever a specific gift of real property is provided for by testamentary instrument, the testator should be made aware of the possibility of ademption.  But, check state law.  Some states have “anti-ademption” statutes or use the UPC rule mentioned above. 

May 2, 2017 in Estate Planning | Permalink | Comments (0)