Thursday, June 29, 2017
Farm and ranch clients face many income tax issues that require special attention and planning. Likewise, they also encounter many estate and business planning opportunities that they can either take advantage of miss out on. For those representing farm and ranch clients, professional training in these issues is an important part of proper client representation. Our upcoming summer conference in the Bighorn Mountains of Sheridan, Wyoming on July 13-14, will dig into these issues and provide an opportunity for professional development. My teaching partner for the two days is Paul Neiffer of CliftonLarsonAllen.
Day 1 – Farm Income Tax
On Day 1, Paul and I will dig into numerous farm income tax topics. I will begin the day with an update of key developments in farm taxation. Before lunch, we will address various depreciation issues, farm income averaging and financial distress tax issues along with tax-deferral opportunities. In the afternoon, cash accounting issues for farmers, an update on the repair/capitalization regulations and a number of other specific farm income tax issues are on the agenda.
Day 2 – Farm Estate and Business Planning
On Day 2, we get into key estate and business planning issues for farmers and ranchers including how to maintain a stepped-up basis, planning strategies, the use of charitable trusts and FSA planning issues and opportunities. We will also get into other topics related to farm/ranch estate and business planning.
In-Person or Webinar
If you can’t attend the event in-person, the conference will also be webcast live. For in-person attendees, you can enjoy the beautiful Bighorn Mountains nearby with numerous outdoor opportunities. Also, the Sheridan Rodeo will be going on while we are there.
Here’s the link to the conference brochure: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
We hope to see you in Sheridan in two weeks. There’s a week left for early registration. After that, the registration rates increase.
Tuesday, June 27, 2017
The power to “take” private property for public use (or for a public purpose) without the owner's consent is an inherent power of the federal and state government. However, the United States Constitution limits the government's eminent domain power by requiring federal and state governments to pay for what is “taken.” The Fifth Amendment states in part “...nor shall private property be taken for public use without just compensation.” The clause has two prohibitions: (1) all takings must be for public use, and (2) even takings that are for public use must be accompanied by compensation.
Whether a taking has occurred is not an issue when the government physically takes the property, with the only issue being whether the taking is compensable and the amount of compensation due to the landowner. However, for non-physical takings, the issue is murkier. At what point does government regulation of private property amount to a compensable taking? The Supreme Court has addressed this issue on numerous occasions, and most recently dealt with a key issue that is the starting point in these matters – how to define the actual property that the landowner claims that the government has taken. This definitional issue is important to landowners because the way a tract is defined can either restrict the government’s regulation of the tract or expand it.
Regulatory (Non-Physical) Takings
A non-physical taking may involve the governmental condemnation of air space rights, water rights, subjacent or lateral support rights, or the regulation of property use through environmental restrictions. How is the existence of a regulatory taking determined? There are several approaches that the Supreme Court has utilized.
Multi-factor balancing test. In a key case decided in 1978, the U.S. Supreme Court set forth a multi-factored balancing test for determining when governmental regulation of private property effects a taking requiring compensation. In Penn Central Transportation Co. et al. v. New York City, 438 U.S. 104 (1978), the Court held that a landowner cannot establish a “taking” simply by being denied the ability to exploit a property interest believed to be available for development. Instead, the Court ruled that in deciding whether particular governmental action effects a taking, the character, nature and extent of the interference with property rights as a whole are the proper focus rather than discrete segments of the owner’s property rights. In 2005, the Court confirmed the multi-factor test and noted that the touchstone for deciding when a regulation is a taking is whether the restriction on property usage is functionally equivalent to a physical taking of the property. Lingle, et al. v. Chevron U.S.A., Inc., 544 U.S. 528 (2005).
Total regulatory taking. In Lucas v. South Carolina Coastal Council, 505 U.S. 1003 (1992), the landowner purchased two residential lots with an intent to build single-family homes. Two years later, the state legislature passed a law prohibiting the erection of any permanent habitable structures on the Lucas property. The law's purpose was to prevent beachfront erosion and to protect the property as a storm barrier, a plant and wildlife habitat, a tourist attraction, and a “natural health environment” which aided the physical and mental well-being of South Carolina's citizens. The law effectively rendered the Lucas property valueless. Lucas sued the Coastal Council claiming that, although the act may be a valid exercise of the state's police power, it deprived him of the use of his property and thus, resulted in a taking without just compensation. The Coastal Council argued that the state had the authority to prevent harmful uses of land without having to compensate the owner for the restriction.
The Supreme Court ruled for Lucas and opined that the state's interest in the regulation was irrelevant since the trial court determined that Lucas was deprived of any economically viable alternative use of his land. The Lucas case has two important implications for environmental regulation of agricultural activities. First, the Lucas court focused solely on the economic viability of the land and made no recognition of potential noneconomic objectives of land ownership. However, in the agricultural sector land ownership is typically associated with many noneconomic objectives and serves important sociological and psychological functions. Under the Lucas approach, these noneconomic objectives are not recognized. Second, under the Lucas rationale, environmental regulations do not invoke automatic compensation unless the regulations deprive the property owner of all beneficial use.
Under the Lucas approach, an important legal issue is whether compensation is required when the landowner has economic use remaining on other portions of the property that are not subject to regulation.
Unconstitutional conditions. In Nollan v. California Coastal Commission,483 U.S. 825 (1987), the plaintiff owned a small, dilapidated beach house and wanted to tear it down and replace it with a larger home. However, the defendant was concerned about preserving the public's viewing access over the plaintiff's land from the public highway to the waterfront. Rather than preventing the construction outright, the defendant conditioned the plaintiff's right to build on the land upon the plaintiff giving the defendant a permanent, lateral beachfront easement over the plaintiff's land for the benefit of the public. Thus, the issue was whether the state could force the plaintiffs to choose between their construction permit and their lateral easement. The Court, held that this particular bargain was impermissible because the condition imposed (surrender of the easement) lacked a “nexus” with, or was unrelated to the legitimate interest used by the state to justify its actions - preserving the view. The Court later ruled similarly in Dolan v. Tigard, 512 U.S. 374 (1994). These cases hold that the government may not require a person to give up the constitutional right to receive just compensation when property is taken for a public use in exchange for a discretionary benefit that has little or no relationship to the property. The rule of the cases does not apply to situations involving impact fees and other permit conditions that do not involve physical invasions, but it would apply to monetary exactions where none of the plaintiff’s property is actually taken. See, e.g., Koontz v. St. Johns River Water Management District, 133 S. Ct. 2586 (2013).
Defining The Property At Issue
An important first question in non-physical takings cases is the definition of the boundaries of the subject property. How the property is defined will often determine whether a taking has occurred. For instance, if the government designates a portion of a farm field as a wetland that can no longer be farmed without civil and criminal penalties applying, is the property interest at issue that is subject to a takings analysis the wetland or the entire field? If it is defined as the wetland, then the regulatory designation would result in a severe burden on the landowner with a high likelihood that a compensable taking has occurred. If it is the entire field, then the overall burden on the landowner is much less.
On June 23, the Court decided Murr v. Wisconsin, No. 15-214, 2017 U.S. LEXIS 4046 (U.S. Sup. Ct. Jun. 23, 2017). In Murr, siblings owned two adjacent parcels of waterfront property. A zoning regulation that became effective in 1976, long before the siblings came into ownership of the tracts, designated the tracts as “substandard” – neither tract could be developed individually. But, a grandfather clause in the zoning law said that the tracts could be separately developed if they were owned by different owners and not owned (under a merger clause) in common by a group of owners (such as the siblings). The merger provision also prevented the siblings from selling one of the tracts without selling the other tract. That was the problem. They wanted to sell one of the tracts, and sued for a regulatory taking. The state trial court granted summary judgment to the state on the basis that the siblings still had options available for the use and enjoyment of their property and had not been deprived of all economic value of their property. Indeed, they could either develop or sell the two lots together. The court looked at the subject property as one single lot rather than two separate lots. The case was affirmed on appeal with the appellate court noting that the siblings bought the second tract a year after the first tract and being charged with the knowledge of the merger clause in the zoning law. The state (WI) Supreme Court denied review.
The U.S. Supreme Court affirmed in a 5-3 opinion authored by Justice Kennedy. The Court reasoned that the definition of the subject property, just like the takings analysis itself, is determined by a multi-factor analysis. That multi-factor test, according to Justice Kennedy, involves state law (including lot lines), reasonable expectations about ownership of the subject property, the land’s physical characteristics and the prospective value of the land with attention paid to the effect of the burdened land on the value of other holdings. As applied in Murr, the Court determined that the two tracts should be treated as a single tract for purposes of the takings analysis. That was primarily because state law treated the parcels as one as a result of the merger provision, the two tracts were contiguous, and the fact that they were oddly shaped with rough terrain and bordered a river made land-use regulations foreseeable.
The Court determined that a taking had not occurred. The dissent was critical of the new test for determining what constitutes the subject property in a takings case, arguing that the test was “stacked” in the government’s favor.
The definition of property for purposes of takings analysis is the key starting point in non-physical takings cases. In addition, for rural landowners, “property” may also include more than just the surface estate. See, e.g., The Edwards Aquifer Authority, et al. v. Day, et al., 369 S.W.3d 814 (Tex. Sup. Ct. 2012). How do the “Kennedy Conditions” apply in situations where the surface estate is regulated, but the sub-surface estate is not (or vice versa)? In one case, the plaintiffs owned oil and gas rights in west central Michigan. In 1987, the director of the State Department of Natural Resources prohibited exploration for or development of oil and gas on the bulk of the plaintiff's property. The state appellate court focused solely on the landowner's use of the mineral interests involved to hold that the plaintiff's property had been taken. Even though a non-mineral interest land use possibility remained, the court held that the landowners were denied all economically viable use of the mineral interest. The court found it immaterial that all but one of the plaintiffs had extensive landholdings outside of the protected area. Miller Brothers v. Michigan Department of Natural Resources, 203 Mich. App. 674, 513 N.W.2d 217 (1994)
The new test of Murr will make regulatory takings cases more complex and legal outcomes more unpredictable. The “Kennedy Conditions” could work in favor of a landowner, but are more likely to do just the opposite. It was also Justice Kennedy’s concurring opinion in Rapanos, et ux., et al. v. United States Army Corps of Engineers, 126 S. Ct. 2208 (2006) that has created tremendous confusion for the lower courts and injected a high degree of uncertainty into the law with respect to the federal government’s jurisdiction over isolated wetlands under the Clean Water Act.
Kennedy’s opinion in Murr again appears to be judicial micro-management, making meaningful the comment of Justice Thomas in the dissent about the need to take a “fresh look” at takings cases and whether the Court’s current analytical approach squares with the Constitution’s “original public meaning.”
Friday, June 23, 2017
Many farmers sell their products through a marketing cooperative of which they are likely to be a member. As a member, they have stock ownership in the cooperative, and typically must buy the right to market certain units of production from their farming business. Along with that right also comes (in most instances) a requirement that the farmer deliver those units of production on an annual basis.
In these situations, the cooperative will annually pay its members a “value-added” which represents the excess amount the cooperative received for a commodity from members over what it paid for the commodity. That raises tax issues associated with how the farmer should report the payment? Is it subject to self-employment tax? What if the grain delivered to the cooperative came from a landlord’s share of the crop under a lease?
The tax issues associated with value-added payments from a cooperative. That’s today’s topic.
The Self-Employment Tax Issue
In recent years, the self- employment tax issue has arisen with respect to payments received by individuals from closed cooperatives, such as local ethanol-production plants. In the typical scenario, an individual subscribes to ownership units that require the individual either to deliver bushels of grain grown on the individual’s farm or to purchase an equivalent amount for delivery to the cooperative. At the end of the production year, the individual receives a “value-added payment” for a share of the cooperative’s profit.
Clearly, the value-added payment is ordinary income to the recipient, but the question remains as to whether the payment is also subject to self-employment tax. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax if the operation constitutes a trade or business “carried on by such individual.” Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business. In general, to be subject to self-employment tax, an activity must be engaged in on a substantial basis with continuity and regularity.
In 1996, the IRS ruled that the value-added payments represented a part of the recipient’s farming business and were, therefore, subject to self-employment tax. Tech. Adv. Memo. 9652007 (Aug. 30, 1996). Under the facts of the ruling, the taxpayer was a grain grower that was obligated to deliver stated quantities of grain to the cooperative for processing three times annually. The farmer could satisfy the obligation by delivering grain grown on the farm, by delivering “pooled” grain maintained by the cooperative, or by delivering grain purchased from other growers. For the most part, the taxpayer satisfied his obligation by delivering grain grown by others. Grain that was grown on the farm was primarily used as livestock feed. Indeed, the taxpayer stated that “except for one year, all of the raised grain was fed to the taxpayer’s livestock and he had not raised sufficient amounts of grain to provide a full year’s supply of grain for the livestock. Consequently, the farmer purchased grain from other local farmers to feed the livestock. While the farmer indicated that he joined the cooperative as an investor with the intent of purchasing the grain that he would need to deliver to the cooperative rather than producing it on his own farm, the IRS determined that the value-added payments to the farmer were subject to self-employment tax because he remained an active farmer.
In Hansen v. Commissioner, T.C. Sum. Op. 1998-91, the taxpayer had retired from active farming in 1990. In 1993 (the year at issue), the taxpayer received $12,052 in value-added payments. The taxpayer reported the payments as farm rental income, not subject to self-employment taxes, on Form 4835 attached to the taxpayer’s 1993 return. The IRS determined that the value-added payments constituted Schedule F farm income and thereby subjected the payments to self-employment tax. While the taxpayer maintained that the value-added payments were not subject to self-employment tax because the taxpayer did not personally participate in the trade or business of growing corn or processing corn during 1993, the IRS argued that the cooperative’s corn processing activity was attributable to the taxpayer for the purpose of determining whether the taxpayer was engaged in a trade or business.
The Tax Court disagreed with the IRS’s position, noting instead that the taxpayer’s relationship with the cooperative ceased to be a principal-agent relationship as of the date the taxpayer retired from the trade or business of growing corn. In addition, the Tax Court concluded that the cooperative’s activity was not attributable to the taxpayer as a member of a partnership because a cooperative is an incorporated organization which is not considered a partnership. In April, 1999, the Chief Counsel of IRS announced a change in litigating position concerning value-added payments and self-employment tax, conceding to the Tax Court’s decision in Hansen. IRS Notice (36)000-3, Apr. 21, 1999.
In Bot v. Comm’r., 118 T.C. 138 (2002), aff’d, 353 F.3d 595 (8th Cir. 2003), a retired farmer and his wife (who were members of a value-added cooperative which also required the delivery of corn) were operating under a crop-share lease with their sons as tenants. The court held that the value-added payments the farmer and his wife received from the cooperative were subject to self-employment tax. The court noted that Hansen could not be cited as precedent and held that the taxpayers were engaged in the trade or business of producing, marketing and selling corn and corn products in relationship with the cooperative. The court determined that, inasmuch as the value-added payments were directly related to the volume of corn delivered to the cooperative, the value-added payments had a direct nexus to their trade or business and must be included in self-employment income. The court reached its conclusion in light of the involvement by the taxpayers in the operation and the involvement of their sons. However, since 1974, imputation of activities by an agent to a principal as a property owner under a lease (and involving the production of agricultural or horticultural commodities) has been barred for purposes of self-employment tax liability. In the case, the only apparent business relationship of the taxpayers and their sons was through the crop-share lease. On that basis, the court’s opinion is inconsistent with the statute. But, even without imputing the sons’ activities, the taxpayers might have been sufficiently involved in the business for self-employment tax to apply. See also Fultz v. Comm’r, T.C. Memo. 2005-45 and Fultz v. Comm’r, T.C. Memo. 2005-46 in which the Tax Court followed its earlier opinion in Bot.
Thus, for individuals who are members of cooperatives that require the members to buy equity shares and to deliver an amount of grain based on the number of equity shares purchased, any payment received by the member for the value added to the grain during processing is subject to self-employment tax if the member is an active farmer. The value-added payment received as a patronage distribution would be reported on lines 3a and 3b of Schedule F (Form 1040). It is ordinary income subject to self-employment tax. The same reporting result is reached if the farmer is a landlord under a material participation crop-share lease who satisfies the delivery obligation out of grain produced under the lease.
For members of such cooperatives that serve as landlords pursuant to a cash lease where the cash rent is reported on Schedule E, or a non-material participation crop share or livestock lease with minimal involvement by the landlord (where the rent is reported on Form 4835), the value-added payments should not be subject to self-employment tax. If a member is retired at the time the member subscribes to ownership units in the cooperative and satisfies the member’s obligation to the cooperative solely with pooled grain, the value-added payments represent investment income and are not subject to self-employment tax. However, Bot makes it clear that retired members of value-added cooperatives need to watch their involvement under the arrangement with the cooperative if self-employment tax is to be avoided. To avoid a CP-2000 Notice from the IRS in this situation, the distribution could be reported on Schedule F so that the IRS computer gets a match, and then an offsetting deduction could be taken.
The self-employment tax issue reaches many areas for agricultural producers. Cooperative value-added payments creates a self-employment tax issue for farmers, but the basic principles still apply.
Wednesday, June 21, 2017
One issue that I occasionally receive questions on concerns liability for animal disease. The questions can take several forms, including diseased animals of the owner as well as another person’s diseased animals that cause an infection.
Given that animal disease can result in significant economic loss, the liability question is an important one. Today’s post takes a brief look at the issue.
Trespassing or Straying Animals
If an owner of diseased animals knows of an infection and knows that it would be communicated to other animals if contracted, some states hold the owner liable for damages caused by transmission of the disease. Knowledge that the animals were infected is typically an essential element. Once the animals' owner has knowledge of the disease, the owner is under a duty to take reasonable steps to ensure that the animals do not come into contact with healthy, uninfected livestock of anyone else. Knowledge that the animals were infected is typically an essential element. Several states, by statute, require restraint of animals that are known to have an infectious or contagious disease from running at large or coming into contact with other animals. These statutes have been enacted by the major livestock producing states.
The injured party may be barred from recovering damages if the complaining party is contributorily negligent. Knowledge that animals running at large were infected coupled with the complainant's failure to attempt to prevent the infected animal from coming in contact with the complainant's own animals may preclude recovery. Moreover, allowing infected animals to remain on the complaining party's premises after being aware of their diseased condition may be a bar to damages.
Landlord's Duty Regarding Diseased Premises
Sometimes questions arise concerning a landlord's liability for diseased or contaminated premises when a tenant brings healthy animals to the premises. In most jurisdictions, the liability of the landlord depends largely upon the landlord's deceit to the tenant concerning the past presence of disease on the premises. Thus, if a tenant has healthy animals and brings those animals onto the landlord's diseased or contaminated premises and the animals become diseased themselves, it will be difficult for the tenant to recover against the landlord. Failure to disclose the diseased condition of the leased premises is usually not a basis for action. Instead, actual deceit is required. Therefore, if the tenant fails to ask whether the premises are disease or contamination free, the landlord is under no duty to disclose that fact to the tenant. However, if the tenant asks and the landlord responds less than fully or less than truthfully, actual deceit may be present and provide the tenant a basis for recovery. See, e.g., Wilcox v. Cappel, No. A-95-798, 1996 Neb. App. LEXIS 243 (Neb. Ct. App. Dec. 3, 1996).
For farm tenants that claim that the landlord’s premises caused damage to the tenant’s animals, the law is fairly clear. As a prerequisite for recovering damages against a landlord arising from defects in the leased premises, the tenant should make a thorough inspection of the property and ask questions. It is also a really good idea to reduce the lease agreement to writing and include in the lease a provision that specifies which party is liable for damages resulting from disease or contamination.
Disposal of Animal Carcasses
All states have statutory requirements that must be satisfied in order to properly dispose of a dead animal. In most states, disposal must occur within 24 hours after death. By statute, states typically acknowledge that disposal may be by burying, burning or feeding the carcass to other livestock. The option of feeding the carcass to other livestock is typically only available if the animal did not die of a contagious disease. Disposal is also usually available to a licensed rendering company. The typical state statute requires direct delivery to the point of disposal with an exception often made for stops to load additional carcasses. Vehicles used to transport the carcass of an animal typically must be lined or other measures taken to prevent any leakage of liquid, and must be disinfected after each transport.
Most states prohibit certain methods of dead animal disposal. For instance, placing the carcass of dead animal in a water course or roadway is a misdemeanor in many states. Similarly, knowingly allowing a carcass to remain in such an area is also typically a misdemeanor. But, in most jurisdictions, cattle and horse carcasses may be moved from one farm to another if they are not diseased.
Animal diseases are a natural aspect of livestock production activities. Knowing the liability issues that might arise is an important aspect of livestock risk management.
Monday, June 19, 2017
The like-kind exchange rules of I.R.C. §1031 have restrictions that can apply when related parties are involved. One of those restrictions is a two-year rule. The rule applies when related parties engage in an exchange, and results in the tax-deferred benefit of the transaction being lost if the property exchanged of is disposed of within two years.
So, who are “related parties” for purposes of the two-year rule? Can the related party rules create an issue with an estate plan? For instance, if an estate plan for a married couple establishes a trust for the surviving spouse with the surviving spouse receiving the income from trust property for life and the remainder passing to the children, will the children be able to exchange their interests so that at least one child can receive money for their interest without triggering immediate gain?
Today’s post takes a look at the related party rules in the context of like-kind exchanges and the potential impact on traditional estate plans.
Related Party Rules
General rule. Under I.R.C. §1031(a)(1), no gain or loss is recognized on the exchange of property that is held for productive use in a trade or business or for investment if the property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. If the exchange occurs between “related parties,” a two-year rule applies. I.R.C. §1031(f)(1)(C). Under that rule, non-recognition treatment is lost if the related party with which like-kind property is exchanged disposes of the property within two years of the exchange. I.R.C. §1031(f)(1)(A)-(C). The two-year holding period starts running on the date of the transfer or conveyance of the last property involved in the exchange.
Exceptions. There are exceptions to the two-year rule for: (1) transfers that occur after the taxpayer’s death or the related party’s death; (2) transfers that occur due to an involuntary conversion, and; (3) transfers that do not involve tax avoidance as the purpose of the transfer. I.R.C. §1031(f)(2). There is also a “suspension” provision in I.R.C. §1031(g). Under that provision, the two-year holding period is suspended if either the taxpayer’s or the related party’s risk of loss is substantially decreased (due to an option, put, short sale or other transaction). Once the risk of loss ceases, the two-year period continues from the point where it stopped.
Definition of “related parties.” I.R.C. §1031(f)(3) defines “related party” by routing the answer through I.R.C. §§267(b) or 707(b)(1). Under those provisions, related persons to the taxpayer are:
- Brothers and sisters (whether whole or half-blood)
- The taxpayer’s spouse, ancestors, lineal descendants
- Certain types of entity relationships – a corporation, limited liability company or partnership and a person that owns (directly or indirectly) more than 50 percent of the stock, membership interests or partnership interests or more that 50 percent of the capital interests or profits interests, and two partnerships in which the same persons owns (directly or indirectly) more than 50 percent of the capital or profits interests
- Two entities in which the same individuals own directly or indirectly more than 50 percent of each entity
- An estate in which the taxpayer is either the executor or beneficiary of the estate
- A trust in which the taxpayer is the fiduciary and the related party is a beneficiary either of that trust or a related trust or a fiduciary of a related trust
Related parties, however, do not include step-parents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.
Related Party Scenarios
It is possible for a taxpayer to relinquish property to a related party and acquire like-kind replacement property from a non-related party without violating the I.R.C. §1031 exchange related party rules. The related parties must each hold their respective properties for a minimum of two years. The deferral rules also apply when property is acquired from a related party and the related party then completes a separate tax-deferred exchange transaction using the sales proceeds from the sale of the related party's property that was received in the initial exchange.
Related party transactions will also be respected if a “basis swap” is not involved. See, e.g., Priv. Ltr. Rul. 200810016 (Dec. 6, 2007).
The exchange of interests in real estate among related parties can also qualify under the rules. In Rev. Rul. 73-476,9 IRS ruled that exchanges of undivided interests in multiple parcels of real estate for 100 percent ownership of one or more parcels of the same real estate qualify as valid like-kind exchanges. In addition, IRS has also ruled that an exchange of partial interests in two parcels of property between related persons, followed by the sale of one of the parcels to an unrelated party within two years, qualified for non-recognition of gain. Priv. Ltr. Rul. 200730002 (April 26, 2007).
Estate Planning Implications
The related party rules can apply after the implementation of common estate plans. For example, assume that Jimmy owns farmland that he transfers to a trust for his wife, Beulah. The trust terms specify that if Beulah survives Jimmy, she is to receive the income from the farmland for life with the farmland passing upon her death to their three children equally. Beulah survives Jimmy, and on her subsequent death the farmland is transferred to the children with each child owning an undivided one-third interest in the farmland as tenants in common. Each of the children then deeds their respective undivided interests to their own grantor trust. One child farms his undivided one-third interest that is held in his trust, and also serves as a co-trustee of his trust. One child dies, and her undivided one-third interest remained in her trust with the trust income payable to her surviving spouse for life and the remainder interest passing to her children (nieces and nephews of her siblings). The third child continues to hold his undivided one-third interest in trust and farms with it.
Thus, after the one child’s death, the ownership of the farmland is as follows: (1) a one-third undivided interest by a farming child held via his trust; (2) a one-third undivided interest held in trust by another farming child; and (3) a one-third undivided interest in trust split equally among the children of the deceased child subject to a life income interest in that child’s surviving spouse. The co-trustees of this last trust were the deceased child’s surviving spouse and their two children. They have no care for the farmland, and would like to liquidate their one-third ownership interest in the farmland. The two sons of Jimmy and Beulah wish to continue farming the land that they hold in their trusts.
After visiting with their legal and tax counsel to determine a way to allow the two sons to continue farming and allow their niece and nephew to liquidate their interest, and do so in a tax efficient manner, a solution is proposed. The solution is to have the three trusts exchange each of their undivided one-third interests in the farmland for 100 percent fee simple (outright ownership) interests in the same farmland. The exchange will be based on surveys and appraisals that will result in a three-way split of equal value. There will be no liabilities assumed, and none of the trusts will receive money or other property in the exchange. The exchange will be straight-up. The only difference among the trusts is that the one-third farmland interest in the deceased daughter’s trust will have a higher income tax basis because of her death and the resulting step-up in basis to fair market value at that time. After the exchange, the daughter’s trust will sell its parcel to a third party for cash, and the two sons of Jimmy and Beulah will continue to farm their tracts.
The IRS has blessed this type of a scenario. In PLRs 200919027 (Feb. 3, 2009) and 200920032 (Feb. 3, 2009), the IRS said that the related party rule of I.R.C. §1031(f) didn’t apply and the gain from the sale by the niece and nephew of their parcel within two years of the exchange was deferrable. The two sons were not related parties to their sister’s trust or its trustees (her surviving spouse and children). The related party rule would apply, however, if either of the two brothers would sell their respective tracts within two years of the initial exchange.
The related party rules are important provisions in like-kind exchange transactions. With respect to real estate swaps, proper estate planning techniques can be utilized to achieve the desired result. The use of a like-kind exchange in a situation such as that presented above is a much better solution than a partition and sale of the property. It’s one way to get cash into the hands of a non-farm heir without disrupting the farming operation, and doing so on a tax-deferred basis.
Thursday, June 15, 2017
Tuesday’s post started the discussion of how farm program payment limitation rules can impact the estate and business planning for a farmer. That post discussed the basics of the provisions under the 2014 Farm Bill, and discussed PLC and ARC, the overall payment limit, the AGI limitation and the attribution rule.
Today, we dig deeper and examine the “active personal management” rule, recordkeeping requirements and how the rules impact the planning process.
Keep in mind, this is an overview of a very technical subject. Make sure to find counsel that deals with farm programs so that you can properly integrate payment limitation planning into the overall estate and business plan. I am often asked for recommendations of practitioners that have a good grasp of the payment limitation rule that can work with their tax counsel to put an effective plan together. One person I would suggest that may also know others that I am not aware of is Bill Bridgforth in Pine Bluff, Arkansas. He's a good friend that is easy to work with and has a great deal of experience with the payment limitation rules.
Active Personal Management
Three-part test for "active engagement." Under 7 C.F.R. Part 1400, a person must be “actively engaged” in farming to receive farm program payments. To satisfy the “actively engaged in farming” test, three conditions must be met. First, the individual's or entity's share of profits or losses from the farming operation must be commensurate with the individual's or entity's contribution to the operation. Second, the individual's or entity's contributions must be “at risk.” Third, an individual must make a significant contribution of land, capital or equipment, and active personal labor or active personal management.
What is "management“? Active personal management” is defined as significant contributions of management activities that are performed on a regular, continuous and substantial basis to the farming operation – basically the I.R.C. §1402 test for self-employment tax purposes. In addition, the management activities must represent at least 25 percent of the total management time that is necessary for the success of the farming operation on an annual basis, or represent at least 500 hours of specific management activities annually. That is a more defined test for active management than was contained under the previous Farm Bill, which required that the management be “critical to the overall profitability of the farming operation.”
How many "person" determinations can be achieved? The rules also restrict the number of persons that may qualify for payment by making a significant contribution of active personal management. For this purpose, the limit is one person unless the farming operation is large or complex. A "large" farming operation is one that has crops on more than 2,500 acres (planted or prevented from being planted). If the acreage limitation is satisfied, an additional person may qualify upon making a significant contribution of active personal management. If the farming operation satisfies another test of being “complex,” an additional payment limit may be available. This all means that, for large and complex, farming operations, a total of three payment limits may be obtained. Who decides whether a farming operation is "complex"? That determination is made by the State FSA Committee. These rules establish a more restrictive test than was in place before the 2014 Farm Bill became effective. The prior rules did not limit the number of persons that could qualify for farm program payments via the significant contribution of active personal management route. Now, the maximum potential limit is three.
Special rules. Special rules apply to tenant-operated farms and family-owned operations with multiple owners. In some situations, a person meeting specified requirements is considered to be actively engaged in farming in any event. For example, a crop-share or livestock-share landlord who provides capital, equipment or land as well as personal labor, or active personal management meets the test. But, neither a cash rent landlord nor a crop share landlord is actively engaged in farming if the rent amount is guaranteed. Also, if one spouse meets the active engagement test, the other spouse is deemed to meet the test.
Exemption for family operations. The active personal management test applies to non-family general partnerships and joint operations that seek to qualify more than one farm manager based solely on providing management or a combination of management and labor (another rule). However, it does not apply to farming operations where all of the partners, stockholders or persons with an ownership interest in the farming operation (or any entity that is a member of the farming operation) are “family members.” For this purpose, “family member” means a person to whom another member in the farming operation is related as a lineal ancestor, lineal descendant, sibling, spouse or otherwise by marriage. Legally adopted children and step-children count as “family members.”
The rule also doesn’t come into play where only one person attempts to qualify under the rule or when combined with a contribution of labor. The rule also doesn't apply to farming operations that are operated by individuals or entities other than general partnerships or joint ventures.
When multiple payments are sought for a farming operation under the active management rule, the operation must maintain contemporaneous records or logs for all persons that make any contribution of management. Those records must include, at a minimum, the location where the management activity was performed, and the amount of time put into the activity and its duration. In addition, every legal entity that receives farm program payments must report to the local FSA committee the name and social security number of each person who owns, either directly or indirectly, any interest in the entity. Also, the entity must inform its members of the payment limitation rules.
The FSA Handbook (5-PL, Amendment 3) specifies that the farming operation must maintain contemporaneous records or logs for all persons that make management contributions. The records must provide: (1) the location (either on-site or remote) where the management activity was performed; (2) the time spent on the activity and the timeframe in which it occurred; and (3) a description of the activity. FSA Handbook, Paragraph 222A. It is important that the records be maintained and be timely made available to the FSA for their review upon request. FSA Handbook, Paragraph 222B. Fortunately, the FSA provides a Form (CCC-902 MR) to track and maintain all of the necessary information. Note that these are the present references to the applicable FSA Handbook Paragraphs and Form. Those paragraph references and Form number can change. FSA modifies its handbook frequently and Forms are modified and numbers often are changed. Practitioners and their farm clients must be diligent in monitoring the changes.
Two things happen if the necessary records aren’t maintained – (1) the person’s contribution of active personal management for payment eligibility purposes will be disregarded; and (2) the person’s payment eligibility status will be re-determined for that particular program year.
The “substantive change” rule. In general, any structural change of the farming or ranching business that increases the number of payment limits must be bona fida and substantive and not a “scheme or device.” See, e.g., Val Farms v. Espy, 29 F.3d 1570 (10th Cir. 1994). In addition, reliance on the advice of local or state USDA officials concerning the payment limitation rules is at the farmer or rancher's own risk. But, the substantive change rule does not apply to spouses. Thus, for example, a spouse of a partner that is providing active management to a farm partnership can be added to the partnership and automatically qualify as a partnership member for FSA purposes. However, a “substantive change occurs when a “family member” is added to a partnership unless the family member also provides management or labor.
"Scheme or device." The USDA is adept at alleging that a farming operation has engaged in a "scheme or device" that have the purpose or effect of evading the payment limitation rules. But, this potential problem can be avoided if multiple payments are not sought, such as by having one manager for each entity engaged in farming. Of course, this is not a concern if all of the members of a multi-person partnership are family members. If non-family members are part of the farming operation, perhaps they can farm individually or with other non-family members that can provide labor to the farming business. That might be a safe approach.
"Combination" rule. There is also a “combination” rule that can apply when the farming business is restructured. If the rule applies, it will result in the denial of separate “person” status to “persons” who would otherwise be eligible for a separate limit.
Entity type based on size. From an FSA entity planning standpoint, the type of entity structure utilized to maximize payment limits will depend on the size/income of the operation.
For smaller producers, entity choice for FSA purposes is largely irrelevant. Given that the limitation is $125,000 and that payments are made either based on price or revenue (according to various formulas), current economic conditions in agriculture indicate that most Midwestern farms would have to farm somewhere between 3,000 and 4,000 acres before the $125,000 payment limit would be reached. Thus, for smaller producers, the payment limit is not likely to apply and the manner in which the farming business is structured is not a factor.
For larger operations, the general partnership or joint venture form is likely to be ideal for FSA purposes. If creditor protection or limited liability is desired, the partnership could be made up of single-member LLCs. For further tax benefits, the general partnership’s partners could consist of manager-manager LLCs with bifurcated interests.
Farm program payment limitation planning is a complicated mix of regulatory and administrative rules and tax/entity planning. It’s not an area that a producer should engage in without counsel if maximizing payments in conjunction with an estate/business plan is the goal. Unfortunately, only a few practitioners are adept at navigating both the tax planning rules and the FSA regulatory web.
Tuesday, June 13, 2017
A unique aspect of estate planning for farmers and ranchers is the need to incorporate (for many of these clients) farm program payment limitation planning into the mix. The way the farming or ranching business is structured can impact eligibility for farm program benefits.
So, what are the essential farm program rules that impact the planning/structuring process? That’s our focus this week. Today is part one of the two-part series
2014 Farm Bill
Primary programs. Under the 2014 Farm Bill, the total amount of payments received, directly and indirectly, by a person or legal entity (except joint ventures or general partnerships) for Price Loss Coverage (PLC) Agricultural Risk Coverage (ARC), marketing loan gains, and loan deficiency payments (other than for peanuts), may not exceed $125,000 per crop year. A person or legal entity that receives payments for peanuts has a separate $125,000 payment limitation ($250,000 for married persons). Cotton transition payments are limited to $40,000 per year. For the livestock disaster programs, a total $125,000 annual limitation applies for payments under the Livestock Indemnity Program, the Livestock Forage Program, and the Emergency Assistance for Livestock, Honey Bees and Farm-Raised Fish program. A separate $125,000 annual limitation applies to payments under the Tree Assistance Program.
Beginning in 2014, farmers were given a one-time opportunity to elect PLC or ARC for the 2014-2018 crop years. If an election was not made, PLC applied beginning in 2015 with no payment available for 2014. If ARC was elected, all producers with respect to a farm had to sign the election form. If PLC was elected, the owners of the farm had an option to update their yields to 90 percent of their average yields from 2008-2012. All farm owners also could elect to reallocate their base acres based on the actual plantings for 2009-2012.
PLC and ARC. The PLC option works in tandem with a crop insurance Supplemental Coverage Option (SCO). It is a risk management tool that is designed to address significant, multiple-year price declines. It compliments crop insurance, which is not designed to cover multiple-year price declines. A farmer that chooses the PLC option will receive a payment (consistent with payment limitations) when the effective price of a covered commodity is less than the target (“reference”) price for that commodity established in the statute (e.g., the target price for corn is $3.70/bu). The effective price is the higher of the mid-season price or the national average loan rate for the covered commodity. Thus, the PLC payment rate is the reference price less the effective price, and the PLC payment amount is the payment rate times the payment acres. Putting it another way, the PLC payment is equal to 85 percent of the base acres of the covered commodity times the difference between the target price and the effective price times the program payment yield for the covered commodity. SCO provides additional county-level insurance coverage not to exceed the difference between 86 percent and the coverage level in the individual insurance policy. Because SCO is a form of crop insurance, payment limits do not apply. But, a farmer selecting the PLC option must pay an additional premium for SCO coverage (but, the cost of the additional premium is 65 percent taxpayer subsidized).
ARC is a risk management tool that addresses revenue losses. Under the ARC, payments are issued when the actual county crop revenue of a covered commodity is less than the ARC county guarantee for the covered commodity and are based on county data, not farm data. A producer electing ARC must unanimously select whether to receive county-wide coverage on a commodity-by-commodity basis or choose individual coverage that applies to all of the commodities on the farm. Payment acres are 85 percent of base acres for county coverage, and 65 percent for individual farm coverage. Under ARC, a producer must incur at least a 14 percent loss (defined as 86 percent of benchmark revenue) for coverage to kick-in. The ARC county guarantee equals 86 percent of the previous five-year average national farm price, excluding the years with the highest and lowest price (the ARC guarantee price), times the five-year average county yield, excluding the years with the highest and lowest yield (the ARC county guarantee yield). This guarantee revenue is based on five-year Olympic production and average crop price excluding the high and low years. Both the guarantee and actual revenue are computed using base acres, not planted acres. The payment is equal to 85 percent of the base acres (this is for county-elected ARC) of the covered commodity times the difference between the county guarantee and the actual county crop revenue for the covered commodity, not to exceed 10 percent of the benchmark county revenue (the ARC guarantee price times the ARC county guarantee yield). In other words, if revenue is less than 76 percent of the previous five-year average national farm price, then the maximum 10 percent of benchmark revenue is paid, subject to the payment limit of $125,000 per person.
For 2014 and 2015 crops, ARC was more likely to result in a payment to a producer because of the higher Olympic average. But, it is now less likely to make a payment in for 2016-2018 crops due to low crop prices. If prices remain low, PLC will result in a payment. The choice for any given producer will be different (there is no “one size fits all” with respect to the election) and ARC may be desired with respect to one crop and PLC may be best for another crop, for example. In general, the bigger margin between expected prices and reference prices, the more likely it is that a producer would choose ARC. However, the ARC and PLC was an irrevocable election and whatever the producer elected in 2014 will apply through the 2018 crop year. The only way to make a new election is by having acres come out of CRP that are then put back into production.
Payments for PLC and ARC are issued after the end of the respective crop year, but not before Oct. 1. Thus, the 2016 crop payment will not be made until after October 1, 2017. That means that no payments will be received in 2016, other than for ACRE or other related payments that are normally paid after the crop year. In 2017, producers enrolled in the PLC who also participate in the federal crop insurance program may choose whether to purchase SCO.
From a practical/procedural standpoint, because a payment (if any) will not be issued until at or near the end of the producer’s marketing year, lenders could have a more difficult time determining a producer’s cash flow for crop loans.
Monetary limit. As previously noted, the Farm Bill established a payment limit of $125,000 per person or legal entity (excluding general partnerships and joint ventures). This is the general rule. Peanut growers are allowed an additional $125,000 payment limitation, and the spouse of a farmer is entitled to an additional $125,000 payment limit if the spouse is enrolled at the local Farm Service Agency (FSA) office. The limit applies to all PLC, ARC, marketing loan gains, and loan deficiency payments.
The payment limit is applied at both the entity level (for entities that limit liability) and then the individual level (up to four levels of ownership). Thus, general partnerships and joint ventures have no payment limits. Instead, the payment limit is calculated at the individual level. However, an entity that limits the liability of its shareholders/members is limited to one payment limitation. That means that the single payment limit is then split equally between the shareholders/members.
AGI limitation. To be eligible for a payment limit, an adjusted gross income (AGI) limitation must not be exceeded. That limitation is $900,000, and applies to commodity programs, conservation programs and disaster programs. The AGI limitation is an average of the three prior years, with a one-year delay. In other words, farm program payments received in 2017 are based off of the average of AGI for 2013, 2014 and 2015. While FSA had not treated the I.R.C. §179 deduction as allowed against AGI for S corporations and LLC’s taxed as partnerships, but did allow it for C corporations and individuals, beginning with 2017 crop year the deduction will be allowed against AGI for all entities.
The AGI limitation, which does not apply for crop insurance purposes, applies to both the entity and the owners of the entity, as illustrated in the following example:
Example. Assume that FarmCo receives $100,000 of farm program payments in 2015. FarmCo’s AGI is $850,000. Thus, FarmCo is entitled to a full payment limitation. But, if one of FarmCo’s owners has AGI that exceeds the $900,000 threshold, a portion of FarmCo’s payment limit will be disallowed in proportion to that shareholder’s percentage ownership. So, if the shareholder with income exceeding the $900,000 threshold owns 25 percent of FarmCo, FarmCo’s $100,000 of farm program payment benefits will be reduced by $25,000.
Attribution Rule. Under a rule of direct attribution, individuals and entities are credited with both the amount of payments received directly and also the amount received indirectly by holding an interest in an entity receiving payment. In general, payments to a legal entity are attributed to the persons who have a direct or indirect interest in the legal entity. But, payments made to a joint venture or general partnership are determined by multiplying the maximum payment amount by the number of persons and entities holding ownership interests in the joint venture or general partnership. That means that joint ventures and partnerships are not subject to the attribution rules.
Program payments to legal entities are tracked through four levels of ownership. If another legal entity owns any part of the ownership interest at the fourth level, then the payments to the entity receiving payments will be reduced by the amount of the indirect interest. Thus, the entity has a limitation, and then each member has a limitation. The measuring date for purposes of direct attribution is June 1.
As applied to marketing cooperatives, the attribution rules apply to the producers as persons, and not to the cooperative association of producers. Also, children under age 18 are treated the same as the parents. It is also assumed that if one parent has filled their payment limit, payments made to a child could be attributed to the parent that has not filled their payment limit. For payments made to a revocable trust, they are attributed to the trust’s grantor. As applied to irrevocable trusts and estates, the Ag Secretary is directed to administer the rules so as to ensure "equitable treatment" of the beneficiaries.
In the next post, I will take a look at the payment limitation rules. That will include a discussion of the “active personal management” test, recordkeeping requirements and entity planning implications. Farm program payment limitation planning certainly complicates estate and business planning for farmers.
Friday, June 9, 2017
When financial and economic conditions sour, one of the issues that can come up concerns the ability to collect on debts. Agriculture has been through some difficult times for the past few years, and the occurrence of bad debts has been on the rise. Ag retail businesses are experiencing tougher credit relations with farm clients.
What does it take to be able to deduct a bad debt? Is there a difference in the tax of a business bad debt or a non-business bad debt? What if a parent guarantees the debt of a child? How do bad debts get reported? Today’s post examines the basic rules that come into play when dealing with a creditor that doesn’t pay.
Elements Necessary For Deductibility
Debtor-creditor relationship. An income tax deduction is allowed for debts which become worthless within the taxable year. For a bad debt to be deductible, there must be a debtor-creditor relationship involving a legal obligation to pay a fixed sum of money. See, e.g., Meier v. Comm’r, T.C. Memo. 2003-94. A bad debt deduction may be claimed only if there is an actual loss of money or the taxpayer has reported the amount as income. It can’t be claimed if the taxpayer doesn’t have any records or activity to establish that the money transferred created an enforceable loan to her son entered into for profit. That’s a key point with many farming operations and loans between family members. See, e.g., Vaughters v. Comr., T.C. Memo. 1988-276. It’s critical to properly document the arrangement.
A debt may be totally or partially worthless. A debt is a totally worthless bad debt if the taxpayer is unable to collect what is still owed even though some of the debt had been collected in the past. The amount remaining to be paid is eligible for a bad debt deduction. Factors indicating total worthlessness include the debtor being in a serious financial position, insolvency, lack of assets, ill health, or bankruptcy.
Establishing worthlessness. To be deductible, the debt must be proved to be worthless with reasonable steps taken to collect the debt. Bankruptcy is generally good evidence that at least part of the debt is worthless, but the debtor’s technical insolvency may not be. The debtor’s technical insolvency is not enough to conclude that a debt is worthless. O’Neal Feeder Supply, Inc., v. United States, No. 2:96 CV 0514, 2017 U.S. Dist. LEXIS 1085 (W.D. La. 2000). But, it is not necessary to resort to legal action if it can be shown that a judgment would not be collectible.
Claiming a Bad Debt Deduction
A deduction may only be claimed in the year a debt becomes worthless – when there is no longer any change it will be paid. It is not necessary to wait until the debt is due to determine its worthlessness. But, if a taxpayer recovers a bad debt or part of a bad debt that was allowed as a deduction in a prior year, it is includible in gross income in the year of recovery. The amount of the deduction is the taxpayer’s adjusted basis in the debt.
Business and Nonbusiness Bad Debts
Bad debts may be business bad debts or nonbusiness bad debts, except that corporations have only business bad debts. Business bad debts are deducted directly from gross income while a nonbusiness bad debt of a non-corporate taxpayer is reported as a short-term capital loss when it becomes totally worthless.
A business bad debt relates to operating a trade or business and is mainly the result of credit sales to customers or loans to suppliers, clients, employers or distributors. A bad debt deduction may be taken for accounts and notes receivable only if the amount had been included in gross income for the current or prior taxable year. While this largely limits bad debt deductions to accrual-basis taxpayers, a business bad debt deduction for a cash basis taxpayer is possible. For example, a business loan may go sour and the obligation may become worthless. A business bad debt is one that is incurred in the taxpayer's trade or business. In money lending situations, the business of the taxpayer must be lending money.
Nonbusiness bad debts are bad debts not acquired or created in the course of operating the taxpayer's a trade or business, or a debt the loss from the worthlessness of which is not incurred in the taxpayer's trade or business. Thus, a noncorporate taxpayer's bad debts may be either business or nonbusiness bad debts. To be deductible, nonbusiness bad debts must be totally worthless; partially worthless nonbusiness bad debts are not deductible. Nonbusiness bad debts are deductible only as short-term capital losses and are reported on Schedule D, Form 1040. That means that they are not as valuable as business bad debts.
If payment of another's debt is guaranteed, a bad debt deduction may be claimed by the guarantor if payment is made under the guarantee. To qualify for a deduction, these guarantees must meet one of two conditions - (1) the guarantee must have been entered into for profit with the guarantor receiving something in return; or (2) the guarantee must be related to the taxpayer's trade, business or employment. In many instances, these requirements can be very difficult to satisfy. For example, most guarantees are entered into as an accommodation. In addition, the amount that the guarantor receives in return must be a reasonable amount under the circumstances.
With respect to the requirement that the guarantee be related to the taxpayer's trade, business or employment, the IRS particularly scrutinizes intra-family arrangements and generally holds that for parents guaranteeing a child's debt, the parent is not in the trade or business of guaranteeing loans. Instead, the parent typically is in the trade or business of farming or some other enterprise. In one Tax Court case, for example, the court held that a father's guarantee of his sons' bad debts was not a business bad debt. The father was receiving rent from his sons, and argued that the rental amounts represented a receipt of consideration. The father also argued that the guarantee was given in the ordinary course of business. The Tax Court disagreed on both counts. See, e.g., Lair v. Comr., 95 T.C. 484 (1990).
The loss associated with a guarantee may be either from a business or be a nonbusiness bad debt depending upon the facts of the situation. To qualify as a business bad debt, the taxpayer must show that the reason for guaranteeing the debt was closely related to the taxpayer's trade or business. If the reason for making the guarantee was to protect the taxpayer's investment but not as part of the taxpayer's trade or business, a guarantee may give rise to a nonbusiness bad debt. Guarantees made as a favor to friends where the taxpayer received nothing in return do not give rise to a deduction.
Related Issues With Guarantees
Because a guarantor is only secondarily liable and becomes liable only on the principal's default and notice, a release of the guarantor before becoming primarily liable does not appear to involve discharge of indebtedness income. In the event a guarantor has become primarily liable, release of the guarantor would seem to produce the possibility of discharge of indebtedness income.
Likewise, a deduction may be available for interest paid by a guarantor after the primary obligor is discharged in bankruptcy.
Reporting Bad Debts
A bad debt deduction must be explained on the income tax return with a statement attached that shows a description of the debt, the name of the debtor, the business or family relationship between the creditor and debtor, if any, the date the debt became due, efforts made to collect the debt and basis upon which the decision was made that the debt was worthless. For business bad debts, the amount claimed as a deduction should be reported on Form 1120 or 1120-S in the case of a corporation.
The amount of deduction attributable to a business bad debt should be reported on Form 1065 for partnerships and Form 1040 for bad debts incurred in relation to a trade or business as an employee. The amount claimed as a deduction for a business bad debt for individuals carrying on the business of farming as a sole proprietor are reported on Schedule F of Form 1040. For individuals carrying on a trade or business other than farming as a sole proprietor, business bad debts are reported on Schedule C of Form 1040.
Nonbusiness bad debts for individuals are deducted on Form 8949 as a short-term capital loss. with various notations. A separate line should be used for each bad debt. In addition, a nonbusiness bad debt, to generate a deduction, requires a separate detailed statement attached to the return.
Nonbusiness bad debts for partnerships are entered on Schedule D, Form 1065 in the same manner as above shown for Schedule D, 1040, for individuals.
Tough times create financial issues, and associated tax issues. But, if the rules are followed, the tax Code can help soften the blow of uncollectable debts by allowing a deduction.
Wednesday, June 7, 2017
In early 2014, the 2014 Farm Bill passed the Congress and was signed into law. The legislation contains a projected $956 billion in spending over the next 10 years (much of which is attributable to spending on Food Stamps and related programs) which is approximately 50 percent more than the 2008 Farm Bill. The Farm Bill also contained numerous other provisions such as repealing direct payments immediately, repealing seven other current commodity programs and making adjustments to payment limitations, program eligibility rules and the income limitation rule.
The Farm Bill also removed both the farm and non-farm AGI limitations of the 2008 Farm Bill and replaces them with a $900,000 AGI limitation applicable to any individual or entity. The $900,000 AGI limitation applies to both commodity and conservation programs. While the Farm Service Agency initially did not take into account any I.R.C. §179 deduction for an S corporation or a partnership, but did for a C corporation or an individual, their position has now changed so that issue is no longer on the table
However, the Farm Bill did not include a provision that was contained in the initial House version that would have barred a state, absent legitimate public safety concerns, from enacting legislation designed to regulate the production of out-of-state agricultural goods and livestock that are sold in that state.
So, can a state regulate the manner in which agricultural goods are produced in another state? That’s the focus of today’s post.
The House Farm Bill provision was in response to a 2008 California (CA) ballot initiative (Proposition 2) that required all California egg producers to produce eggs from laying hens in cages that allowed the hens to “lie down, stand up, fully extend its limbs, and turn around freely.” Because of the additional cost placed on CA egg producers which made their eggs non-competitive with eggs produced in other states not subject to such restrictions, CA passed a law in 2010 (A.B. 1437) making it a crime to sell shelled eggs in CA (regardless of whether the eggs were produced in CA) that came from a laying hen that was confined in a cage not allowing the hen to “lie down, stand up, fully extend its limbs, and turn around freely.” The law was purportedly based on consumer health concerns, but it had the effect of regulating egg production in all states. The law applied to the sale of eggs for human consumption in CA occurring on or after January 1, 2015.
Legal challenge. In 2014, the Missouri (MO) Attorney General (and officials from other states) sued CA officials over the law. They sought declaratory and injunctive relief, costs and fees, associated with blocking enforcement of the CA law. The claim was that the law would increase size of egg-laying hen enclosures and decrease flock densities for egg producers in other states desiring to sell eggs in CA. The lead plaintiff (MO) noted that CA consumers bought one-third of all eggs produced in MO in 2013 and that the CA requirement would substantially increase the cost of MO egg production if egg producers continue to sell eggs in CA, which will also make eggs too expensive to sell in other states. The plaintiff also noted that if MO producers choose to not participate in CA market, other markets will have surplus eggs and egg prices will fall which could force some producers out of business; suit claims that CA provision was an unconstitutional violation of the Commerce Clause by "conditioning the flow of goods across its state lines on the method of their production." In the alternative, the suit alleged federal preemption via 21 U.S.C. Sec. 1052(b) – the Federal Egg Products Inspection Act.
The trial court held that the plaintiff lacked standing for failure to articulate an interest separate and apart from the interests of private parties, and that the claim involving the egg price-effect on consumers was remote and speculative. Missouri v. Harris, No. 2:14-cv-00341-KJM-KJN, 2014 U.S. Dist. LEXIS 76305 (E.D. Ca. Jun. 2, 2014). The trial court also determined that the CA law was not discriminatory. On further review, the appellate court affirmed, but remanded for dismissal without prejudice. Missouri v. Harris, 842 F.3d 658 (9th Cir. 2016). Last week, the U.S. Supreme Court declined to hear the case. Missouri v. Becerra, No. 16-1015, 2017 U.S. LEXIS 3405 (U.S. Sup. Ct. May 30, 2017).
Legal ‘standing.” There is no doubt that “Parens patriae” standing (a federal court doctrine) is difficult to obtain in a case asserting economic loss. The states have to show injury to the citizens of their respective states as a whole, rather than injury to a small group of their citizens (egg producers and egg consumers). While the states did claim that their residents would be paying higher prices for eggs, the trial court and the appellate court both determined that the claim was speculative at this stage of the litigation. Certainly, any time a regulation is imposed that requires a change in production activities (here, requiring the replacement of “battery” cages with alternative structures that meet the CA specifications) higher costs will be imposed on egg producers. To the extent those costs can be passed-on to egg consumers, they will. The more market power any individual egg producer has will determine how much, if any, of that cost gets passed-on.
Related to the egg production matter were developments involving animal rights groups and foie gras, a delicacy that is a product of enlarged livers of ducks and geese that have been force-fed corn. While a federal court, in 2013, refused the groups’ attempt to force USDA to regulate the delicacy as an adulterated food product, the Ninth Circuit upheld a CA ban on foie gras. In 2014, the U.S. Supreme Court declined to hear the case, leaving the CA ban in place. Association Des Eleveurs De Canards Et D’Oies Du Quebec, et al. v. Harris, 729 F.3d 937 (9th Cir. 2013), cert. den., 135 S. Ct. 398 (2014). Importantly, the California ban only applies to products produced by force feeding a bird to enlarge its liver. It does not ban the sale of duck breasts, down jackets, or other non-liver products from force-fed birds.
After the Ninth Circuit upheld the CA ban, the plaintiffs amended their complaint to include a challenge to the ban on preemption grounds. In early 2015, the district court struck down the CA law on the basis that the CA ban was preempted by the Poultry Products Inspection Act, the federal law that regulates the sale and distribution of poultry products. The court pointed out that the plaintiffs had suffered economic injury. Association Des Eleveurs De Canards Et D'oies Du Quebec, et al. v. Harris, No. 2:12-cv-5735-SVW-RZ (C.D. Cal. Jan. 7, 2015).
Egg Law Litigation Current Status.
Presently no court has decided the merits of the case. But, if standing can be established, do the states challenging the CA law have a legitimate claim? The Ninth Circuit’s dismissal of the case was “without prejudice.” Koster v. Harris, 847 F.3d 646 (9th Cir. 2017). That means that if standing can eventually be established, the case can be brought again.
State Regulation of Interstate Commerce - U.S. Supreme Court Precedent
The U.S. Supreme Court has long held that one state cannot regulate economic conduct in another state in a manner that is clearly excessive in relation to the benefits to the regulating state, even if the law is facially neutral. See, e.g., Bibb v. Navajo Freight Lines, Inc., 359 U.S. 520 (1959). In Bibb, various interstate motor carriers challenged an Illinois statute that required the use of certain type of mud-flap on trucks and trailers that operated on Illinois highways. They claimed that the statute violated the Constitution’s Commerce Clause because it placed an “undue” burden on them that outweighed any safety benefit the state might receive in return. In essence, the statute required that the mud-flap had to contour with the rear wheels, with the inside surface “being relatively parallel to the top 90 degrees of the rear 180 degrees of the whole surface.” In addition, the mud-flap surface had to extend down to within 10 inches of the ground on a fully-loaded truck. Furthermore, the mud-flap had to be wide enough to cover the width of the tire, be installed within six inches from the tire surface on a loaded truck and have a flange on its outer edge that did not exceed two inches. Basically, these detailed requirements made conventional mud-flaps that were legal in at least 45 states at the time illegal in Illinois.
The trial court held that the Illinois statute “unduly and unreasonably burdened and obstructed interstate commerce” in violation of the Commerce Clause and enjoined the state from enforcing it. On direct appeal to the U.S. Supreme Court, the Court unanimously affirmed. While safety measures carry a “strong presumption of validity” the Court determined that the enhanced safety resulting from the statutory requirement did not outweigh the national interest in “keeping interstate commerce free from interferences that seriously impede it.”
So how does Bibb apply to the CA egg law? If standing is ever established (and the proper plaintiff may, indeed, be actual egg producers rather than respective states), the burden will be on the plaintiff(s) to show that the CA law imposes an undue and unreasonable burden on interstate commerce in relation to the benefit that CA derives on behalf of its citizens (e.g., health and safety). Thus, the citizens of CA can, via their elected representatives, determine the law and regulations for the economic activity of other states to an extent. The limits of that extent have not yet been established in the egg case, but it seems that the egg case is a clearer illustration of a state trying to regulate economic activity in other states instead of protecting the health and/or safety of its own citizens than the state statute involved in Bibb.
Monday, June 5, 2017
Generally, an exchange of property for other property is treated as a sale. 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. The new property is treated as a continuation of the original property. That means that neither gain nor loss is recognized until (if ever) the replacement property is sold. Gain, however, is recognized to the extent of any boot or unlike property received in the exchange.
Like-kind exchanges are very popular in agriculture. Whether the transaction involves a trade of real estate or equipment, ag producers find tax-deferred exchanges to be a useful tax planning tool. Today’s post looks at just a few of the aspects of like-kind exchanges.
What is “Like-Kind”?
Personal property. 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.
Real estate. 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. Thus, agricultural real estate may be traded for residential real estate. 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.
A leasehold interest can be exchanged for fee interests if the leasehold interest has at least 30 years to run at the time the exchange is entered into. Treas. Reg. §1.1031(a)-1(c). Case law also indicates that, at the time the transaction is entered into, the lease must have at least 30 years remaining. See, e.g., VIP Industries Inc. & Subsidiaries v. Comm’r, T.C. Memo. 2013-357.
Water rights that are limited in duration are not considered like-kind to a fee interest in land, (Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002)), but if the water rights are limited only as to annual use the IRS has ruled that they are of sufficient like-kind to a fee interest in land to qualify the transaction for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).
The “Holding” Requirement
The statute is silent about how long the relinquished and replacement properties must be held. Thus, the key is the taxpayer’s intent in holding the exchange properties. However, the IRS has ruled that if the taxpayer acquires the relinquished property immediately before the exchange, or disposes of the replacement property immediately after the exchange, the holding requirement of I.R.C. §1031(a) is not met. See, e.g., Rev. Rul. 75-291, 1975-2 C.B. 332; Rev. Rul. 77-297, 1977-2 C.B. 304; Rev. Rul. 84-121, 1984-2 C.B. 168.
The courts tend to consider whether the relinquished property was held for investment or for use in a business, and whether the replacement property was held for investment or for use in a business. See, e.g., Bolker v. Comr., 760 F.2d 1039 (9th Cir. 1985). Clearly, acquiring property in an exchange which is then immediately fixed-up and sold, does not meet the test of having been held for investment or for use in a trade or business. Similarly, based on the facts of the case, IRS may argue that the transaction really involved the intent to make a gift and that the property was not held for investment or for use in a trade or business. See, e.g., Wagensen v. Comr., 74 T.C. 653 (1980); Click v. Comr., 78 T.C. 225 (1982). In any event, the taxpayer bears the burden to prove the requisite intent. See, e.g., Land Dynamics v. Comr., T.C. Memo. 1978-259.
For exchanges between related parties, if property that was part of the exchange is disposed of within two years of the last transfer that was part of the exchange, the tax deferral is eliminated. In addition, I.R.C. §1031(f)(4) provides that the like-kind exchange rules do not apply to any exchange that is part of a transaction or series of transactions structured to avoid the related party prohibition. The IRS has ruled that taxpayer who transfers relinquished property to a qualified intermediary in an I.R.C. §1031 exchange for replacement property formerly owned by a related party does not qualify for non-recognition treatment. Rev. Rul. 2002-83, IRB No. 2002-49 (intermediary used to circumvent the related party prohibition). The IRS has also disallowed tax-deferred treatment where a taxpayer attempted several related party exchanges, moving low basis property in exchange for the high basis property of a related party, before the sale of the low basis property. Priv. Ltr. Rul. 200126007 (Mar. 22, 2001). However, the IRS has allowed tax-deferred treatment where the related party exchange preceded the sale to a third party by more than the two-year statutory minimum. Field Service Advice 200137003 (Sept. 17, 2001).
What About Debt?
The IRS has prescribed rules that govern the handling of debt in a like-kind exchange. Treas. Reg. §1.1031(d)-(2). Gain recognized on a like-kind exchange with debt is the greater of the excess value of the relinquished property over the value of the acquired property, or the excess of the equity in the relinquished property over the equity in the acquired property (this excess equal to the cash received in the exchange). Thus, if the value of the acquired property equals or exceeds the value of the relinquished property and the equity in the acquired property equals or exceeds the equity in the relinquished property, no gain is recognized on the exchange.
These are just a few of the points concerning like-kind exchanges that seem to generate a lot of questions. These transactions are popular in agriculture. But, anytime a tax-deferred exchange is desired, competent tax and legal advice is a must.
Thursday, June 1, 2017
For farmers on the cash method of accounting, certain types of financing arrangements may create questions concerning when inputs are considered paid and, hence, qualify for a deduction. Similarly, for livestock growers and feeders, letters of credit and advance payments for management services are common but can raise similar deductibility issues.
For a cash basis farmer, inputs are deducted in the year that they are paid for. In pre-payment situations, as long as the rules for pre-paying inputs are followed, there shouldn’t be an issue with achieving the up-front deduction. See Rev. Rul. 79-229, 1979-2 C.B. 210. But, what if the inputs are financed via a promissory note or a letter of credit? Can a deduction be taken when the agreement is entered into? What if the inputs are financed by a lender that is a subsidiary of the input supplier? Relatedly, when can a deduction be claimed for financed improvements of depreciable property? What about financing arrangements for feeding cattle? What about buying a farm with a depreciable structure on it?
There are a lot of arrangements out there. It can get messy in a hurry. Today’ post takes a look at these issues.
Payment Via Promissory Note and/or Letter of Credit
The purchase of depreciable property on credit generally allows the buyer to receive an income tax basis for the purchase price cost of the property – including any liability assumed. But, there can be situations where payment in accordance with a promissory note, even if secured by collateral, may not result in a deduction. See Rev. Rul. 77-257, 1977-2 C.B. 174; Helvering v. Price, 309 U.S. 409 (1940). The same could be true if payment is secured by a letter of credit.
In livestock feeding situations, letters of credit and advance payments for management services are common. For example, in Chapman v. United States, 527 F. Supp. 1053 (D. Minn. 1981), a farmer entered into a purchase agreement for $30,000 worth of cattle feed. The farmer paid one-half of the total amount in cash in 1973 and the remaining $15,000 was due and payable when each cattle lot was sold and was subtracted from cattle sale proceeds before any remaining balance was disbursed to the farmer. To insure payment if the cattle sale proceeds didn’t cover the amount owed the seller of the feed, the farmer gave the seller a promissory note for $15,000 and a secured letter of credit for the same amount. The farmer deducted the entire $30,000 in 1973 and recognized income of $15,000 in 1974 when the letter of credit expired. The court held that the letter of credit was synonymous with a promissory note secured by collateral, and denied the $15,000 deduction in 1973 that was attributable to the note.
In Bandes, et al. v. Comr., T.C. Memo. 1982-355, two taxpayers got into the cattle feeding business by contracting with a cattle company in Guymon, Oklahoma, to act as their agent and advisor for the purchase, feeding and sale of 1200 head of livestock. The taxpayers agreed to share expenses and proceeds equally, and the contract with the cattle company appointed the cattle company as agent to select feedlots, negotiate and execute feeding contracts, and oversee the buying, managing and selling of the cattle. The cattle company was also authorized to negotiate and contract for the delivery of the cattle by the end of 1972. The cattle company would receive $8 per head for its management services and the taxpayers paid the fee on December 12, 1972 ($4,800 for each taxpayer). The cattle company arranged for a line of credit to each taxpayer for 180 days from a bank set at a maximum of $210,000 per taxpayer at eight percent interest. In the summer of 1973, the line of credit was renewed for another 180 days at 9 percent interest. Security for the loan was the feed and livestock, and the taxpayers were not personally liable for any advances under the line of credit. The advances from the bank paid a portion of the purchase price of the cattle and feedyard charges, and were repaid (except for interest which was paid in advance by the taxpayers) out of cattle sale proceeds. In addition, advances were only made after each taxpayer had a net equity in the cattle of $90 per head. Thus, on December 15, 1972, each taxpayer opened an account with the bank and deposited $54,000 ($90 x 600 head).
On December 22, 1972, the cattle company purchased $96,000 worth of feed on each taxpayer’s behalf. In early 1973, the cattle company bought 1,200 head of cattle for $411,352 that were then shipped to a feedyard. During the remainder of 1973 the 1,153 surviving cattle were sold for $578,476. Also in 1973, the unused feed was sold for $3,424.
Both taxpayers were on the cash method and each of them deducted the $4,800 management fee on their respective 1972 returns along with a $48,000 deduction for cattle feed. The IRS disallowed the deduction for the cattle feed in accordance with Rev. Rul. 79-229, but the court allowed the deduction on the basis that the taxpayers had a legitimate business purposes (locking in price) and that the payment was not a deposit and did not materially distort income. As for the management fee, the court allowed one-half of the fee to be deducted in 1972 and the other half in 1973, absent evidence as to the value of the services that the cattle company performed.
As for monthly maintenance fees paid under an agreement involving the purchase of cattle, the IRS has said that those fees are not deductible for the period before purchase of the cattle. Rev. Rul. 84-35, 1984-1 C.B. 31. Where an advance payment was made for management services for the current year and the succeeding year, the Tax Court has allocated the fee between the two years and allowed a deduction for the amount related to the current year. Bandes v. Comr., T.C. Memo. 1982-355.
Financing Input Costs
In Rev. Rul. 77-257, 1977-2 C.B. 174, a limited partnership, was engaged in acquiring and holding land for investment and for farming. The limited partnership was on the cash method of accounting. A partnership was involved in management of farm properties. The two entities were not related and had no common owners. In the year in question, the limited partnership purchased farmland from the partnership and then entered into a management agreement with the partnership whereby the partnership was to provide development services on the farmland produced by the limited partnership. The management expenses were billed monthly to a partnership account, and were paid by checks drawn on another partnership bank account. At the end of the development period, the limited partnership gave the partnership a note for the account receivable on the partnership account’s books. The IRS cited Helvering v. Price, 309 U.S. 409 (1940) where the U.S. Supreme Court said that the issuance of a note by a cash method taxpayer, without any disbursement of cash or property with a cash value, does not give rise to a deduction. But, the IRS also stated that “the actual payment of an expense with funds borrowed from a third party does give rise to a current deduction.”
Vendor-financed inputs. That last portion of Rev. Rul. 77-257, where the IRS said that actual payment of an expense with borrowed funds from a third party, opens the door to allow costs paid by vendor financing to be deductible. Sometimes a farmer buys inputs that are financed by a lending subsidiary of the input supplier. In many of these situations, the interest rate is set low to enhance sales. But, the key is whether the lender that finances the input purchase is really independent from the vendor. Rev. Rul. 77-257 says that when the funds are borrowed from a “third party,” a deduction for expenses incurred can be taken in the year the funds are loaned. But what if the lender is wholly-owned subsidiary of the vendor? In that situation is the lender really a “third party” lender?
Another issue can be created when the input financing by a wholly-owned subsidiary of the vendor occurs without the farmer writing out a check. Does that give rise to deductibility? What if the financing is provided by a different legal entity within the vendor’s business group? It that really third-party financing if the financing company is wholly-owned by the vendor? It gets a little blurry, doesn’t it? All of this presents farmers with a challenge to identify the true nature of all parties that are involved in a transaction.
Financed improvements to depreciable property. Improvements to property which are financed by a promissory note or other obligation do not add to basis until the obligation is paid. This is different than paying for the cost using borrowed funds, which doesn’t raise a concern. Without a basis increase, there can be no depreciation deduction. In Owen v. United States, 34 F. Supp. 2d 1071 (W.D. Tenn. 1999), the taxpayers financed improvements to office condominiums by promissory notes issued to an entity that the taxpayers owned and controlled. The taxpayers did not make any payment on the notes before selling the improved property. The taxpayers argued that the issuance of the notes for payment of the improvements increased their basis in the property, but the court distinguished the case (which involved a subsequent adjustment to basis) from those situations involving the taxpayer’s initial cost basis in property. The court noted that cash-basis taxpayers do not recognize income or expenses until cash is actually received or paid. Thus, the issuance of a promissory note as payment for benefits received was not a cash payment that allowed the taxpayers to take a current-year deduction. It also did not increase the basis in the condominiums by the cost of the improvements. The result was that no depreciation deductions would be allowed.
The Owen decision raises some interesting questions (which the court did not address), including how a taxpayer handles the sale of property purchased and financed by the taxpayer and subsequently sold while the taxpayer remained personally liable on the note. For instance, assume that a farmer buys farmland with a building on it for cash. The farmer financed improvements to the building, and then later sold the entire property while principal amounts were still outstanding on the note. How does the farmer compute gain on the sale? Does he count the amount financed as basis, or only add to basis any amount that has been paid on the note’s principal? Or, does the farmer report more gain (because of no basis increase attributable to the amount financed) and then reduce the gain as payments are made on the note’s principal? In the latter situation, the farmer would have to file an amended return for the year of sale each year that a principal payment is made. If he doesn’t get the note paid off soon enough, he could end up with closed tax years that can’t be amended. That would mean he would have gain recognition with no basis offset and the responsibility to still make principal payments.
You have heard it said many times that “cash is king.” That’s true not only from a debt standpoint. The tax issues associated with transactions can get complex fast when structured financing deals take place.