Monday, July 31, 2017
Today's post is a deviation from my normal posting on an aspect of agricultural law and tax that you can use in your practice or business. That’s because I have a new book that is now available that you might find useful as a handbook or desk reference. Thanks to West Academic Publishing, my new book “Agricultural Law in a Nutshell,” is now available. Today’s post promotes the new book and provides you with the link to get more information on how to obtain you copy.
The Nutshell is taken from my larger textbook/casebook on agricultural law that is used in classrooms across the country. Ten of those 15 chapters are contained in the Nutshell, including some of the most requested chapters from my larger book – contracts, civil liabilities and real property. Also included are chapters on environmental law, water law and cooperatives. Bankruptcy, secured transactions, and regulatory law round out the content, along with an introductory chapter. Not included in this Nutshell are the income tax, as well as the estate and business planning topics. Those remain in my larger book, and are updated twice annually along with the other chapters found there.
The Nutshell is designed as a concise summary of the most important issues facing agricultural producers, agribusinesses and their professional advisors. Farmers, ranchers, agribusinesses, legal advisors and students will find it helpful. It’s soft cover and easy to carry.
Rural Law Program
The Nutshell is another aspect of Washburn Law School’s Rural Law Program. This summer, the Program placed numerous students as interns with law firms in western Kansas. The feedback has been tremendous and some lawyers have already requested to be on the list to get a student for next summer. Students at Washburn Law can take numerous classes dealing with agricultural issues. We are also looking forward to our upcoming Symposium with Kansas State University examining the business of agriculture and the legal and economic issues that are the major ones at this time. That conference is set for Sept. 18, and a future post will address the aspects of that upcoming event.
You can find out more information about the Nutshell by clicking here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/agriculturallawnutshell/index.html
Thursday, July 27, 2017
Low commodity prices over the past couple of years for many commodities, particularly in the Midwest and the Great Plains, have resulted in financial stress for many farmers. For example, 2015 farm income in Kansas was the lowest since 1985. Prices have dropped and are volatile and subject to economic conditions around the world. In addition, the cost of production has continued to rise. All of this have an impact on a farmer’s ability to repay debt. That repayment capacity has dropped dramatically over the past two-three years. All of this makes marketing important as well as the proper utilization of crop revenue insurance. Ultimately, continued low prices will also have an impact on land values and, in some areas, that impact is already being noticed.
An associated concern is the strain placed on grain elevators. If an elevator fails, what’s the impact on farmers that have deposited grain and on the agricultural community? What are the rights that a farmer has when an elevator fails? How much can be recovered, and when can it be recovered? Are there any legal remedies? These issues are the focus of today’s post.
A farmer that has stored grain at an elevator that files bankruptcy is not a creditor of the elevator. That’s because the grain in storage is the farmer’s property. The farmer’s ownership of the grain is evidenced by a warehouse receipt or a scale ticket. Both of those serve as prima facie evidence of the farmer’s ownership of the stored grain. So, the farmer’s relationship with the elevator is not a creditor/debtor relationship, but a bailee/bailor one. Uniform Commercial Code (U.C.C.) §7-102(a)(1). In addition, that relationship is not impacted just because the elevator will return to the farmer grain of like quality rather than the identical grain that the farmer delivered to the elevator. See 54 A.L.R. 1166 (1928).
Under the UCC, commingled grain that is stored in an elevator is owned in common by the persons storing the grain. U.C.C. §7-207(b); see also, United States v. Luther, 225 F.2d 499 (10th Cir. 1955), cert. den., 350 U.S. 947 (1956); In re Bucyrus Grain, Co., Inc., 78 B.R. 296 (Bankr. D. Kan. 1987). So, if there isn’t a grain shortage when an elevator fails, a farmer with grain stored at the elevator can get his grain in accordance with his warehouse receipt or scale ticket. The bankruptcy trustee can’t retain farmer-stored grain in the bankruptcy estate if there isn’t a shortage. The trustee only succeeds to the rights the that bankrupt elevator had and, as noted above, stored grain is not the elevator’s property. Under the Bankruptcy Code, the bankruptcy trustee, after notice and hearing, can dispose of property which an entity other than the bankruptcy estate has an interest in. 11 U.S.C. §725. This all means that once a farmer establishes ownership to the grain and pays the associated storage costs, the farmer is entitled to his grain.
But, what if there isn’t enough grain in the elevator to cover all of the claims of farmers that have warehouse receipts or scale tickets. If that is the case at the time the elevator files bankruptcy, the farmers holding those indicia of ownership share pro rata in the remaining grain. In this situation, what typically happens is that the bankruptcy trustee will sell all of the grain that is in storage and make a pro rata distribution of the proceeds of sale along with any bond money that the elevator’s bonding company might have. If, after the pro rata distribution, a famer has not been made whole, the famer becomes a general, unsecured creditor of the elevator to the extent of the shortfall.
Farmer Priority in Bankruptcy
In the shortfall situation, there is a bit of relief that the Bankruptcy Code provides. Under 11 U.S.C. §507(a)(6), an unsecured claim of a farmer (grain producer) in an amount of up to $6,325 against a grain storage facility (e.g., grain elevator) has priority. The priority is a sixth priority claim. It’s after domestic support obligations, administrative expenses, certain types of other specified unsecured claims, “allowed” unsecured claims, and unsecured claims for contributions to an employee benefit plan, but before certain unsecured claims of individuals and governmental units. For purposes of the priority provision, a “grain producer” is someone (“an entity”) that engages in the growing of wheat, corn flaxseed, grain sorghum, barley, oats, rye, soybeans, other dry edible beans, and rice. 11 U.S.C. §557(b)(1). “Grain storage facility” means a site or physical structure used to store grain for producers or to store grain acquired from producers for resale. 11 U.S.C. §557(b)(2).
While the $6,325 provision is likely to be of limited assistance, the Bankruptcy Court for the District of Kansas, affirmed by the Kansas Federal District Court, has held that the priority provision also gives priority status ahead of secured creditors with respect to grain owned by farmers that the elevator stores. In re Esbon Grain Co., 55 B.R. 308 (Bankr. D. Kan. 1985), aff’d., First National Bank v. Nugent, 72 B.R. 528 (D. Kan. 1987). That means that the financier of the elevator cannot participate in the pro rata distribution of the elevator’s remaining grain to the farmers that stored grain in the elevator at the time the elevator filed bankruptcy. The court reached its decision based on a Kansas statutory provision that gives grain depositors priority over a warehouse owner and the owner’s creditors in the grain stored in the elevator. Kan. Stat. Ann. §34-2,107. A different court in a different state could reach a different conclusion.
There is also another bankruptcy priority provision that can aid a farmer with grain stored in an elevator that fails. 11 U.S.C. §503(b)(9) includes as an administrative expense, entitled to first-tier priority, “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.” If a farmer can qualify for this provision, it is much stronger that the sixth-priority claim under 11 U.S.C. §507(a)(6). That’s because it is an administrative expense under the definition of 11 U.S.C. §507(a)(1) which makes it a first-tier priority. It also is not subject to the limit of $6,325 noted above that applies to sixth-priority claims.
There is also an expedited procedure for determining ownership of the grain that is stored at an elevator at the time the elevator files bankruptcy. 11 U.S.C. §557(c).
Grain Sold on Contract
One of the perils of grain contracting is the financial instability of the buyer. For grain that has been sold on contract to an elevator that then files bankruptcy before the delivery date specified in the contract, the farmer-seller can refuse to deliver the grain if the elevator is insolvent. The only exception to that rule is if the elevator can make cash payment. U.C.C. §2-702. If delivery has already been made as specified in the contract (whether under a forward, deferred payment or deferred pricing contract) and then the elevator files bankruptcy, the farmer-seller is an unsecured creditor and also is ineligible to participate in state indemnity/insurance funds or elevator bonding protection. See e.g., Iowa Code §203D; In re Woods Farmers Co-op Elevator Co., 107 B.R. 678 (Bankr. N.D. 1989). While ownership of grain stored under a warehouse receipt or scale ticket remains with the farmer, delivery of grain that is sold under a contract causes title to the grain to pass to the elevator. As noted, that makes the outcome different.
As noted in my blogpost of July 19, co-op directors are subject to fiduciary duties of obedience, loyalty and care. If a breach of any of those duties can be tied to the elevator’s failure, that might provide a legal remedy for disaffected farmers. However, that could be a difficult connection to make, and take time and money to establish it.
Tough economic times can lead to numerous legal issues. The failure of a grain elevator can cause large problems for farmers and for the local community it serves. A farmer that knows their rights and where they stand if an elevator fails, can be in a better position than are those farmers that aren’t as well informed.
Tuesday, July 25, 2017
For many people, the federal estate tax is not a concern. But, for a farming operation, other small business operation, and high-wealth individuals, it is. If a goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT). The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time period.
Today’s post looks at the use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner
What Is An IDGT?
An IDGT is a specially designed irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §671. That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. Thus, a sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
This is what makes the trust “defective.” The seller (grantor) and the trust are treated as the same taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected for federal estate and gift tax purposes. The result is that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments are paid to the grantor in-kind, and the trust is an eligible S corporation shareholder. See, e.g., Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A).
How Does An IDGT Transaction Work?
The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor. The IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.
The trust language should be carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate. It’s a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death. This is why an IDGT is generally viewed as an “estate freeze” technique.
What about the note? Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term. The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Given the current low interest rates, it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).
The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995). I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an “applicable retained interest” is not a creditor interest in bona fide debt. The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply. If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments. For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).
Pros and Cons of IDGTs
An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the low interest rate on the installment note payable. Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes.
On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death. Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.
Proper Structuring of the Sale to the IDGT
A key point is that the installment note must constitute bona fide debt. That is the crucial aspect of the IDGT transaction from an income tax and estate planning or business succession standpoint. If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate. In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701 and 2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt. The case was settled before trial on terms favorable to the taxpayer with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied. However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013). The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016 that resulted in no additional gift or estate tax. The total amount of the gift tax, estate tax, and penalties at issue was $152 million.
Another concern is that I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it. But, again, in the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.
So, as you can imagine, all of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note represents bona fide debt.
Administrative Issues with IDGT’s
An IDGT is treated as a separate legal entity. That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost. That’s especially true for highly appreciating assets and family business assets. But, again, it is critical to get good legal and tax counsel before trying the IDGT strategy.
Friday, July 21, 2017
The issues associated with spray-drift of dicamba have generated numerous questions to me. I devoted a blog post to the issue last week. Since then I have received more calls and emails from farmers experiencing drift issues. One farmer raised an interesting question – does the drift of dicamba constitute a hazardous waste that is regulated under federal law? That’s an interesting question and the focus of today’s blog post.
Comprehensive Environmental Response Compensation & Liability Act (CERCLA)
Hazardous waste is regulated by the federal CERCLA. CERCLA became law in late 1980, set as a goal the initiation and establishment of a comprehensive response and financing mechanism to abate and control problems associated with abandoned and inactive hazardous waste disposal sites. In general, CERCLA was enacted as a response to several then high-profile hazardous waste trouble spots such as Love Canal in New York and the Valley of the Drums in Kentucky. While CERCLA focuses on hazardous waste sites, it can have significant ramifications for agricultural operations because the term “hazardous waste” has been defined to include most pesticides, fertilizers, and other chemicals commonly used on farms and ranches. See, e.g., 40 C.F.R. § 261. As such, CERCLA liability is a concern any time that agricultural land is purchased or leased.
CERCLA Components. There are four basic components to CERCLA. First, the statute sets up an information gathering and analysis system to allow state and federal governments to determine more accurately the danger level at various disposal sites and to develop cleanup priorities accordingly. 42 U.S.C. § 9604. The EPA is authorized to designate as hazardous any substance which, when released into the environment, may present a “substantial danger” to public health and welfare, or to the environment. The act requires notification of any release into the environment of these substances. The act requires owners and operators of hazardous waste storage, treatment, and disposal sites to provide EPA with notification of the volumes and composition of hazardous wastes that can be found at their facility, and of any known or possible releases. The EPA uses this information to develop a national priorities list (NPL) in order to prioritize hazardous waste sites from those most dangerous and in need of immediate cleanup to those least dangerous and not as urgently in need of cleanup.
With respect to releases of hazardous substances, CERCLA provides that any person in charge of a “facility” from which a hazardous substance has been released in a reportable quantity must immediately notify the National Response Center. 42 U.S.C. § 9603(a) (2008). Releases that exceed 100 pounds per day must be reported. A key question of major importance to agriculture is whether large-scale livestock/poultry confinement operations operated by individual growers pursuant to contractual arrangements with vertically integrated firms constitute a single “facility,” or whether each confinement structure on a farm is a separate facility. In Sierra Club, Inc. v. Tyson Foods, Inc., 299 F. Supp. 2d 693 (W.D. Ky. 2003), the court held that Tyson was an operator of the chicken farms at issue pursuant to the production contracts with growers and that an entire chicken farm site is a facility from which releases must be reported under CERCLA. In a later case, Sierra Club v. Seaboard Farms, Inc., 387 F.3d 1167 (10th Cir. 2004), the United States Court of Appeals for the Tenth Circuit ruled similarly that the term “facility,” as defined in CERCLA, meant any site or area where hazardous substances come to be located. As a result, a large-scale confinement hog operation was held to be subject to CERCLAs reporting requirements for ammonia emissions that exceeded the per-day limit for the operation as a whole, even though no single “facility” at the operation exceeded the limit. The rulings make it much more likely that large-scale confinement operations will be subject to the reporting requirements of CERCLA.
Second, CERCLA established two funds: (1) the hazardous substance response trust fund (“Superfund”) which is funded by taxes on crude oil and chemicals and finances the government's response costs and damage claims for injury to or destruction or loss of natural resources; and (2) the post-closure liability trust fund which is financed by taxes on hazardous wastes and out of which payments are made to cover the costs of response damages or other compensation for injury or loss to natural resources.
Third, CERCLA provides the federal government with authority to respond to emergencies involving hazardous substances and to clean up leaking disposal sites. The EPA is given authority to require parties responsible for contamination to clean up the contamination or reimburse EPA for the costs of remediation. If the liable or “potentially responsible party” cannot be found or cannot afford to pay, then EPA may use the Superfund to clean up the contamination.
Fourth, the statute holds persons responsible for releases of hazardous material liable for cleanup and restitution costs. Liability is strict, joint and several, and can be applied retroactively to those having no continuing control over the hazardous substance. However, liable parties at a multi-party Superfund site are not jointly and severally liable if a reasonable basis exists to apportion their liability. See, e.g., Burlington Northern and Santa Fe Railway Co., et al. v. United States et al., 129 S. Ct. 1870 (2009). But, state law still might provide for joint and several liability.
Elements of Liability. The government must establish four elements to prevail against a party under CERCLA. For example, the government must establish that the site in question is a covered facility subject to CERCLA regulation. The government must also establish that a release or threatened release of a hazardous substance has occurred which caused the U.S. to incur “response costs.” The government need not prove that a particular defendant’s waste caused the government to incur response costs. In addition, the defendant must be a “covered person” (also termed a “potentially responsible party”). If the four elements are proved, the defendant is strictly liable (absent a statutory defense).
Typically, the government has little trouble establishing the first three elements. Consequently, most CERCLA litigation concerns the issue of whether the defendant is a “covered person” as defined by CERCLA. A current owner or operator of a “covered facility” is a covered person. This includes such individuals as tenants, as well as bankers, insurers and other lenders that finance the purchase of the land, limited partners and stockholders, officers and employees, and may also include easement holders. Also deemed to be a “covered person” is any owner or operator of the site at the time of disposal, any person who arranged for disposal or treatment of hazardous substances at the site, and any person who transported hazardous substances to the site. Persons or entities serving as an executor, administrator, conservator or trustee whether serving as an individual or as a corporate fiduciary may also be deemed a “current owner or operator” and, as such, be a “covered person.” For example, in a 1994 case, the court held that a conservator or executor could be held liable as an owner under CERCLA by virtue of leasing a ranch. Castlerock Estates, Inc. v. Estate of Markham, 871 F. Supp. 360 (N.D. Calif. 1994). The environmental contamination at issue was caused by dipping cattle over a period of several years. The current owner of the ranch was obligated to pay the cleanup costs under CERCLA and sought to recover the cleanup costs from a bank that had acquired another bank that had served as conservator and executor for one of the owners of the ranch who had become disabled. While the court noted that bare legal title held by a conservator or executor was inadequate to make the conservator or executor liable for cleanup costs, the court noted that liability could attach if there were additional “indicia of ownership.” The court said that could come from leasing the ranch (which occurred for three years), the granting of additional powers to the fiduciary (which had occurred) or participation in the operation of the ranch. The court ultimately concluded that there was sufficient evidence to go to trial as to the fiduciary's liabilities. Consequently, fiduciaries of property in current use may want to consider executing an indemnity agreement with the operator concerning indemnification for liability arising from environmental problems caused by the operator's use.
Pesticide Exemption. There can be no recovery of response costs or damages under CERCLA from the application of a pesticide product registered under the Federal Insecticide, Fungicide, Rodenticide Act (FIFRA). This is known as the “pesticide exemption.” However, one federal court has construed the pesticide exemption narrowly to not apply to the application of pesticides to unauthorized crops and in a manner that caused off-site drift. See, e.g., United States v. Tropical Fruit, S.E., 96 F. Supp. 2d 71 (D. P.R. 2000). The court held that a farmer’s improper application of pesticides was inconsistent with the product label and rendered the farmer a potentially responsible party for an “escape” of a hazardous substance.
The dicamba drift matter is a big issue in certain parts of the country right now. The recent question concerning drift and hazardous waste is an interesting one. While CERCLA contains a “pesticide exemption” there is potential for CERCLA liability when it can be established that dicamba isn’t applied in accordance with label directions.
Wednesday, July 19, 2017
Many farmers and ranchers belong to one or more agricultural cooperatives, commonly referred to as co-ops. A co-op is a business entity that distributes its income to its members in accordance with a member's use of the co-op. Co-ops are designed to give farmers and ranchers the benefits of group action in the production and marketing of agricultural commodities, and in obtaining supplies and services.
A co-op is characterized by two levels of management – a board and a manager. The board of directors is the policymaking body and board members are elected from within the membership by members to represent them in overseeing the co-op's business affairs. The directors establish policy, report to members, give direction to the manager, and are accountable to the membership for their actions in conducting business affairs.
But, what are the responsibilities of the directors to the member-shareholders? That’s the focus of today’s post.
Co-op directors have the same fiduciary duties of obedience, loyalty and care that corporate directors have. Fiduciary duties are duties assigned to or incumbent upon someone who is a trustee or in a position of trust, such as a co-op director. The duty of obedience requires directors to comply with the provisions of the incorporating statute, articles of incorporation, bylaws, and all applicable local, state and federal laws. The duty of loyalty requires directors to act in good faith, and the duty of care requires directors to act with diligence, care and skill. Both the duty of loyalty and the duty of care are dependent upon the particular state's statutory or common law standard of director conduct.
Obedience to Articles of Incorporation, Bylaws, Statutes and Laws
Illegality. Directors engaging in an act, or permitting the co-op to engage in action, that violates the articles of incorporation, bylaws, state co-op statute, other state law, federal law, or public policy may incur liability for damages. Damages from such liability normally accrue only to the co-op. However, directors causing their co-op to engage in illegal actions may be personally liable for culpable mismanagement for violating their duty of care by failing to attend to co-op activities or neglecting their decisionmaking responsibilities.
Ultra Vires. Board of director actions that are not within the powers conferred by the co-op's articles or bylaws are “ultra vires.” When a director acts outside of the scope of authority as established in the co-op's articles, bylaws or applicable state statute to the injury of the co-op, the director may be liable to the co-op for the resulting damage. Directors may be liable for ultra vires acts both in jurisdictions that consider a co-op director to be a fiduciary or trustee and in jurisdictions that consider a co-op director to be an agent of the co-op. The non-timely return of member equities is a frequent subject for an allegation that the co-op has acted beyond the scope of its powers.
Fiduciary Duty of Obedience, Loyalty and Care
Co-op directors must discharge the duties of their respective positions in good faith. To satisfy the duty of obedience, a director must comply with the cooperative’s articles of formation, bylaws and all applicable local, state and federal laws. In general, good faith includes doing what is proper for the co-op, treating stockholders and patrons fairly, and protecting the shareholders’ investments in a diligent, careful and skillful manner. The duty of loyalty is the fiduciary duty that is most often litigated. The duty of loyalty requires directors to avoid conflicts of interest, not to take advantage of corporate opportunities for personal gain (such as self-dealing and insider trading), to treat the co-op and the shareholders fairly, and not to divulge privileged information.
Conflicts of Interest. A conflict of interest arises between a director and a co-op when a director has a material personal interest in a contract or transaction that either affects the co-op or includes the co-op as a party. In general, a director's duty of loyalty requires interested directors to disclose any conflict of interest between themselves and their co-op. Also, conflict issues may arise in situations involving capitalization of the cooperative, redemption rights of members and preferential treatment in insolvency. Major potential areas of conflict of interest include decisions involving director compensation, the payment of dividends, marketing and purchasing contracts, and whether a directorship position should also be taken with a second co-op or corporation.
Corporate Opportunities. A co-op director's duty of loyalty prevents a director from personally taking advantage of opportunities that would also be of value to the co-op unless the co-op chooses not to pursue the particular opportunity. This applies to business opportunities that the director learns about by reason of the director's position with the co-op. A director is liable if the director appropriated a business opportunity rightfully belonging to the co-op where there was also a violation of the director's fiduciary duty of loyalty in appropriating the opportunity.
Fairness. A director must act fairly when making decisions or taking actions that affect the competing interests of the co-op, its stockholders or patrons, or minority holders of co-op interests. Fairness may also involve the open and fair disclosure of information from both the co-op and its directors to the co-op and its directors, stockholders and patrons. In general, a co-op's bylaws are a contract between the members and the co-op which imposes on the board of directors an implied duty of good faith and fair dealing in its relationship with its members.
Co-op directors may breach their duty of fairness in providing for the payment of dividends to current members or in redeeming co-op equities of former members. But, this is largely a matter that is governed by state statute, and those statute vary widely on the manner in which retained equities must be returned to former members.
Where directors have the authority to either allocate net earnings as patronage refunds or pay dividends on preferred stock, the failure to pay dividends on stock could be unfair. The injustice arises because the preferred stockholder is not receiving any return on money invested in the co-op. Director discretion in the redemption of co-op retained equities also may be a breach of loyalty if the directors provide different treatment for different persons or classes of members or patrons. For example, some courts have ruled unfair a board of directors' refusal to redeem certificates when other certificates had been redeemed upon demand. See, e.g., Mitchellville Cooperative v. Indian Creek Corp., 469 N.W.2d 258 (Iowa 1991).
Confidentiality. The fiduciary relationship existing between a director and co-op includes the duty of confidentiality. This duty prohibits a director from disclosing privileged information. Lawsuits against directors for the breach of this duty are rare. The federal and state securities acts, with their strict provisions concerning the nondisclosure of certain information, constitute more demanding legislation which may affect the directors' duty of confidentiality.
Duty of Care
Co-op directors have a duty to act carefully in directing co-op affairs. In general, directors must use that degree of diligence, care and skill which an ordinarily prudent person would exercise under similar circumstances and in the same position. The facts and circumstances of each case determine how much care a director must use in fulfilling directorship responsibilities.
Attention to Co-op Matters. Directors must attend to co-op matters in a timely fashion. This duty requires directors to attend meetings, follow the articles and bylaws, be cognizant of the various laws affecting the co-op and comply with their provisions, appoint and supervise officers and employees, and perform any other matters that reasonably require the directors' attention. The main issue for consideration is the standard of attention required. Usually, this is determined by reference to a particular state's corporation laws.
Reliance on Officers and Employees. This duty concerns the ability of a director to rely on information, reports, statements or financial data prepared or presented by co-op officers or employees. Directors may not rely upon information from others unless the directors have first made a good faith inquiry into the accuracy and truthfulness of the information.
Delegation of Duties. The board of directors manages co-op affairs. Administrative functions are performed by the co-op's executives and managers. The board of directors should be able and willing to delegate duties to provide for the business operations of the co-op, but must have the authority to do so.
Decision Making—The Business Judgment Rule. The Business Judgment Rule is a defense that a director may assert against personal liability where the director has fulfilled the duty of care. If a board of directors decision proves to be unwise or unprofitable, the directors will not be personally liable unless the decision was not made on the basis of reasonable information or was made without any rational basis whatsoever. But, the rule does not protect the directors from liability for self-dealing, lack of knowledge and personal bias.
Common Law Liability
Fraud. Co-op members, or former members if the cause of action occurred during their membership, who are dissatisfied with the management of the co-op may institute an action against the co-op and its directors for fraud. For example, director action that conceals information that should be disclosed to co-op members constitutes fraud.
Conversion. Co-op directors may also be sued for conversion. Such examples may include approving chattel mortgages which result in the loss of members' property. The absence of director authorization or inaction involving a wrongful property transfer is a defense which may shield defendant directors from liability for conversion.
Tort. Corporate directors may also be sued in tort for personal injury or damages resulting from their negligent or intentional acts.
Corporate Waste. Co-op directors may also be sued for the waste of corporate assets. While courts generally do not interfere with directors' management of a co-op, one court stated that “directors will be held liable if they permit the funds of the corporation or the corporate property to be lost or wasted by their gross or culpable negligence.”
Nuisance. The directors of co-ops that create offensive odors, dust, noise or other pollution may be named in lawsuits brought by neighbors seeking to stop the offensive activity.
Co-ops play an important role in agriculture. Being a member of a co-op’s board is an important role, but along with it comes the responsibility to act in the best interest of co-op members.
Monday, July 17, 2017
One step in the estate planning process involves an examination of possible alternatives for disposing of property during life including a sale for cash, an installment sale, a private annuity or a part-gift, part-sale transaction. As for an installment sale, it can be used in an estate plan to “freeze” the value of an estate (typically that of a parent), and simultaneously shift future appreciation in asset value caused by inflation or improvements to the next generation successor-operator. Structured as an installment sale with an appropriate rate of interest, the transaction does not constitute a gift, and can provide a stream of income for the parents (as the sellers). In addition, if the value of the assets subject to the installment sale drop in value, the transaction can be renegotiated and the purchase price decreased while still maintaining installment sale tax treatment.
Transitioning the farm via an installment sale – that’s the topic of today’s post.
One way to facilitate the transfer of farm assets from one generation to the next is via the installment sale. Given that the current level of the present interest annual exclusion for gift tax purposes is $14,000, an installment sale transaction could be established whereby farm assets could be conveyed to a child, for example, for a $14,000 principal amount interest-bearing note, payable semi-annually. This provides an income stream to the parents and does not trigger any gift tax. That’s because installment sales are not within the scope of I.R.C. §2701. But, if the parents desire to make a gift to the child, they could forgive the payments as they become due. In that situation, it might be possible to discount the gift below the face value of the installment obligation. Also, if a gift is made within three years of death, any gift tax that the decedent (or the estate) pays on the gift is pulled back into the estate. I.R.C. §2035. In addition, in an estate, an installment obligation is income in respect of decedent (IRD). It is not an item of property. That means that there is no basis step-up in accordance with I.R.C. §1014 in the hands of the recipient of the obligation.
Of course, the IRS has its own view of the tax treatment of installment sales. It may assert that the entire value of the property involved in an installment sale is a gift. Indeed, in Rev. Rul. 77-299, 1977-2 C.B. 343, the IRS said that an installment sale of land to grandchildren where the annual payments were forgiven constituted a gift of the full amount of the land in the year the transaction was entered into. The IRS said that was the result because the grandparent had made been gifting property to his grandchildren in prior years and because they didn’t have any other source of income. The courts, however, don’t tend to agree with the IRS position. That’s especially true if the notes involved are legally enforceable, subject to sale to third parties or assignable, and the property involved is subject to foreclosure if the buyer defaults. See, e.g., Estate of Kelley v. Comr., 63 T.C. 321 (1974); Haygood v. Comr., 42 T.C. 936 (1964); Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975).
The IRS may also assert that a gift may occur on an installment sale of land if the interest rate is below a market rate of interest. The IRS, U.S. Tax Court, the Eighth and Tenth Circuit Courts of Appeals and the United States District Court for the Northern District of New York agree that the use of an interest rate in an installment sale other than the market rate of interest results in a gift of the present value of the difference in interest rates. See, e.g., Ltr. Rul. 8804002, Sept. 3, 1987; Frazee v. Comm’r, 98 T.C. 554 (1992); Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996); Lundquist v. United States, 99-1 U.S. Tax Cas. (CCH) ¶60,336 (N.D. N.Y. 1999). The 7th Circuit Court of Appeals disagrees, however. Ballard v. Comm’r, 854 F.2d 185 (7th Cir. 1988). The U.S. Supreme Court has twice declined to resolve the conflicting views of the Circuit Courts of Appeal. Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996).
The take home is that if the transaction is an arm’s length transaction where the parents are not legally obligated to forgive payments or make cash gifts to enable the buyer (child(ren)) to make the payments, then the installment sale should be respected and not gift in the year the transaction is entered into would result. This is particularly the case is the parents actually do receive payments in the early years of the installment sale and a market rate of interest is utilized.
Variation – The Sale-Leaseback
For parents that aren’t ready to retire from farming/ranching, a sale-leaseback transaction might be a consideration. Under this structure, the parents sell the property to the children and then lease it back. While this type of transaction would result in gain recognition to the parents, that gain could be at least partially offset by a deduction for rent. In addition, the rental payment that the parents make to the children will help the children make the payments. A bona fide sale-leaseback transaction will result in the children being able to deduct interest on the installment obligation to the extent the children use the rental payments they receive from the parents to repay the mortgage on the property purchased under the installment sale. There won’t be any interest deduction allowed for annual payments attributable to cash gifts. The sale-leaseback transaction works if ownership is completely transferred to the children and they have a non-contingent obligation to pay. See, e.g., Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975); Stiebling v. Comr., No. 95-70391, 1997 U.S. App. LEXIS 11447 (9th Cir. 1997).
Are There Any Related Party Concerns?
Of course, concerns about sales to related parties arise. That’s because when depreciable property is sold to a “related party” ordinary income is the result. I.R.C. §1239. In addition, the seller can’t use the installment method to report the income unless a principal purpose of the sale was something other than the avoidance of federal income tax. I.R.C. §453(g)(2); see, e.g., Priv. Ltr. Rul. 9926045 (Apr. 2, 1999). A “related party” is for this purpose is defined under I.R.C. §1239(b).
When a related party resells the property within two years of the original sale, gain is accelerated to the original seller. There are some exceptions to the two-year rule. See, e.g., I.R.C. §453(e)(6)). A primary one is that a disposition after the death of the seller or buyer to the original transaction is not treated as a second disposition. That’s probably also the case when there is a death of a joint tenant with respect to jointly owned property. But, any installment sale contract should contain language that bars any disposition by the buyer within two years of the original sale unless the original seller consents. The same can be said with respect to pledging the property. In that instance, the original buyer should continue to bear any risk of loss associated with the property.
There are various ways to transition the family farm/ranch. An outright gift or an outright sale are two options. Another one is the installment sale. An installment sale can provide a means to transfer the assets to the next generation in a tax efficient manner. But, as with any transaction, the details must be paid close attention to in order to achieve the desired tax (and legal) result. The drafting of the installment sale contract must be crafted with care. Of course, as with any complex legal transaction, competent legal (and tax) advice and counsel should be sought and obtained.
Thursday, July 13, 2017
The financial difficulties in agriculture have strained relationships between farmers and their creditors. Back in vogue are the Uniform Commercial Code (UCC) rules for the dispositions of collateral by a creditor when a debtor defaults. But, even when a creditor repossesses collateral and takes action to dispose of it, the debtor still has some rights. One of those rights involves the requirement that the disposition of the collateral be done in a reasonable manner
Commercially reasonable collateral sales – that’s the topic of today post.
Right and Duty to Dispose of Collateral
In General. Upon a debtor's default, a secured party can repossess the collateral and may sell (either by public or private sale), lease or otherwise dispose of the collateral either in its existing condition or following any commercially reasonable preparation or processing.
Two rules on timing of collateral sales apply:
- If the debtor has paid 60 percent of the cash price of a purchase money security interest (PMSI) in consumer goods, or 60 percent of the loan in the case of another security interest in consumer goods and has not signed, after default, a statement renouncing or modifying the debtor's right, a secured party who has taken possession of the collateral must dispose of the collateral within 90 days after possession or suffer liability to the debtor. A PMSI is involved in situations where the lender provides the financing.
- In all other situations, the secured creditor may, after repossessing the collateral, retain the collateral in full satisfaction of the debt unless the debtor objects within 21 days of receipt of notice of the creditor's intent to retain the collateral. If the creditor does retain the collateral, the security interest is discharged along with any liens that are subordinate to such interest. If the collateral is not worth the amount that is owed against it, the creditor is not entitled to the deficiency.
Commercial Reasonableness. If the creditor disposes of the collateral, every aspect of the secured party’s disposition of the collateral, including the method, manner, time, place and other terms must be commercially reasonable. If collateral is not disposed of in a commercially reasonably manner, the liability of a debtor or a secondary obligor for a deficiency may be limited. See, e.g., Ford Motor Credit Co. v. Henson, 34 S.W.3d 448 (Mo. Ct. App. 2001).
Unless the collateral is perishable or threatens to decline speedily in value or is of a type customarily sold on a recognized market, the creditor must give the debtor reasonable notification of the time and place of any public sale, private sale or other intended disposition of the collateral unless the debtor, after default, has signed a waiver of notification of sale. For example, in In re Krug, 189 B.R. 948 (Bankr. D. Kan. 1995), the creditor repossessed registered shorthorn cattle without giving the debtor notice, and placed them under care of other ranchers while seeking foreclosure. The court held that repossession was proper because the security agreement allowed lack of notice; the creditor gave the debtor time to cure the default and did not intend to harm the debtor; however, debtor allowed an offset for damage to the cattle and calves against the creditor's claim because the caretakers failed to properly feed the cattle and bred them improperly.
When Article 9 of the UCC was revised, those revisions did not change existing law with respect to the statutory language for the recognized market exception. See Revised UCC § 9-611(b)-(d). Local livestock auctions cannot qualify for the recognized market exception to the notification requirement because livestock sold at auction are not tangible items and bidders by bidding are individually negotiating the price for the particular livestock in the ring.
If the repossessed collateral fails to bring enough at sale to cover the creditor’s claim, the creditor may bring a legal action against the debtor for the amount of the deficiency. But, again, to recover the deficiency, the sale of the collateral must have been made in a commercially reasonable manner. For instance, in Dallas County Implement, Inc. v. Harding, 439 N.W.2d 220 (Iowa 1989), the sale of repossessed collateral was held to not be reasonable where collateral the collateral (farm equipment) was sold at a private sale without notice to the debtor. As a result, the creditor was not entitled to a deficiency judgment. However, some courts hold that failure to send notice to the debtor may not invalidate a sale of repossessed property if the collateral is sold at a recognized market or for fair market value. See, e.g., First National Bank v. Ruttle, 108 N.M. 657, 778 P.2d 434 (1989). Proof that a greater amount could have been obtained for the collateral by its disposition at a different time or in a different method is not alone sufficient to preclude the secured party from establishing that the disposition was commercially reasonable. But, a low sales price suggests the court should scrutinize carefully all the aspects of the disposition to insure each aspect was commercially reasonable.
Ultimately, the issue of whether the disposition of collateral was commercially reasonable is one of fact. Courts consider a number of factors to evaluate whether collateral was disposed of in a commercially reasonable manner. These factors include whether the secured party tried to obtain the best price possible, whether the sale was private or public, the condition of the collateral and any efforts made to enhance its condition, the advertising undertaken, the number of bids received and the method used in soliciting bids.
The secured party may buy repossessed collateral at a public sale and may also buy the collateral at a private sale if the goods are of a type customarily sold in a recognized market or of a type which is the subject of widely distributed standard price quotations.
Revised Article 9
As noted above, a few years ago the UCC was revised. Under the Revisions to Article 9, in non-consumer deficiency cases, the secured party need not prove compliance with the default provisions unless compliance is placed in issue. If compliance is placed in issue, the secured party has the burden to show compliance. If the creditor cannot prove compliance, the rule is that the failure will reduce the secured party’s deficiency to the extent that the failure to comply affected the price received for the goods at the foreclosure sale. Under the revisions, the value of the collateral is deemed to equal the unpaid debt and the noncomplying creditor is not entitled to a deficiency, unless the creditor seeking a deficiency proves by independent evidence that the price produced at sale was reasonable. Thus, the creditor must prove what the collateral would have been sold for at a commercially reasonable sale and that this amount is less than the unpaid debt.
While Revised Article 9 does not define “commercially reasonable,” UCC §9-611(c) provides that in a commercial transaction notice must be given to debtors, secondary obligors, any person who has given the foreclosing creditor notice of a claim, and any other secured party that holds a perfected security interest in the collateral. When consumer goods are involved, notice need only be given to debtors and secondary obligors.
Times of financial distress always strain relationships between debtors and creditors. That’s a tough situation in agricultural settings because of the typical close relationship that many farmers and ranchers have with their lenders. But, the law establishes many rules that must be followed in financial transactions – including rules that govern how collateral dispositions are handled. The rule of “commercial reasonableness” is one of those rules.
Tuesday, July 11, 2017
Spray-drift issues with respect to dicamba and the use of XtendiMax with VaporGrip (Monsanto) and Engenia (BASF) herbicides for use with Xtend Soybeans and Cotton are on the rise. Usage of dicamba has increased recently in an attempt to control weeds in fields planted with crops that are engineered to withstand it. But, Missouri (effective July 7) and Arkansas (as of June) have now taken action to ban dicamba products because of drift-related damage issues.
So, what factors help determine the proper application of dicamba? In addition, if drift occurs and damage crops in an adjacent field, how should the problem be addressed? Can the matter be settled privately by the parties involved? If not, what legal standard applies in resolving the matter – negligence or strict liability?
Issues associated with dicamba drift – that’s the focus of today’s post.
Uniqueness of Dicamba
In many instances, spray drift is a straightforward matter. The typical scenario involves either applying chemicals in conditions that are unfavorable (such as high wind), or a misapplication (such as not following recommended application instructions). But, dicamba is a unique product with its own unique application protocol.
I asked an expert on chemical applications to provide me with an assist on the issues associated with the application of dicamba. Jeff Haggerty of Heinen Bros. Ag near Seneca, KS, has many years in the agricultural chemical application business and provided some helpful comments to me, and the following bullet points summarize his thoughts on the matter:
- Dicamba is a very volatile chemical and is rarely sprayed in the summer months. This is because when the temperature reaches approximately 90 degrees Fahrenheit, dicamba will vaporize such that it can be carried by wind for several miles. This can occur even days after application.
- The typical causes of spray drift are application when winds are too strong, a temperature inversion (temperature not decreasing with atmospheric height) exists or there has been a misapplication of the chemical.
- For the new dicamba soybeans, chemical manufacturers reformulated the active ingredient to minimize the chance that it would move off-target due to it volatility.
- Studies have concluded that the new formulations are safe when applied properly, but if a user mixes-in unapproved chemicals, additives or fertilizer, the safe formulations revert to the base dicamba formulation with the attendant higher likelihood of off-target drift.
- Soybeans have an inherit low tolerance to dicamba. As low as 1/20,000 of an application rate can cause a reaction. A 1/1000 of rate can cause yield loss.
- The majority of crops damaged from vapor drift may not actually result in yield loss. That’s particularly the case if drift damage occurs before flowering. However, if the drift damage occurs post-flowering the likelihood of yield loss increases. Also, studies have shown that a slight rain event can stop the volatilizing of dicamba.
- The label is the law. This is particularly true with the new chemicals used on Xtend crops. The labels are very specific with respect to additives, nozzles, boom height, and wind speed and direction.
Damage Claims – Building a Case
Negligence. For a person to be deemed legally negligent, certain conditions must exist. These conditions can be thought of as links in a chain. Each condition must be present before a finding of negligence can be obtained. The first condition is that of a legal duty giving rise to a standard of care. To be liable for a negligent tort, the defendant's conduct must have fallen below that of a “reasonable and prudent person” under the circumstances. A reasonable and prudent person is what a jury has in mind when they measure an individual's conduct in retrospect - after the fact, when the case is in court. The conduct of a particular tortfeasor (the one causing the tort) who is not held out as a professional is compared with the mythical standard of conduct of the reasonable and prudent person in terms of judgment, knowledge, perception, experience, skill, physical, mental and emotional characteristics as well as age and sanity. For those held out as having the knowledge, skill, experience or education of a professional, the standard of care reflects those factors. For example, the standard applicable to a farmer applying chemicals to crops is what a reasonably prudent farmer would have done under the circumstances, not what a reasonably prudent person would do.
If a legal duty exists, it is necessary to determine whether the defendant's conduct fell short of the conduct of a “reasonable and prudent person (or professional) under the circumstances.” This is called a breach, and is the second element of a negligent tort case.
Once a legal duty and breach of that duty are shown to exist, a causal connection (the third element) must be established between the defendant's act and (the fourth element) the plaintiff's injuries (whether to person or property). In other words, the resulting harm to the plaintiff must have been a reasonably foreseeable result of the defendant's conduct at the time the conduct occurred. Reasonable foreseeability is the essence of causality (also known as proximate cause).
For a plaintiff to prevail in a negligence-type tort case, the plaintiff bears the burden of proof to all four elements by a preponderance of the evidence (just over 50 percent).
Typical drift case. In a straightforward drift case, the four elements are typically satisfied – the defendant misapplied the chemical or did so in high winds (breach of duty to apply chemicals in a reasonable manner in accordance with industry standards/requirements) resulting in damages to another party’s crops. In addition, the plaintiff is able to pin-down where the drift came from by weather reports for the day of application combined with talking with neighbors to determine the source of the drift (causation). In many of these situations, a solution is worked out privately between the parties. In other situations, the disaffected farmer could file a complaint with the state and the state would begin an investigation which could result in a damage award or litigation.
Generally, what are contributing factors to ag chemical drift? For starters, the liquid spray solution of all herbicides can physically drift off-target. This often occurs due to misapplication including such things as applying when wind speed exceeds the recommended velocity, improper spray pressure, and not setting the nozzle height at the proper level above the canopy of the intended plant target. Clearly, not shielding sprayers and aerial application can result in an increased chance of off-site drift. Also, the possibility of drift to an unintended field can be influenced by droplet size if the appropriate nozzle is not utilized.
Dicamba drift cases. As noted above, dicamba is a different product that is more volatile than other crop chemicals. That volatility, the increased likelihood of drift over a broader geographic area, and that dicamba drift damages can occur several days after application, makes it more difficult for a plaintiff to determine the source of the drift. Thus, the causation element of the plaintiff’s tort claim can be more difficult to establish with dicamba-related damage claims. In addition, soybeans are inherently sensitive to extremely low dicamba concentrations, thus elevating the potential for damages.
Clear patterns of injury indicate physical drift which could make the causation element easier to satisfy. Wind speed at time of application, sprayer speed, sprayer boom height above the plant canopy, nozzle height, tank cleaning, sprayer set-up and whether the application occurs at night rather in the daylight, are also factors that are within the applicator’s control. Failure to follow label directions, meet common industry standards or manufacturer guidance on any of those points could point toward the breach of a duty and could also weigh on the causation element of a tort claim.
Relatedly, another factor with dicamba, as noted above, is whether it was applied on a hot day. The chemistry of dicamba has a “vapor curve” that rises with the temperature. While I have not seen that vapor curve, it would be interesting to see whether that curve has a discernibly steeper slope at a particular temperature. If so, that would indicate the point at which dicamba becomes very volatile and should not be applied. Indeed, the Banvel (brand name of dicamba) label specifically states that the chemical is not to be applied “adjacent to sensitive crops when the temperature on the day of the application is expected to exceed 85 [degrees Fahrenheit] as drift is more likely to occur.” To the extent any particular defendant can establish that application occurred when temperature on the day of application was forecast to exceed 85 degrees, the duty and breach elements of the plaintiff’s tort claim would be easier to satisfy.
Dicamba manufacturers have protocols in place to aid in the safe application of the products. Thus, in quantifiable damage cases, it is likely that an application protocol was not followed. But, establishing that breach to the satisfaction of a jury could be steep uphill climb for a plaintiff. That’s particularly the case with dicamba given its heightened volatility. As previously noted, damages could be caused by physical drift, temperature, volatility or temperature inversions. Is a particular cause tied to the defendant’s breach of a duty owed to the plaintiff?
Strict liability. Most pesticide drift cases not involving aerially-applied chemicals are handled under the negligence standard. However, a strict liability approach is sometimes utilized for aerially applied chemicals. See, e.g., Langan v. Valicopters, Inc., 567 P.2d 218 (Wash. 1977); but see Mangrum v. Pique, et al., 359 Ark. 373, 198 S.W.3d 496 (2006)(the aerial application of chemicals commonly used in farming communities that are available for sale to the general public is not an ultrahazardous activity triggering application of strict liability). In such a situation, liability results from damages to others as a result of the chemicals. It makes no difference whether the applicator followed all applicable rules for applying the chemicals and did so without negligence. The strict liability rule is harsh, and is normally reserved for ultra-hazardous activities. Do the present issues associated with dicamba drift damages warrant the application of the strict liability rule? Only time will tell whether the theory is pled in a future case and whether the court would apply it.
The dicamba drift issue is an important one in agriculture at the present time with respect to soybean and cotton crops. While the new dicamba formulations will not eliminate the problem of physical drift, proper application procedures by following label directions can go a long way to minimizing it. Likewise, drift issues can also be minimized by communication among farmers that helps determine the planting location of particular crops, their relative sensitivities to dicamba and following acceptable setbacks. But, farmers that sustain damage should quantify the economic loss, and see whether it can be determined if the source of the loss arose from a causally-connected breach of a duty.
Friday, July 7, 2017
Wednesday’s post was the first of a two-part series on timber tax issues. In that post, I took a look at the tax issues facing timber farmers and investors. In Part Two today, I examine timber casualty loss issues and timber like-kind exchanges.
Defined. A deductible casualty loss is the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Thus, losses due to hurricanes, tornadoes, wild fires and similar natural disasters are deductible. However, timber losses due to disease or insect damage are generally not deductible because they are progressive in nature.
Calculating the loss. For deductible casualty losses (which are deducted from ordinary income), the loss is the lesser of the decrease in the fair market value of a “single identifiable property” (SIP) or the adjusted basis of the SIP, less any insurance proceeds, salvage value or other compensation received. In effect, the measure of the loss is the economic loss suffered limited by the basis.
For casualty loss deduction purposes, the SIP is any unit of property having an identifiable adjusted basis that can be identified in relation to the area impacted by the casualty. Thus, the allowable loss isn’t limited to merchantable units of timber totally destroyed. Instead, it is also allowed for trees that were damaged but not made worthless. Rev. Rul. 99-56, 1999-2 CB 676. The deductible loss is equal to the difference in fair market value of the SIP immediately before and after the casualty, limited by basis. Thus, in an IRS Field Service Advice from 2002, it was not correct for a taxpayer to deduct as a casualty loss the difference between the fair market value for the volume of timber from each type of affected tree before an ice storm and the reduced fair market value for the volume of timber remaining after a storm. F.S.A. 200229007 (Apr. 5, 2002).
Claiming the loss. A casualty loss is claimed in the year that the loss takes place. Also, deductible are costs incurred to substantiate the loss (such as appraisal or timber cruise). The loss is reported on Form 4684, Section B where it is then carried to Form 4797, Part II (an ordinary loss, which avoids the netting against §I.R.C. 1231 gains). For a casualty loss to timber held as an investment, the loss is reported on Form 1040, Schedule A. There is an exception for casualty losses that occur in Presidentially declared disaster areas. Those losses can be deducted on an original or amended return for the year immediately before the year the disaster took place.
Postponing the loss. If a gain results from a casualty loss due to proceeds from a salvage sale or other form of reimbursement that exceed the taxpayer’s adjusted income tax basis in the timber, the gain can be postponed if the taxpayer acquires replacement property within two years after the end of the first tax year in which the taxpayer realizes any portion of the gain. I.R.C. §1033.
Example: Boris owns 80 acres of timber with 1280 cords of pulpwood-sized timber. Boris’s basis in the timber is $10,000. A tornado damaged trees containing 300 cords of wood such that they will have to be removed. The tornado damage reduced the fair market value of the timber by $2,000. Boris found a buyer willing to pay $4,000 for the damaged timber. Boris calculates his casualty loss deduction as follows:
Step 1: Adjusted basis in the tract: $10,000
Step 2: Difference in fair market value before and after the casualty: $10,000 - $8,000 = $2,000
Step 3: Smaller of Steps 1 and 2: $2,000
Adjusted basis in timber after the casualty: $10,000 - $2,000 = $8,000 ($6.25/cord)
Boris has gain on sale of the damaged timber of $2,125: ($4,000 – ($6.25 x 300)). The $2,125 gain recognition can be postponed if Boris purchases qualified replacement property within two years.
Losses for investors. The above discussion on losses was restricted to timber farmers. For investors, the loss is a non-business casualty loss. For property held for nonbusiness use, the first $100 of casualty or theft loss attributable to each item is not deductible. The deduction is also limited to the excess of aggregate losses over 10 percent of AGI, except for victims of certain hurricanes. Nonbusiness losses are deductible only to the extent total nonbusiness casualty losses exceed 10 percent of the taxpayer’s AGI. However, each casualty loss of nonbusiness property is deductible only to the extent the loss exceeds $100.
Personal casualty gains and losses (from nonbusiness property) are netted against each other. If the losses exceed the gains, all gains and losses are ordinary. Losses to the extent of gains are allowed in full. Losses in excess of gains are subject to the 10 percent AGI floor. All personal casualty losses are subject to the $100 floor before netting. If the personal gains for any taxable year exceed the personal casualty losses for the year, all gains and losses are treated as capital gains and losses.
Like-Kind Exchange of Timber and Timberland
Under the like-kind exchange rules of IRC §1031, a broad definition of “like-kind” for purposes of real estate exchanges is utilized. For instance, undeveloped real estate can be exchange for developed real estate. The “class” and “type” requirements that apply to tangible personal property do not apply with respect to real estate exchanges. However, the real estate needs to be held for investment or used in the taxpayer’s trade or business, and not held for sale. Thus, real estate can be exchanged for real estate as long as the traded properties are held for either a business or investment purpose.
Whether land has timber on it or not is immaterial for purposes of a like-kind exchange with other real estate. See Rev. Rul. 72-515, 1972-2 C.B. 466; Rev. Rul. 76-253, 1976-2 C.B. 51 and Rev. Rul. 78-163, 1978-1 C.B. 257. Thus, an exchange of real estate for standing timber or right to cut standing timber can qualify as a like-kind exchange. To qualify, an interest in standing timber must be treated as real property under state law. In many states, growing timber is considered part of the land. See, e.g., Hutchins v. King, 68 U.S. 53 (1863); Laird v. United States, 115 F. Supp. 931 (W.D. Wis. 1953).
The quantity, quality, age and/or species of timber may relate to grade or quality of timberland, but has no impact on whether timberland is like-kind to other real estate, whether or not the replacement land is timberland. See Priv. Ltr. Rul. 200541037; Ltr. Rul. 8621012.
For like-kind exchanges involving timberland, a key case is Oregon Lumber Co. v. Comr., 20 T.C. 192 (1953). Under the facts of the case, a timber harvesting company exchanged timberland with the U.S. government for the right to cut certain timber marked for cutting on other timberland owned by the U.S. The exchange agreement contained a provision obligating the exchanger to cut certain timber marked for cutting within a certain time period. The Tax Court held that the conveyance was not like-kind because Oregon law treated the right to cut timber as a right to acquire goods only (personal property), and under the exchange agreement, the exchanger acquired the right and obligation to cut timber marked for cutting that was limited in duration.
So, state law may dictate that a right to cut timber on someone else’s land is not like-kind to timberland. Relatedly, the IRS has considered whether an exchange of standing timber and cut timber located on 60 acres owned by the exchanger for a fee interest in three parcels of timberland qualified as like-kind exchange. The IRS determined that it did not. Tech. Adv. Memo. 9525002 (Feb. 23, 1995). The relinquished property was conveyed by a “timber deed” of all standing and cut timber located on 60 acres that would be removed within a specified period with any remaining timber reverted to the exchanger and constituted personal property. The two-year contract period amounted to a de facto restriction on the number of trees that could be removed. Thus, the duration of interests was dissimilar.
The key points on exchanges can be summarized as follows:
- Know state law;
- Based on state law, is the timber right being conveyed limited in duration or is it perpetual (e.g., fee simple)?
- Under state law, are rights to cut timber in the nature of a service contract as opposed to a property right?
- Are the rights to harvest timber conveyed by deed? Are they conveyed by bill of sale? Are they conveyed by a license?
- Does the conveyance instrument contain any obligation to cut and remove timber?
For rights to harvest timber conveyed by license, the Tax Court issued a key decision in 1994. In Smalley, the issue was whether the taxpayer had constructive receipt of a payment for purposes of the installment sale rules. The taxpayer sold “the exclusive license and right to cut all merchantable pine and hardwood timber suitable for poles, saw timber, or pulpwood” on 95 acres of land. Under the contract terms, the buyer paid the purchase price to an escrow agent so that the taxpayer could complete a deferred exchange. The court held that if the taxpayer had a bona fide right to complete a like-kind exchange, then the taxpayer did not have constructive receipt of the payment to an escrow agent even if he did not acquire like-kind property within the replacement period. The court did not provide any analysis of whether like-kind property was involved, but did state that it was reasonable for taxpayer to believe that proposed transaction would qualify as a like-kind exchange. State law (GA) specified that standing timber that the buyer severs constitutes a transfer of real property.
Timber casualty loss and like-kind exchange tax issues are important to timber producers and investors. This post and the previous one provide an overview of the basic issues.
Wednesday, July 5, 2017
Another aspect of agricultural taxation involves the timber industry. Most of the time we tend to think of tax issues for grain farmers, but there are also tax issues for producers that raise fruits and vegetables. In addition, livestock producers have some tax issues that are unique to them. But, there are certain areas of the country where the timber industry is significant, with taxpayers involved in the industry having unique tax issues of their own.
In the first of two blog posts involving timber tax issues, today’s post looks at the tax issues for timber producers and timber investors.
Timber Sellers in the Trade or Business of Timber Farming
A timber seller is either an investor or is engaged in the timber business. For an investor, resulting gain or loss is capital in nature. However, if the seller is in the trade or business of timber farming, the tax treatment of the sale depends on the amount of timber sold and how the taxpayer chooses to treat the sale.
For taxpayers that are engaged in the trade of business of timber farming, the income resulting from the sale of cut timber, whether cut personally or cut via contract by another party, the income on sale is ordinary gain or loss unless the taxpayer elects to treat the cutting as a sale under I.R.C. §631(a). That’s because the sales are generally treated as occurring in the ordinary course of the taxpayer’s business. If the election is made, the difference between the standing timber’s fair market value (as of the first day of the tax year) and basis is I.R.C. §1231 gain or loss that is netted with other I.R.C. §1231 gains or losses for the year. The difference between the net proceeds and the standing timber’s fair market value is ordinary in nature. Form T is required; this form tracks the taxpayer’s depletion in the timber.
To qualify for the election, standing timber must be cut by the owner or someone who has held a contract right to cut the timber for more than a year. The holding period must include the first day of the tax year in which timber is cut. The election statement must be attached to the return and the gain or loss is reported as of the first day of the tax year on Form 4797 and on Schedule F
If the taxpayer sells standing timber, the gain or loss is I.R.C. §1231 gain or loss (reported on Form 4797 along with a subtraction for the costs of sale and basis in the timber) that is netted with taxpayer’s other I.R.C. §1231 gains or losses for the year. I.R.C. §631(b). Net proceeds from annual sales of timber products (e.g., firewood, pine straw) and from sale of timber products after cutting (e.g., tree stumps) is ordinary income or loss.
Investors as Timber Sellers
For investors, lump-sum sales of standing timber are treated as a capital gain or loss under I.R.C. §1231. For land that is inherited with standing timber, the holding period is deemed to be long-term irrespective of how long either the taxpayer or the decedent held the land. I.R.C. §1223(9). The timber’s basis is its fair market value as of the date of the decedent’s death (or I.R.C.§2032 date).
The tax treatment of timber-related expenses depends on the type of expense and the tax status of the timber activity. I.R.C. §263A(c)(5) provides exception from uniform capitalization rules for timber and ornamental trees, other than Christmas trees (an evergreen tree that is more than six years old when it is severed from its roots).
Management and operating expenses. Ordinary and necessary expenses associated with the daily operation and management of timber property are currently deductible in accordance with IRC §162, even if no income is produced from the property, if the timber activity is engaged in for profit and the expenses are directly related to the property’s income potential. If the timberland is investment property, management and operating expenses are deductible in accordance with I.R.C. §212.
Expenses that are associated with the sale or other disposition of timber are deducted from the sale proceeds.
Carrying charges. Carrying charges (taxes, interest and other expenses that are related to the development and operation of timber properties) may be treated as deductible expenses or, by election, may be capitalized. Investors can also make the election. The election is made by attaching a statement to the original return for the tax year for which the election is desired to apply. The statement should explain that the taxpayer is electing to capitalize carrying charges and include sufficient information with respect to the activity that the charges relate to. If carrying charges are not deducted in a particular year, it is not assumed that an election to capitalize the costs has been made.
If the election to capitalize is made, the carrying charges are allocated to the capital accounts to which the charges apply. Non-commercial thinning and timber stand improvement costs are allocated in full to the timber accounts associated with the timber involved.
Holding costs. Annual property taxes, mortgage interest, insurance premiums and similar costs can be expensed or capitalized as the taxpayer chooses during any year in which timberland is “unimproved and unproductive.” Unimproved real property is generally defined as land without buildings, structures or any other improvements that contribute significantly to its value. Timberland is unproductive in any year in which it produces no income from any source (such as hunting lease income, timber sales, or sale of forest products from cut timber). The election to capitalize carrying charges characterized as holding costs cannot be made in any year that the taxpayer receives income from the timberland.
Development costs. Expenses for developing real property (such as non-commercial thinning and timber stand improvements) constitute carrying charges and must be treated consistently from year-to-year. It is immaterial whether the property is improved or unimproved, productive or unproductive.
Management costs. Management costs are deductible by individual taxpayers who hold timber activities as an investment as a miscellaneous itemized deduction on Schedule A. Property taxes (and other taxes attributable to timber operations) are deductible by investors as an itemized deduction (not subject to 2% of AGI floor). The interest deduction is limited to investment income. Fertilizer expenses are deductible under I.R.C. §194.
Reforestation expenses. Under I.R.C. §194(b), qualifying taxpayers can deduct up to $10,000 of reforestation expenses annually per individual tract of timberland. But, each reforestation project must be separately tracked and be shown on Form T. Cost–share payments may be available for expenses associated with reforestation activities. Cost-share expenses are excludible in accordance with a formula set forth in I.R.C. §126. But, unless a taxpayer is in a high tax bracket, the taxpayer may be better off to include cost-share expenses in income so as to claim the reforestation deduction (or amortization deduction) on total qualified reforestation expenses.
Non-deductible expenses. Non-deductible expenses for “qualified timber property” can be amortized over 84 months using the half-year convention. I.R.C.§194(a). For this purpose, “qualified timber property” is a woodlot or other site located in the U.S. that will contain trees in significant commercial quantities and is held by the taxpayer for the planting, cultivating, caring for and cutting of trees for sale or use in the commercial production of timber products. “Commercial production” means that the timber is grown for eventual sale to commercial timber processors or for use in the taxpayer’s trade or business. In addition, the tract (whether owned or leased) being reforested must be at least one acre in size, and the tract must contain sufficient trees to be adequately stocked for purposes of commercial timber production. Thus, trees grown for personal use do not qualify. The same is true for Christmas trees irrespective of whether the trees are grown for personal use or for commercial purposes.
Timber tax issues are, obviously, very important to timber producers. In Part Two on Friday, I will examine timber-related casualty loss issues and like-kind exchanges involving timber.
Monday, July 3, 2017
A taxpayer that manufactures, produces, grows or extracts property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business by or to an Interest Charge Domestic International Sale Corporation (IC-DISC) for direct use, consumption or disposition outside the U.S., and not more than 50 percent of the fair market value of the property is attributable to articles imported into the U.S. can get some favorable tax breaks.
The IC-DISC concept may not be that well known, but it can be utilized by agricultural businesses. It’s also a topic that Paul Neiffer and I will cover at our two-day summer ag tax/estate and business planning conference in Sheridan, Wyoming (and online) next week. http://washburnlaw.edu/employers/cle/farmandranchincometax.html
An IC-DISC has as its statutory basis I.R.C. §§991-997. It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter. To meet the statutory definition of an IC-DISC, it must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year equals or exceeds 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year. Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year. In addition, the corporation must make an election to be treated as an IC-DISC for the tax year. I.R.C. §992(a)(1).
As such, it is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at the more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1).
“Destination test.” As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S. This is known as the “destination test.” This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery. It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold. The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale. Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S.
The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing. This is particularly the case with fruits and vegetables. Growers can trace their products to grocery stores and other end-use foreign destinations. The same is true for grain producers that deliver crops to export elevators. They will likely be able to get the necessary documents showing the precise export location of their grain products.
Once an IC-DISC is set-up (by competent legal and tax counsel), the producer, manufacturer, reseller or exporter can pay the IC-DISC a commission that is tax deductible. This is the most common way that the IC-DISC earns income. The commission is tied to the producer’s (or manufacturer or reseller or exporter) foreign sales or foreign taxable income for the tax year. It is that commission that then can be distributed (after the tax year) to the IC-DISC shareholders as qualified dividends at qualified long-term capital gain rates.
There is a safe harbor for the commission which is the greater of four percent of the qualified export receipts on reselling the property, or 50 percent of the combined taxable income from the export sales. For instance, assume that a Kansas what farmer (sole proprietor) sells wheat to an export elevator for $2 million. The elevator is able to document that all of the wheat was exported. The farmer pays four percent of $2 million ($80,000) to the IC-DISC, and claims a deduction of that amount on Schedule F. The IC-DISC has income of $80,000 (less any expenses incurred). If that income is distributed to the farmer, it takes the form of a qualified dividend which will be taxed at long-term capital gain rates.
What’s the benefit to the farmer? It's in the form of a reduction in self-employment taxable income, and the replacement (to an extent) of ordinary income with qualified dividend income.
There’s also a benefit if the farmer operates in the C corporate form. In that case, the commission that is paid to the IC-DISC reduces C corporate taxable income. As a result, if the IC-DISC shareholders are individuals, there is only a single layer of tax. In addition, as noted, the IC-DISC ordinary income is converted to qualified dividends and taxed at long-term capital gain rates.
Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral. Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate. Each shareholder does their own computation. Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate.
The IC-DISC may be unheard of by many farmers and practitioners. However, it can play a role in the overall income tax and estate planning process. As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes. In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling. Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation. That will please the on-farm heirs (and, likely, the parents).
The IC-DISC can also reduce tax liability to an extent that exceeds its cost of formation, operation and administration. But, as is the case with any tax tool, all applicable Code requirements must be satisfied, and competent professional help should be utilized in setting up the IC-DISC structure.