Wednesday, August 30, 2017
Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end. Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few.
But, what about those equipment rentals? This can be a big issue for many farmers, including those that have recently retired. Must self-employment tax be paid on the income from equipment rents? The answer, as it is with many tax questions, depends on the facts of each situation.
That’s the focus of today’s post – self-employment tax on the rental of farm equipment.
The statute. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200. It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent. That’s because the self-employment tax is also a deductible expense. In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level.
In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §§1402(a)(1) and 1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax only if the activity constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.
This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate. But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357.
The reporting. Income from a rental activity is normally passive and is reported on Schedule E (Form 1040). From there it flows to page one of Form 1040 and is reported on the line for “Other Income.” Self-employment tax would not apply (but the additional 3.8 percent “passive tax” of I.R.C. §1411 could apply if the taxpayer has income over the applicable threshold). However, as noted at the top of Schedule E, Part 1, taxpayer are directed to report the income and expense from a personal property rental activity on Schedule C (or Schedule C-EZ). Schedule C is for reporting of business income, and the IRS instructions for completing Schedule E (at page E-4) say that Schedule C (or Schedule C-EZ) is to be used to report the income and expense associated with the rental of personal property if the taxpayer is in the business of renting personal property.
Trade or Business
Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property. The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer’s activity is engaged in regularly and continuously with the intent to profit from the activity. Comr. v. Groetzinger, 480 U.S. 23 (1987). But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court. Batok v. Comr., T.C. Memo. 1992-727.
As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21). Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040. A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.
The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business. But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax. Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership. If that is done, the income from the rental activity would flow through to the owner without self-employment tax. However, with an S corporation, reasonable compensation would need to be paid. For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income.
Many farmers lease farm equipment, particularly if they have retired from farming and still own the equipment. In that situation, it is often desirable not to incur self-employment tax on the equipment rental. To achieve that result, the rental activity should not rise to the level of a trade or business, or the equipment should be leased with real estate. Alternatively, the leasing should be done through an S corporation or a partnership.
Monday, August 28, 2017
Incorporation of an existing farming or ranching operation can be accomplished tax-free. A tax-free incorporation is usually desirable because farm and ranch property typically has a fair market value substantially in excess of basis. But, how is it done? What are the basics? What if liabilities are transferred to a corporation when it is formed? Are there special rules concerning debt assumption? What’s the IRS assignment of income theory all about?
Tax-free incorporation – that’s our topic today.
Three conditions – no election needed. For property conveyed to the corporation, neither gain nor loss is recognized to the transferor(s) on the exchange (I.R.C. §357(a)) if three conditions are met. I.R.C. §351. First, the transfer must be solely in exchange for corporate stock. Second, the transferor (or transferors as a group) must be “in control” of the corporation immediately after the exchange. This requires that the transferors of property end up with at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of the total number of shares of all classes of stock. Third, the transfer must be for a “business purpose.”
Because of the 80 percent control test, if it is desirable to have a tax-free incorporation, there can be no substantial stock gifting occurring simultaneously with, or near the time of, incorporation. Also, care should be taken to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation. See, e.g., Priv. Ltr. Rul. 9405007 (Oct. 19, 1993).
Income tax basis and holding period. The income tax basis of stock received by the transferors is the basis of the property transferred to the corporation, less boot received, plus gain recognized, if any. I.R.C. §362. If the corporation takes over a liability of the transferor, such as a mortgage, the amount of the liability reduces the basis of the stock or securities received. I.R.C. §358. The basis reduction can’t go below zero in the event the corporation assumes liabilities that exceed the basis of the assets transferred to the corporation. See, e.g., Wiebusch v. Comr., 59 T.C. 777 (1973), aff’d., 487 F.2d 515 (1973).
But, there is no basis reduction for a liability that generates a deduction when it is paid. Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash. The holding period of the transferor’s stock is pegged to the holding period of the assets that were transferred to the corporation. I.R.C. §1223(1). However, inventory and other non-capital assets do not qualify for “tacking-on” of the holding period. Thus, to get long-term gain treatment when the stock that is received on incorporation is sold, the stock seller will have to have held the stock for at least 12 months. See Rev. Rul. 62-140, 1962-2 C.B. 181.
The corporation's income tax basis for property received in the exchange is the transferor's basis plus the amount of gain, if any, recognized to the transferor. Also, the holding period of the transferred property carries over from the transferor to the corporation. I.R.C. §1223(2). Depreciable property received by the corporation at the time of incorporation is not eligible for “fast” methods of depreciation (for non-recovery property), expense method depreciation or a shift in ACRS or MACRS status. In other words, ACRS or MACRS property continues to be ACRS or MACRS property.
Transferring liabilities. If the sum of the liabilities assumed or taken subject to by the corporation exceeds the aggregate basis of assets transferred, a taxable gain is incurred as to the excess. I.R.C. §357(c). The test is applied to each transferor individually, with the computation accomplished by aggregating the adjusted tax basis of all assets and measuring that result against all of the liabilities of that particular transferor. The gain is capital gain if the asset is a capital asset or ordinary gain if the asset is not a capital asset. I.R.C. §357(c)(1).
But, some liabilities don’t count for purposes of the computation – specifically, those that give rise to a deduction when they are paid. So, for example, accrued expenses of a transferor that is on the cash method of accounting would not be considered to be “liabilities” for purposes of the computation. I.R.C. §357(c)(3).
Can taxable gain that would otherwise be incurred upon incorporating (when liabilities exceed basis) be avoided by giving the corporation a personal promissory note for the difference and claiming a basis in the note equivalent to the note's face value? The IRS has said “no,” determining that this technique will not work because the note has a zero basis. Rev. Rul. 68-629, 1968-2 C.B. 154. The Tax Court agrees. Alderman v. Comr., 55 T.C. 662 (1971); Christopher v. Comr., T.C. Memo. 1984-394.
However, an appellate court, in reversing the Tax Court in a different case eighteen years later, held that a shareholder's personal note, while having a zero basis in the shareholder's hands, had a basis equivalent to its face amount in the corporation's hands. Lessinger v. United States, 872 F.2d 519 (2d Cir. 1989), rev'g, 85 T.C. 824 (1985). The Tax Court was reversed again in a 1998 case. Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191. In this case, the taxpayer contributed two parcels of real estate to the taxpayer's closely-held corporation. The transferred properties were encumbered with liabilities that together exceeded the taxpayer's total basis of the properties by more than $500,000. In order to avoid immediate gain recognition as to the amount of excess liabilities over basis, the taxpayer also executed a promissory note, promising to pay the corporation $1,060,000 over a term of ten years at eleven percent interest. The taxpayer remained personally liable on the encumbrances even though the corporation took the properties subject to the debt. The taxpayer did not make any payments on the note until after being audited, which was approximately three years after the note was executed. The IRS argued that the note was not genuine indebtedness and should be treated as an enforceable gift. In the alternative, the IRS argued that even if the note were genuine, its basis was zero because the taxpayer incurred no cost in issuing the note to the corporation. As such, the IRS argued, the note did not increase the taxpayer's basis in the contributed property.
The court held that the taxpayer had a basis of $1,060,000 (face value) in the note. As such, the aggregate liabilities of the property contributed to the corporation did not exceed aggregate basis, and no gain was triggered. The court reasoned that the IRS's position ignored the possibility that the corporation could go bankrupt, an event that would suddenly make the note highly significant. The court also noted that the taxpayer and the corporation were separated by the corporate form, which was significant in the matter of C corporate organization and reorganization. Contributing the note placed a million dollar “nut” within the corporate “shell,” according to the court, thereby exposing the taxpayer to the “nutcracker” of corporate creditors in the event the corporation went bankrupt. Without the note, the court reasoned, no matter how deeply the corporation went into debt, creditors could not reach the taxpayer's personal assets. With the note on the books, however, creditors could reach into the taxpayer's pocket by enforcing the note as an unliquidated asset of the corporation. The court noted that, by increasing the taxpayer's personal exposure, the contribution of a valid, unconditional promissory note had substantial economic effect reflecting true economic investment in the enterprise. The court also noted that, under the IRS's theory, if the corporation sold the note to a third party for its fair market value, the corporation would have a carryover basis of zero and would have to recognize $1,060,000 in phantom gain on the exchange even if the note did not appreciate in value at all. The court reasoned that this simply could not be the correct result. In addition, the court noted that the taxpayer was creditworthy and likely to have funds to pay the note. The note bore a market rate of interest related to the taxpayer's credit worthiness and had a fixed term. In addition, nothing suggested that the corporation could not borrow against the note to raise cash. The court also pointed out that the note was fully transferable and enforceable by third parties. The court also acknowledged that its assumptions would fall apart if the shareholder was not creditworthy, but the IRS stipulated that the shareholder's net worth far exceeded the value of the note.
The court was careful to state that the court's rationale was limited to C corporations. Thus, the opinion will not apply in the S corporation setting for shareholders attempting to create basis to permit loss passthrough. Likewise, a partner in a partnership cannot create basis in a partnership interest by contributing a note. Rev. Rul. 80-235, 1980-2 C.B. 229.
What if the transferor remains personally liable? A similar technique designed to avoid gain recognition upon incorporation of a farming or ranching operation (where liabilities exceed basis) is for the transferors to remain personally liable on the debt assumed by the corporation, with no loan proceeds disbursed directly to the transferors. However, gain recognition is not avoided unless the corporation does not assume the indebtedness. Seggerman Farms, Inc. v. Comm’r, 308 F.3d 803 (7th Cir. 2002), aff’g, T.C. Memo. 2001-99. But, nonrecourse debts of a transferor, under I.R.C. §357(d), are presumed to be transferred to the corporation unless the transferor holds other assets subject to the debt that are not transferred to the corporation and the transferor remains subject to the debt. The same rule applies to recourse liabilities.
What if gain is triggered? If liabilities exceed basis, the gain is “phantom” income. That’s because the taxpayer hasn’t generated any cash to pay the tax on the gain that is triggered by transferring assets to the corporation with less basis than debt. In addition, for farm/ranch incorporations, the gain is likely to be ordinary in nature (determined as if the transferred assets were sold – I.R.C. §357(c)(1)). The one favorable factor if gain is recognized upon incorporation is that the basis of the transferred assets is increased by the amount of the gain. I.R.C. §358(a)(1(B)(ii)).
Business purpose. As noted above, one of the three requirements that must be satisfied to accomplish a tax-free incorporation is that the transfer must be for a business purpose. If the corporate assumption of liabilities has as a purpose the avoidance of federal income tax or lacks a bona fide business purpose, the assumed liabilities are treated as boot paid to the transferor. I.R.C. §357(b); 351(b). If the liabilities are created shortly before incorporation and are then transferred to the corporation, the IRS will raise questions. See, e.g., Weaver v. Comr., 32 T.C. 411 (1959); Thompson v. Campbell, 353 F.2d 787 (5th Cir. 1965); Harrison v. Comr., T.C. Memo. 1981-211.
Assignment of Income
In general, formation of a farm or ranch corporation in the regular course of business not involving substantial tax avoidance motives or a manifest desire to artificially shift income tax liability should not result in income recognition. However, the IRS has several theories available to challenge transfers carried out in the presence of obvious tax avoidance motives or a manifest desire to shift income tax liability artificially. See, e.g., I.R.C. §482. For instance, the “assignment of income” doctrine may override an otherwise tax-free exchange and cause the proceeds from the sale of transferred assets to be taxed to the transferor. See, e.g., Weinberg v. Comr., 44 T.C. 233 (1965); Slota v. Comr., T.C. Sum. Op. 2010-152. The IRS utilization of this theory should be watched in situations where the transferor has, via incorporation, shifted income to the corporation but claimed associated deductions on the transferor’s personal return. However, the theory does not apply to the transfer of cash method accounts receivable. See, e.g., Hempt Bros., Inc. v. United States, 354 F. Supp. 1172 (M.D. Pa. 1973), aff’d, 490 F.2d 1172 (3d Cir. 1974); Rev. Rul. 80-198, 1980-2 C.B. 113.
Distortion of Income
The IRS also has, under I.R.C. §482, broad powers to reallocate income, deductions, credits or allowances as necessary “in order to prevent the evasion of taxes or clearly to reflect...income.” See, e.g., Rooney v. United States, 305 F.2d 681 (9th Cir. 1962). However, if all of the farm income and expense that is incurred before incorporation stays with the transferor and is reported on the transferor’s return accordingly, an IRS challenge to a tax-free incorporation is not likely. See, e.g., Heaton v. United States, 573 F. Supp. 12 (E.D. Wash. 1983). One thing to avoid is the incurring of a substantial net operating loss shortly before incorporation.
A corporation can be formed tax-free. But, certain requirements must be satisfied and the transferred assets must have more basis than liabilities. In addition, stock should not be issued for basis, unless there is only one transferor or, for all transferors, the income tax basis of transferred assets bears a uniform relationship to the fair market value of the transferred property.
Carefully following the rules can lead to a happy tax result. Unfortunately, the opposite is also true.
Thursday, August 24, 2017
The Migratory Bird Treaty Act (MBTA) 16 U.S.C. § 703 et seq. (2008). protects migratory birds that are not necessarily endangered and, thereby, protected under the Endangered Species Act. The MBTA is important to agricultural producers and rural landowners because it has been broadly interpreted such that routine daily activities can become subject to the MBTA and create criminal liability at the hands of the U.S. government.
The Scope of the MBTA
What does “take” mean? The MBTA makes it unlawful at any time, by any means or in any manner, to “take” any migratory bird. “Take is defined to mean “pursue, hunt, shoot, wound, kill, trap, capture or collect any migratory bird. 16 U.S.C. §§ 703-712 (2008); 50 C.F.R. §10.12. Practically all bird species in the United States are covered due to regulations developed by the U.S. Fish and Wildlife Service (FWS) that apply the MBTA to species that don’t even migrate internationally or even at all. 50 C.F.R. §10.13.
The Act is not limited to covering only hunting, trapping and poaching activities, but extends to commercial activities that kill migratory birds absent an MBTA permit. The Act prohibits taking or killing of migratory birds (including a nest or egg) at any time, by any means or in any manner. That could include such conduct as operating oil and gas production facilities, aerogenerators, cell towers as well as commercial forestry and common agricultural activities. 16 U.S.C. §703. However, the courts are split on whether the MBTA applies strictly to truly migratory bird deaths that are not inadvertent (see, e.g., United States v. Citgo Petroleum Corporation, 801 F.3d 477 (5th Cir. 2015)) or deaths of a broader classification of birds that are killed only inadvertently.
Type of crime. Violation of the MBTA is a misdemeanor punishable by fine up to $500 and imprisonment up to six months. 16 U.S.C. § 707(a) (2008), as amended by 18 U.S.C. §§3559; 3571. Anyone who knowingly takes a migratory bird and intends to, offers to, or actually sells or barters a migratory bird is guilty of a felony, with fines up to $2,000, jail up to two years, or both.
Strict liability? The MBTA is a strict liability statute, and has been applied to impose liability on farmers who inadvertently poison migratory birds by use of pesticides. While the MBTA is a strict liability statute, constitutional due process requirements must still be satisfied before liability can be imposed. In other words, there still must be an affirmative act that causes the migratory bird deaths. For example, in United States v. Apollo Energies, Inc., et al., 611 F.3d 679 (10th Cir. 2010), oil drilling operators were not liable for deaths of migratory birds under the MBTA to the extent that the operators did not have adequate notice or a reasonable belief that their conduct violated the MBTA. Likewise, in United States v. Rollins, 706 F. Supp. 742 (D. Idaho 1989), a farmer was prosecuted for violating the MBTA when he used a mixture of granular pesticides on an alfalfa field. The chemicals poisoned a flock of geese and killed several of them. The trial court held that even though the farmer had not applied the pesticide in a negligent manner and could not control the fact that the geese would land and eat the granules, liability under the MBTA was based on whether the farmer knew that the land was a known feeding area for geese. The trial court concluded that “a reasonable person would have been placed on notice that alfalfa grown on Westlake Island in the Snake River would attract and be consumed by migratory birds.” The trial court was reversed on appeal on the grounds that the MBTA was too vague to give the farmer adequate notice that his conduct would likely lead to the killing of the protected birds since the farmer's past experience with the pesticide and the geese was that it did not kill them. But, in United States v. Van Fossan, 899 F.2d 636 (7th Cir. 1990), the court confirmed the notion that the MBTA is a strict liability statute and approved its application to a defendant who used pesticides to poison birds, even though the defendant did not know that his use of the pesticide would kill migratory birds protected under the Act.
“Baiting” of birds. The MBTA also prohibits the taking of migratory game birds by the aid of “baiting”. However, it is permissible to take migratory game birds, including waterfowl, on or over standing crops, flooded harvested croplands, grain crops that have been properly shocked on the field where grown, or grains found scattered solely as the result of normal agricultural planting or harvesting. See 50 C.F.R. §§ 20.11(g); 20.21(i)(2008). The FWS has promulgated regulations defining “normal agricultural planting” and “harvesting,” and in Falk v. United States Fish and Wildlife Service, 452 F.3d 951 (8th Cir. 2006), the court held that FWS determinations that harvesting corn after December 1 and aerial seeding of winter wheat in standing corn were not “normal planting” and that the landowners were barred from hunting next to the neighbors’ baited fields were a reasonable interpretation of the MBTA.
Some states also have statutes that prohibit the baiting of wildlife for hunting purposes unless the alleged baiting was the result of commonly accepted agricultural practices. For instance, in State v. Hansen, 805 N.W.2d 915 (Minn. Ct. App. 2011), the defendant’s conviction for using bait to hunt deer was reversed. The court held that the state statute violated due process because it was vague as applied to the defendant’s pumpkin patch operation. The law did not distinguish between normally accepted agricultural practices and the unlawful baiting of deer.
In addition, the Act permits the taking of all migratory game birds, except waterfowl, on or over any lands where shelled, shucked, or unshucked corn, wheat or other grain, salt, or other feed has been distributed or scattered as the result of bona fide agricultural operations or procedures. In United States v. Adams, 383 Fed. Appx. 481 (5th Cir. 2010), a farmer was convicted of violating the Act for hunting doves on a field that he had recently planted to wheat. For purposes of the “baiting” provision of the Act, the trial court judge determined that intent was not an element of the offense for which the farmer was convicted and did not allow the farmer to introduce evidence concerning the procedures commonly used to plant winter wheat in northeast Louisiana. On appeal, the Fifth Circuit Court of Appeals reversed the trial court, holding instead that the government was required to prove that the farmer’s intentions were not in good faith and that the farmer’s acts were merely a sham to attract migratory birds to hunt. Accordingly, the court reversed the farmer’s conviction and rendered acquittal based on the court’s determination that the farmer was entitled to have the lower court consider the evidence of his good faith in growing the wheat, and because there was no evidence from which a jury could find that the farmer’s planting was not the result of a “bona fide agricultural operation or procedure.” In another case, United States v. Andrus, 383 Fed. Appx. 481 (5th Cir. 2010), the court determined that the use of a stripper header to harvest milo was not a "normal agricultural practice" with the result that the defendant's sentence for taking migratory birds by aid of bait in violation of the MTBA was upheld. The defendant's testimony that he could not reasonably have been expected to know that the field he was hunting in was baited because he was not a farmer was not credible. The court noted that the defendant failed to inspect the field and that unharvested milo was clearly present near the defendant's duck blinds and decoys.
Migratory bird facilities. The MBTA regulations specify that “no migratory bird preservation facility shall receive or have in custody any migratory game birds unless such birds are tagged. See, e.g., 50 C.F.R. § 20.36. The requirement has been held to apply to an individual. See, e.g., United States v. Gilkerson, 556 F.3d 854 (8th Cir. 2009).
Supposedly, the FWS (the enforcing agency of the MBTA) is only interested in enforcing the MBTA on activities that “chronically” kill protected birds, and then only after notice has been given to the alleged offending party. 80 Fed. Reg. 30034 (May 26, 2015). But, that might be of little assurance to farmers, ranchers, rural landowners and others whose fate could be left up to FWS discretion and the interpretation of the MBTA by the courts where interpretations can differ by jurisdiction.
Tuesday, August 22, 2017
On September 18, Washburn School of Law will be having its second annual CLE conference in conjunction with the Agricultural Economics Department at Kansas St. University. The conference, hosted by the Kansas Farm Bureau (KFB) in Manhattan, KS, will explore the legal, economic, tax and regulatory issue confronting agriculture. This year, the conference will also be simulcast over the web.
That’s my focus today – the September 18 conference in Manhattan, for practitioners, agribusiness professionals, agricultural producers, students and others.
Financial situation. Midwest agriculture has faced another difficult year financially. After greetings by Kansas Farm Bureau General Counsel Terry Holdren, Dr. Allen Featherstone, the chair of the ag econ department at KSU will lead off the day with a thorough discussion on the farm financial situation. While his focus will largely be on Kansas, he will also take a look at nationwide trends. What are the numbers for 2017? Where is the sector headed for 2018?
Regulation and the environment. Ryan Flickner, Senior Director, Advocacy Division, at the KFB will then follow up with a discussion on Kansas regulations and environmental laws of key importance to Kansas producers and agribusinesses.
Tax – part one. I will have a session on the tax and legal issues associated with the wildfire in southwest Kansas earlier this year – handling and reporting losses, government payments, gifts and related issues. I will also delve into the big problem in certain parts of Kansas this year with wheat streak mosaic and dicamba spray drift.
Weather. Mary Knapp, the state climatologist for Kansas, will provide her insights on how weather can be understood as an aid to manage on-farm risks. Mary’s discussions are always informative and interesting.
Crop Insurance. Dr. Art Barnaby, with KSU’s ag econ department, certainly one of the nation’s leading experts on crop insurance, will address the specific situations where crop insurance does not cover crop loss. Does that include losses caused by wheat streak mosaic? What about losses from dicamba drift?
Washburn’s Rural Law Program. Prof. Shawn Leisinger, the Executive Director of the Centers for Excellence at the law school (among his other titles) will tell attendees and viewers what the law school is doing (and planning to do) with respect to repopulating rural Kansas with well-trained lawyers to represent the families and businesses of agriculture. He will also explain the law school’s vision concerning agricultural law and the keen focus that the law school has on agricultural legal issues.
Succession Planning. Dr. Gregg Hadley with the KSU ag econ department will discuss the interpersonal issues associated with transitioning the farm business from one generation to the next. While the technical tax and legal issues are important, so are the personal family relationships and how the members of the family interact with each other.
Tax – part two. I will return with a second session on tax issues. This time my focus will be on hot-button issues at both the state and national level. What are the big tax issues for agriculture at the present time? There’s always a lot to talk about for this session.
Water. Prof. Burke Griggs, another member of our “ag law team” at the law school, will share his expertise on water law with a discussion on interstate water disputes, the role of government in managing scarce water supplies, and what the relationship is between the two. What are the implications for Kansas and beyond?
Producer panel. We will close out the day with a panel consisting of ag producers from across the state. They will discuss how they use tax and legal professionals as well as agribusiness professionals in the conduct of their day-to-day business transactions.
The Symposium is a collaborative effort of Washburn law, the ag econ department at KSU and the KFB. For lawyers, CPAs and other tax professionals, application has been sought for continuing education credit. The symposium promises to be a great day to interact with others involved in agriculture, build relationships and connections and learn a bit in the process.
We hope to see you either in-person or online. For more information on the symposium and how to register, check out the following link: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
August 22, 2017 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Friday, August 18, 2017
Upon a decedent’s death, any liabilities for deficiencies on the decedent’s tax returns do not disappear. Someone must pay those taxes. In addition, creditors’ claims against the estate must be paid. If one of the creditors is the IRS, there is a federal tax lien that will come in to play. In that situation, the question becomes the priority of the lien. Does the IRS beat out other creditors? What if the estate administrator is entitled to get paid under state law?
Tax liability for deficiencies associated with a decedent’s estate and the IRS as an estate creditor – what are the related issues? That’s the topic of today’s post.
The decedent’s estate, in essence, is liable for the decedent’s tax deficiency at the time of death. Individuals receiving assets from a decedent take the assets subject to the claims of the decedent’s creditors — including the government. Asset transferees (the recipients of those assets) are liable for taxes due from the decedent to the extent of the assets that they receive. In addition, a trust can be liable as a transferee of a transfer under I.R.C. §6901 to the extent provided in state law. See, e.g., Frank Sawyer Trust of May 1992 v. Comr.,, T.C. Memo. 2014-59.
The courts have addressed transferee/executor liability issues in several recent cases. For instance, in United States v. Mangiardi, No. 9:13-cv-80256, 2013 U.S. Dist. LEXIS 102012 (S.D. Fla. Jul. 22, 2013), the court held that the IRS could collect estate tax more than 12 years after taxes were assessed. The decedent died in 2000. At the time of death, his revocable trust was worth approximately $4.58 million and an IRA worth $3.86 million. The estate tax was approximately $2.48 million. Four years of extensions were granted due to a market value decline of publicly traded securities. The estate paid estate taxes of $250,000, and the trust had insufficient assets to pay the balance. The IRS sought payment of tax from the transferee of an IRA under I.R.C. §6324. The court held that the IRS was not bound by the 4-year assessment period of I.R.C.§§6501 and 6901(c) and could proceed under I.R.C. §6324 (10-year provision). The court determined that the 10-year provision was extended by the 4-year extension period previously granted to the estate, and IRA transferee liability was derivative of the estate's liability. The court held that it was immaterial that the transferee may not have known of the unpaid estate tax. The amounts withdrawn from the IRA to pay the estate tax liability were also subject to income tax in the transferee's hands.
In another recent case, United States v. Tyler, No. 12-2034, 2013 U.S. App. LEXIS 11722 (3d Cir. Jun. 11, 2013), a married couple owned real estate as tenants by the entirety (a special form of marital ownership recognized in some states). The husband owed the IRS $436,849 in income taxes. He transferred his interest in the real estate to his wife for $1, and the IRS then placed a lien on the real estate. He died with no distributable assets and there were no other assets with which to pay the tax lien. His surviving wife died within a year of her his death and the property passed to their son, the defendant in the case. The son was named as a co-executor of his mother’s estate. The IRS claimed that the tax lien applied to the real estate before legal title passed to the surviving spouse. Thus, the IRS asserted, the executors had to satisfy the lien out of the assets of her estate. The executors conveyed the real estate to the co-executor son for $1 after receiving letters from the IRS asserting the lien. The son then later sold the real estate and invested the proceeds in the stock market, subsequently losing his investment. The IRS brought a collection action for 50 percent of the sale proceeds of the real estate from the executors. The trial court ruled for the IRS and the appellate court affirmed. Under the federal claims statute, the executor has personal liability for the decedent’s debts and obligations. The rule is that the fiduciary who disposes of the assets of an estate before paying a governmental claim is liable to the extent of payments for unpaid governmental claims if the fiduciary distributes the estate assets, the distribution renders the estate insolvent, and the distribution takes place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes.
United States. v. Whisenhunt, No. 3:12-CV-0614-B, 2014 U.S. Dist. LEXIS 38969 (N.D. Tex. Mar. 25, 2014), is another case that points out that an executor has personal liability for unpaid federal estate tax when the estate assets are distributed before the estate tax is paid in full. The court determined that the executor was personally liable for $526,507 in delinquent federal estate tax and penalties, which was the amount of the distribution at the time of the decedent's death.
Federal Estate Tax Lien
Another recent case illustrates additional peril for estate executors. In In re Estate of Simmons, No. 1:15-cv-01097-TWP-MPB, 2017 U.S. Dist. LEXIS 120487 (S.D. Ind. Jul. 31, 2017), the decedent died in 2014. He and his wife had one son in 1991 and then divorced in 1998. The decedent remarried, and the second wife was the surviving spouse at the time of the decedent’s death. The primary asset of the estate was the decedent’s home. The claims against the estate amounted to $1.8 million, including those of the decedent’s first wife, two of the decedent’s former employees for unpaid wages and benefits of approximately $800,000, and two noteholders for which the decedent had defaulted on the notes. Those amounted to about $250,000 in total. The state of Indiana also filed a tax lien, and the IRS lien was just shy of $600,000. However, the state court determined that the estate was insolvent. The estate only contained assets of $266,873. A state court order required that the estate assets be sold and be distributed in accordance with the priority stated in Indiana law. The state court order indicated that the IRS lien was in a seventh priority position.
On the motion of the IRS, the case was removed to federal district court. The federal district court determined that the IRS had a first priority lien and ordered that the net proceeds of from the sale of the residence ($245,766) go to the IRS. Neither the surviving spouse nor the executor were pleased with this conclusion. The surviving spouse expended substantial funds to get the home ready to be sold, and the executor (and the attorney for the estate) was entitled to be paid in accordance with state law. That’s the normal course of events – administrative expenses and fees generally have priority over other creditors, including the IRS.
However, there is another principal that can come into play. The Supremacy Clause of the Constitution (Article VI, Clause 2) says that state law is subject to federal preemption if there is a federal law on point that would override state law. That’s where the federal priority statute for governmental claims comes into play. 31 U.S.C. §3713. Under this provision, a federal governmental claim has first priority when a decedent’s estate has insufficient funds/assets to pay all of the decedent’s debts. However, courts have generally held that administrative expenses (e.g., fees of the executor and attorney for the estate) are not actually the decedent’s “expenses” with the result that they take priority over governmental claims. But, the In re Estate of Simmons court said that when the IRS files a federal tax lien I.R.C. §6321 comes into play. Under that statute, the federal government has a blanket priority lien on the assets of the estate. The limited exceptions of I.R.C. §6323 don’t apply to claims involving administrative expenses.
The federal court’s determination would seem to have a chilling effect on person’s assuming administrative tasks, including legal counsel for estate’s that have insufficient funds to pay all outstanding taxes, and it’s not the first time a court has reached the same conclusion. See, e.g., Estate of Friedman v. Cadle Co., 3:08CV488(RNC), 2009 U.S. Dist. LEXIS 130505 (D. Conn. Sept. 8, 2009). But, the In re Estate of Simmons court did note that the Internal Revenue Manual, at Section 220.127.116.11(3) says that the IRS has discretion to not assert its priority position so that reasonable administrative expenses can be paid to the persons entitled to them. In In re Estate of Simmons, the IRS stated that it intended to pay the executor’s unreimbursed expenses. That was enough for the court to go ahead and give the IRS priority on its lien.
The discretion of the IRS to allow the payment of reasonable administrative expenses is not terribly reassuring. It’s also troubling that it’s solely up to the IRS to determine what is “reasonable.” From a practitioner’s standpoint, when considering the representation of an estate with sizable outstanding unpaid federal taxes, it’s probably a good idea to first conduct a search for federal tax liens. Also, there probably is also a duty to advise the executor of the potential impact of a federal tax lien.
Executors (and their counsel) already have a mess on their hands in large estates where Form 706 must be filed and the new basis consistency reporting rules are triggered. Those rules already provide a disincentive to serve as an executor. The federal tax lien statute may create another reason not to handle certain estates.
Wednesday, August 16, 2017
Easements are common in agriculture. An easement does not give the holder of the easement a right of possession, but a right to use or to take something from someone else's land. To the holder of the easement, the easement is a right or interest in land, but to the owner of the real estate subject to the easement, the easement is an encumbrance upon that person's estate. Easements may take several forms and are common in agricultural settings. Sometimes, the terminology used to describe an easement can be confusing.
In today’s post, I take a look at the various types of easements that are common in agriculture and some of the common issues that they present.
Easements in Gross and Appurtenant Easements
An easement may be either an easement in gross or an appurtenant easement. An easement “in gross” serves the holder only personally instead of in connection with such person's ownership or use of any specific parcel of land. An easement in gross is a non-assignable personal right that terminates upon the death, liquidation or bankruptcy of its holder.
An easement that is “appurtenant” is one whose benefits serve a particular parcel of land. An appurtenant easement becomes a right in that particular parcel of land and passes with title to that land upon a subsequent conveyance. Examples of appurtenant easements include walkways, driveways and utility lines that cross a particular parcel and lead to an adjoining or nearby tract.
Determining whether an easement is one in gross or is appurtenant depends upon the circumstances of each particular situation. Courts generally prefer appurtenant easements. The particular classification matters when the question is whether the easement in question is assignable or whether it passes with the title to the land to which it may be appurtenant.
Affirmative and Negative Easements
An easement is either an affirmative easement or a negative easement. Most easements are affirmative and entitle the holder to do certain things upon the land subject to the easement. A negative easement gives its holder a right to require the owner of the land subject to the easement to do or not to do specified things with respect to that land. Thus, negative easements are synonymous with covenantal land restrictions and are similar to certain “natural rights” that are incidents of land ownership. These include riparian rights, lateral and subjacent support rights, and the right to be free from nuisances. However, most American courts reject the English “ancient lights” doctrine and refuse to recognize a negative easement for light, air and view. See, e.g., Fontainebleau Hotel Corp. v. Forty-Five Twenty-Five, Inc. 114 So.2d 357 (Fla. App. 1959). However, if a property owner's interference with a neighboring owner's light, air or view is done maliciously, the court may enjoin such activity as a nuisance. See, e.g., Coty v. Ramsey Associates, Inc., 149 Vt. 451, 546 A.2d 196 (1988).
Profits and licenses. A concept related to an easement is that of a profit. For example, O, owner of Blackacre, could grant to A a right to enter Blackacre to cut and remove timber. A is said to have a profit in Blackacre - a right of severance which will result in A's acquiring possession to the severed thing. Easement and profit rights generally include the right to improve the burdened land, perhaps only to a gravel road, but perhaps to erect and maintain more substantial structures, such as bridges, pipelines, and even buildings that facilitate use of the easement or profit. Sometimes a question arises as to whether a point is reached at which structures become so substantial that the rights become those of occupation and possession instead of just use. In answering this question, courts look at the circumstances as a whole instead of the labels the parties use. In general, the existence of permanent, substantial structures is viewed as an estate rather than an easement or profit.
A license is a term that covers a wide range of permissive land uses which, unless permitted, would be trespasses. For example, a hunter who is on the premises with permission is a licensee. The distinction between a license and an easement or profit is that a license can be terminated at any time by the person who created the license. For example, permission to hunt may be denied. Conversely, easements and profits exist for a fixed period of time or perpetually and are rights in land. A license is only a privilege. Likewise, easements and profits are interests in land while licenses are not, and licenses may be granted orally, but because easements and profits are interests in land, they are subject to the statute of frauds and must be in writing.
An easement may also be implied from prior use or necessity, or arise by prescription. An implied easement may arise from prior use if there has been a conveyance of a physical part of the grantor's land (hence, the grantor retains part, usually adjoining the part conveyed), and before the conveyance there was a usage on the land that, had the two parts then been severed, could have been the subject of an easement appurtenant to one and servient upon the other, and this usage is, more or less, “necessary” to the use of the part to which it would be appurtenant, and “apparent.” An easement implied from necessity involves a conveyance of a physical part only of the grantor's land, and after severance of the tract into two parcels, it is “necessary” to pass over one of them to reach any public street or road from the other. No pre-existing use needs to be present. Instead, the severance creates a land-locked parcel unless its owner is given implied access over the other parcel.
Prescriptive Easements (Adverse Possession)
Acquiring an easement by prescription is analogous to acquiring property by adverse possession. If an individual possesses someone else's land in an open and notorious fashion with an intent to take it away from them, such person (known as an adverse possessor) becomes the true property owner after the statutory time period (anywhere from 10 to 21 years) has expired. For an easement by prescription to arise, the use of the land subject to the easement must be open and notorious, adverse, under a claim of right, continuous and uninterrupted for the statutory period.
For example, assume that A owns Blackacre, and that B owns adjacent Whiteacre. A drives across a portion of Whiteacre to reach A's garage on Blackacre. A does this five days a week for 22 years. B then puts up a barbed wire fence in A's path. If A can show an adverse use of Whiteacre and that A's use was continuous for the full statutory period, and that A's use was visible and notorious or was made with B's acquiescence, A will have a prescriptive easement over Whiteacre. However, acquiescence does not mean permission. If A receives permission from B to cross Whiteacre, the prescriptive period never begins to run and no prescriptive easement will arise. See, e.g., Rafanelli v. Dale, 924 P.2d 242 (Mont. 1996)
Adverse possession (prescriptive easement) statutes vary by jurisdiction in terms of the requirements a person claiming title by adverse possession must satisfy and the length of time property must be adversely possessed. Once title is successfully obtained by adverse possession, the party obtaining title can bring a court action to quiet title. A quiet title action ensures that the land records properly reflect the true owner of the property.
Termination of Easements
An easement may be terminated in several ways.
Merger. Merger, also referred to as unity of ownership, terminates an existing easement. For example, assume that A owns Blackacre and B owns adjoining Whiteacre. B grants A an easement across Whiteacre so that A can acquire access to Blackacre. Two years later, A buys Whiteacre in fee simple. Because A now owns both tracts of real estate, the easement is terminated.
Release. An easement may also be terminated by a release. If the easement was for a duration of more than one year, the release must be in writing to be effective and comply with all of the formalities of a deed.
Abandonment. An easement may also be terminated by abandonment. Mere intent to abandon is not effective to terminate the easement. Instead, abandonment can only occur if the holder of the easement demonstrates by physical action an intent to permanently abandon the easement. Mere words are insufficient to cause an abandonment of the easement. For example, assume that an easement holder builds a barn in such a manner that access to the easement is blocked. This action would be sufficient to constitute abandonment of the easement.
Estoppel. An easement may also be terminated by estoppel where there is reasonable reliance by the owner of the servient tenement who changes position based on assertions or conduct of the easement holder. For example, assume that A tells B that A is releasing the easement over B's property. As a result, A doesn't use the easement for a long time. B then builds a machine shed over A's easement. In this situation, the easement would be terminated by estoppel and A could not reassert the existence of the easement after the machine shed has been built.
Prescription. An easement may also be terminated by prescription where the owner of the servient tenement possesses and enjoys the servient tenement in a way that would indicate to the public that no easement right existed.
Easements are common in agriculture and can arise in numerous ways. An understanding of what they are, how they can arise, how they can be terminated, and the associated legal issues can be useful.
Monday, August 14, 2017
While IRS audit activity data shows that less than one percent of returns were audited in fiscal year 2015, there are some areas that receive more attention than others. One of the areas of “low-hanging” fruit for IRS examining agents involves charitable contribution deductions. Numerous cases illustrate that properly substantiating contributions is critical, and that many taxpayers aren’t following the rules. In one recent case, the taxpayer was denied a $33 million charitable deduction because the taxpayer failed to properly substantiate the deduction. RERI Holdings I, LLC v. Comr., 149 T.C. No. 1 (2017). How does that happen when so much value is at stake?
So, what documentation is required to properly substantiate charitable contributions? It depends on the type of the contribution and the amount that is given. Substantiation rules for charitable contributions – that’s the topic of today’s post:
Charitable donations with cash have the most simplistic substantiation rules. For a single donation that is less than $250, a bank record or written receipt from the charity showing the charity’s name, amount and the date of the donation is sufficient. For single cash gifts of $250 and greater, the taxpayer must have an acknowledgement from the charity. That acknowledgement must include the amount of cash and a description of any other property that the taxpayer gave to the charity. It also must indicate whether the charity provided any goods or services in return for the donation. If non-cash goods or services were provided along with the cash gift, the acknowledgement must provide a description of them and a good faith estimate of their value. In addition, a statement must be included that only the contribution in excess of that estimated value is deductible. This also applies if the donor receives something (other than merely de minimis items) in return for a donation exceeding $75. However, if only intangible religious benefits were the only thing that the charity provided, a statement to that effect can be made instead of valuing the benefits.
There is an important point concerning the charity’s acknowledgement. The taxpayer must receive it by the earlier of the date the donor’s return for the year of the donation is filed, or the extended due date of that return. There has been recent litigation on this point, and the outcome hasn’t been taxpayer-favorable. So, it’s critical that charities get the acknowledgements out shortly after the yearend.
The $250 threshold is applied to each contribution separately. Treas. Reg. §1.170A-13(f)(1). Thus, for donors that make multiple cash gifts to the same charitable organization (such as a church, for example) that total $250 or more in a single year, where each gift is less than $250, written acknowledgement is not required unless the smaller gifts are parts of a series of related contributions made to avoid the substantiation requirements
A good approach for charities to take, particularly churches, is to track all donations on a weekly basis by each donor. That information can be easily laid out in a spreadsheet, with a listing of the various funds (e.g., benevolence, building, etc.) being donated to. That information can then be transferred to the acknowledgement form for each donor that contains the required language and the appropriate signature of the person on behalf of the charity. This can all be taken care of shortly after yearend and provided to the donor well before the donor’s return is filed.
For charitable donations of less than $250 that are made via a payroll deduction, a paystub, Form W-2, or other employer statement showing the amount withheld, plus an acknowledgment from the charity is sufficient documentation to support the deduction. For payroll deduction gifts of $250 or more, the acknowledgement from the charity must contain the necessary details that the charity did not provide goods or services in return for the donation. Again, the $250 threshold is applied by treating each payroll deduction as a separate contribution. Treas. Reg. §1.170A-13(f)(11).
For taxpayers that provide volunteer services to qualified charities and incur out-of-pocket expenses, canceled checks, receipts or some other record that shows the date the expense was incurred and the amount along with a description and the reason for incurring the expense is sufficient. If the amount of expense incurred reaches the $250 level, the taxpayer should still keep sufficient records, but the charity will also need to provide a proper acknowledgement.
Publicly traded stock. For small non-cash contributions (less than $250 in value), substantiation is sufficient if the taxpayer has a receipt with the charity’s name on it along with the date of the gift, the location and a description of the donation. In lieu of a receipt, the taxpayer should maintain sufficient records that contain the same information. A key point is to clearly show how the value of the property was determined, including a copy of an appraisal if one was obtained. If the gift involved a partial interest in property, additional information will be necessary.
For non-cash contributions of publicly traded stock that are between $250 and $500, the taxpayer will need a written acknowledgement from the charity along with maintaining written records. While IRS Publication 526 says that written records are to be maintained in all cases, the governing regulation says that written records are only required if the charity doesn’t provide a receipt. Treas. Reg. §1.170A-13(b)(1).
If the contribution is valued in excess of $500 but not over $5,000, an acknowledgement from the charity and written records are required, and Form 8283, Section A must be completed and filed with the IRS. That’s the same result for higher-valued gifts. For gifts of securities that are worth over $500, additional rules must be complied with.
Non-publicly traded stock. The rules for the donation of non-publicly traded stock are the same as for gifts of publicly traded stock, except that Form 8283, Section A must be completed and filed with the IRS. If the gift exceeds $10,000 in value, the donor must obtain a qualified appraisal before the due date of the return. If the value of the gift exceeds $500,000, the written qualified appraisal must be attached to the return.
Several prominent cases in recent years have involved the donation of valuable artwork. Again, the substantiation rules are tied to the value of the donated artwork. For gifts under $500, the substantiation rules basically require the maintenance of written records and an acknowledgement from the charity. Once that level is exceeded, Form 8283 must be completed and filed with the return. Once the $5,000 level is reached, Section B of Form 8283 must be completed and a qualified appraisal must be obtained before the due date of the return. For donated artwork valued at $20,000 or more the appraisal must be attached to the return and the taxpayer must keep a clear photo of the artwork.
Vehicles, Boats and Airplanes
Again, special rules apply to vehicles, boats and airplanes that are donated to charity. The maintenance of good records is again essential. In addition, Form 1098-C must be completed and an acknowledgement must be obtained from the charity. For gifts of such property, up to $5,000 in value, Form 8283, Section A must be completed. For higher-valued donations, Section B of Form 8283 must be completed. If the charity either gives the donated property to a “needy individual” or sells it to such a person at a significantly discounted price, a qualified appraisal must be obtained. Other rules must be complied with if the charity uses the donated property or makes a material improvement to it.
Other Non-Cash Donations
Other property, such as patents and intellectual property can also be donated to charity. If that happens additional special substantiation rules apply. The rules are particularly technical.
The RERI Holdings I, LLC Case
So, what went wrong in RERI Holdings I, LLC? A partnership paid just shy of $3 million in 2002 to acquire a remainder interest in particular property. The acquisition came along with certain covenants that were designed to maintain the property’s value. In addition, if the covenants were breached the remainder interest holder would get immediate possession of the property without any damages being paid by the holder of the term interest. About 18 months later, the partnership assigned the remainder interest to a University and claimed a deduction of over $33 million. The partnership completed and filed Form 8283 with its return, but it left blank the space on the Form where it was to provide its cost or adjusted basis in the property – the partnership either simply forgot or didn’t want to alert the IRS that it had likely overvalued the amount of the donation. But, that was a fatal mistake. The omission of that basis information violated Treas. Reg. §1.170A-13(c)(4)(ii)(E). No deduction was allowed.
Substantiating charitable contributions properly is essential. It is one area that the IRS audits more closely than other areas. Because the deduction can be particularly valuable, the substantiation rules must be carefully complied with.
Thursday, August 10, 2017
Last fall, I devoted a blog post to the definition of a “farmer” for various provisions of the Code. In that post, I pointed out how many variations there are to the definition and how important it is to understand those nuances and how they apply.
Earlier this week, the U.S. Tax Court in Rutkoske, et al. . Comr., 149 T.C. No. 6 (2017), decided a case involving the definition of a “qualified farmer” for purposes of the 100 percent conservation easement deduction of I.R.C. §170(b)(1)(E)(iv)(I). Unfortunately, neither of two brothers that were undoubtedly farmers, were a “qualified farmer” under the rule. The case is important for not only illustrating how important it is to understand Code definitions, but also for the tax planning that might have been utilized to reach the desired outcome.
Qualified Conservation Contribution Rules
Under I.R.C. §170, a taxpayer can claim a charitable deduction for a qualified conservation contribution to a qualified charity. The amount of the deduction is generally limited to 50 percent of the taxpayer’s contribution base (adjusted gross income (AGI) computed without regard to any net operating loss for the year, less the amount of any other charitable contributions for the year). I.R.C. §170(b)(1)(G). Any amount that can’t be deducted because of the limitation can be carried forward to each of the next five years, subject to the same 50 percent limitation in each carryforward year. I.R.C. §170(d)(1).
However, for a taxpayer that is a “qualified farmer” for the tax year of the contribution, the limit is 100 percent of the taxpayer’s contribution base, with a 15-year carryforward provision applying. A “qualified farmer or rancher” is a taxpayer whose gross income from the trade or business of “farming” exceeds 50 percent of the taxpayer’s gross income (all income from whatever source derived, except as otherwise provided) for the tax year. I.R.C. §170(b)(1)(E)(v); IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 4. However, income from farming does not include income derived from hunting and fishing activities (IRS Notice 2007-50, 2007-1, Q&A No. 8) or income from the sale of a conservation easement. IRS Notice 2007-50, 2007-1, Q&A No. 6. But, the income from hunting, fishing and sale of a conservation easement is included in the taxpayer’s gross income. IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A Nos. 6 and 8. Income from timber sales is included in both computations. IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 7.
“Farming” for this purpose is the I.R.C. §2032A(e)(5) definition. There, the term is defined as meaning: “…cultivating the soil or raising or harvesting any agricultural or horticultural commodity…on a farm; handling, drying, packing, grading, or storing on a farm any agricultural or horticultural commodity in its unmanufactured state, but only if the owner, tenant or operator of the farm regularly produces more than half of the commodity so treated; and … planting, cultivating, caring for, or cutting of trees, or the preparation…of trees for market.” I.R.C. §§2032A(e)(5)(A)-(C)(ii).
The contributed property need not be actually used or available for use in crop or livestock production to allow the donor to claim a deduction for the full value, but the property must be subject to a restriction that it remain available for use in either crop or livestock production. I.R.C. §170(b)(1)(E)(iv)(II). That means the entire property, including any improvements. IRS Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 11. See also Treas. Reg. §1.170A-14(f), Example 5.
Facts of Rutkoske
The Rutkoske case involved a limited liability company (LLC) that owned various tracts of land that it leased to a farming general partnership. Two brothers owned the LLC equally and also had ownership interests in the farming general partnership along with other farming entities. The complex structure was established for the purported reason of maximizing farm program payment limitations.
In 2009, the LLC conveyed a conservation easement on a 355-acre tract to a land conservancy on the East Coast. There was no question that the conservancy was a qualified charity under I.R.C. §501(c)(3) that could receive the conveyance and allow the donors a charitable deduction. The conveyance placed development restrictions on the property in exchange for $1,504,960. A simultaneous appraisal valued the property without the easement restriction at $4,970,000 and at $2,130,00 with the development restrictions. The claimed conservation contribution deduction was $1,335,040, which the brothers split evenly between them on their individual returns in accordance with I.R.C. §§702(a)(4); 702(b) and I.R.C. §703(a) and Treas. Reg. §1.703-1(a)(2)(iv). The LLC then sold its interest in the tract to a third party for $1,995,040. The charitable contribution deduction of $1,335,040 was computed by taking the difference between the pre and post-easement restriction value of the property ($2,840,000) and subtracting the payment received for the conveyance ($1,504,960). The brothers claimed the deduction at 100 percent of their contribution base. The IRS disagreed, claiming that the deduction was limited to only 50 percent of their contribution base (i.e., their adjusted gross income).
Each brother, on their respective 2009 returns, each claimed a charitable contribution deduction attributable to the easement of $667,520 along with their respective shares of long-term capital gain from the sale of the LLC’s interest in the tract to the third party – approximately $900,000 each. Each brother had a small amount of wage income along with a miniscule amount of interest income along with about a $200,000 loss from partnerships and S corporations. They claimed that their respective share of sale proceeds from the sale of the tract to the third party, and the proceeds from the sale of the development rights constituted farm income within the definition of I.R.C. §2032A(e)(5). Accordingly, their farm income exceeded the 50 percent mark entitling each of them to a 100 percent of contribution base deduction for the conservation easement donation. Their argument was a novel one – farming requires investment in physical capital such as land and, as an “integral asset” to the farming operation the sale proceeds of the 355-acre tract counted as farm income. The IRS disagreed based on a strict reading of I.R.C. §2032A(e)(5) as applied to I.R.C. §170(b)(1)(E)(v).
Tax Court Decision
The Tax Court upheld the IRS determination. Neither brother was a qualified farmer, although each one was (as the Tax Court noted) unquestionably a farmer. The Tax Court held that the income from the sale of the property wasn’t farm income. The Tax Court reached the same conclusion as to the income from the sale of the development rights. The income from those sales weren’t specifically enumerated in I.R.C. §2032A(e)(5) and didn’t fit within the same category of activities enumerated in that provision. In addition, the Tax Court said that I.R.C. §170(b)(1)(E) was “narrowly tailored” to provide a tax benefit to a qualified farmer which had a specific definition that they wouldn’t broaden. In any event, the Tax Court also determined that the LLC structure doomed the brothers because the character of the deduction flowed through to them from the LLC and the LLC was not in the business of farming. Instead, the Tax Court noted, the LLC was engaged in the business of leasing land. But, on this point, the Tax Court is arguably incorrect (and didn’t need to make the statement; it was unnecessary as to the outcome of the case). As the Tax Court noted, the contribution itself was properly claimed by each brother at the individual level on their respective returns. Each brother did use the 355-acre tract in their farming business. Partnerships don’t pay tax and should be viewed under the aggregate theory. Indeed, the IRS stated in 2007 that when a qualified conservation contribution is made by a pass-through entity (such as a partnership or S corporation) the determination of whether an individual who is a partner or shareholder is a qualified farmer for the tax year of the contribution is made at the partner or shareholder level. Notice 2007-50, 2007-1 C.B. 1430, Q&A No. 5. The Tax Court made no reference to the 2007 IRS statement.
According to the Tax Court, a pass-through entity that owns land on which a conservation easement is conveyed to a charity must be engaged in the trade or business of agriculture. That incorrect conclusion is problematic, even though it was not determinative of the outcome of the case. Also, when a pass-through entity is involved, the computation of the taxpayer’s true gross income must include all of the pass-through income, from farming activities and non-farming activities. It’s not just simply AGI as reported on the return. In Rutkoske, it does not appear that the Tax Court took that into account (even though it wouldn’t have made a difference in the outcome of the case).
From purely a tax planning standpoint, assuming the LLC was engaged in the trade or business of farming (as the Tax Court apparently requires), the land sale income would have still presented a problem for the brothers in reaching the 50 percent gross income threshold. To deal with that problem, structuring both the conveyance of the conservation easement and the LLC’s sale of its remaining interest as an installment sale with the reporting of the gain in the tax year after the tax year of the contribution would have allowed the brothers to meet the 50 percent test.
Also, from a broader, more general perspective, the 100 percent of contribution base limit can work against a qualified farm taxpayer. For instance, if a qualified farmer’s contribution exceeds the qualified farmer’s AGI, the result is that some of the tax savings as a result of the charitable contribution will lose some of their power. That's because they will be realized at the lower tax brackets (presently 10 percent and 15 percent (federal)). In addition, the charitable contribution can have the impact of eliminating all of the taxpayer’s taxable income. For those taxpayers that also have other Schedule A itemized deductions, they won't produce any tax benefit. Neither will the personal exemptions. The statute does not provide any way for the "qualified farmer" taxpayer to use the 50 percent of contribution base limit when the taxpayer is a qualified farmer. This all means that, in certain situations, it might be better from a tax standpoint, for a qualified farmer to make a qualified contribution in a year when the 50 percent test cannot be satisfied.
The Rutkoske decision illustrates a significant limitation for farmers – it is very difficult to get a 100 percent of AGI deduction (as a “qualified farmer”) when property is disposed of at a gain in the same year in which a conservation easement is donated unless an installment sale is structured. In addition, entity structuring for USDA farm program payment limitation purposes, under the Tax Court's rationale, can work to eliminate the deduction in its entirety. Attorneys familiar with USDA farm program payment limitation rules are often not well-versed in farm taxation, and that can be the case even if they anticipate that a client might make a conservation easement donation.
Tuesday, August 8, 2017
Buy-sell agreements can be very important to assuring a smooth transition of the business from one generation to the next. Typically funded by life insurance to make them operational, the type of buy-sell utilized and the drafting of the buy-sell are fundamentally associated with their ability to accomplish client objectives.
Type of Buy-Sell Agreements
Buy-sell agreements are generally of three types:
- Redemption agreements (a.k.a. entity purchase). This type of agreement is a contract between the owners of the business and the business whereby each owner agrees to sell his interest to the business upon the occurrence of certain events.
- Cross-purchase agreements. This type of agreement is a contract between or among the owners (the business is not necessarily a party to the agreement) whereby each owner agrees to sell his shares to the other owners on the occurrence of specified events.
- Hybrid agreements. This type of agreement is a contract between the business and the owners whereby the owners agree to offer their shares first to the corporation and then to the other owners on the occurrence of certain events.
Income Tax Consequences For C Corporation Buy-Outs
For redemption agreements, if I.R.C. §§302(b)-303 are not satisfied, the redemption is taxed as a dividend distribution (ordinary income without recovery of basis) to the extent of the stockholder’s allocable portion of current and accumulated earnings and profits, without regard to the stockholder’s basis in his shares. This can be a significant problem for post-mortem redemptions - the estate of a deceased shareholder would normally receive a basis in the shares equal to their value on the date of death or the alternate valuation date. Thus, dividend treatment can result in the recognition of the entire purchase price as ordinary income to a redeemed estate, whereas sale or exchange treatment results in recognition of no taxable gain whatsoever.
For cross-purchase agreements, unless the shareholder is a dealer in stock, any gain on the sale is a capital gain regardless of the character of the corporation’s underlying assets. I.R.C. §1221. For the estate that sells the stock shortly after the shareholder’s death, no gain is recognized if the agreement sets the sale price at the date of death value. I.R.C. §§1014; 2032. The purchasing shareholders increase their basis in their total holdings of corporate stock by the price paid for the shares purchased under the agreement, even if the shares are paid for with tax-free life insurance proceeds.
A hybrid agreement requires the corporation to redeem only as much stock as will qualify for sale or exchange treatment under I.R.C. §303, and then requires the other shareholders to buy the balance of the available stock. This permits the corporation to finance part of the purchase price, to the extent required to pay estate taxes and expenses, and assures sale or exchange treatment on the entire transaction. I.R.C. §303(b)(3).
Under a “wait and see” type of buy-sell agreement, the identity of the purchaser is not disclosed until the actual time of purchase as triggered in the agreement. The corporation will have first shot at purchasing shares, then the remaining shareholders, then the corporation may be obligated to buy any remaining shares.
The corporation could buy a life insurance policy on the life of each stockholder, with the corporation as the policy owner, premium payer, and beneficiary of these policies. The corporation could then use the life insurance to finance the purchase if, at the end of the first option period, the corporation buys the deceased stockholder’s interest. The corporation could lend the insurance proceeds to the stockholders if, at the end of the corporate option period, it is decided that the surviving stockholders should be the buyers (or to the extent stock remained to be purchased after the corporation’s option expires). Investment payments would be deductible to the stockholders and income to the corporation.
An alternative approach is for each shareholder to buy, pay for, own, and be the beneficiary of a life insurance policy for each of the other shareholders. The surviving shareholders would then receive the proceeds when one shareholder dies, and, if a cross-purchase is indicated and appropriate, use the proceeds as the necessary funds to carry out the buy-sell agreement. The surviving shareholders could also lend the proceeds to the corporation if an entity purchase agreement is utilized, to enable the corporation to buy additional shares, or the surviving shareholders could make capital contributions which would have the effect of increasing each shareholder’s stock basis.
A combination of the above approaches could also be used for funding the wait-and-see buy-sell agreement. For example, the corporation could own cash value life insurance and the owners could own term insurance. Also, the parties could have a split-dollar arrangement whereby the corporation pays for the cash value portion of the premiums and the shareholders own the policy and pay for the term portion of the premiums, with the proceeds split between them.
A buy-sell agreement that imposes employment-related restrictions may create ordinary compensation income (without recovery of basis). I.R.C. §83. However, an agreement containing transfer restrictions that are sufficient to render the stock substantially non-vested (substantial risk of forfeiture) may prevent the current recognition of ordinary income.
Advantages and Disadvantages Of Buy-Sell Agreements
Pros. A well-drafted buy-sell agreement is designed to prevent the sale (or other transfer) of business interests outside the family unit. In general, a buy-sell agreement is a relatively simple agreement. It is a contract between family members. There are few formalities to follow under state law, and no filing or registration fees. It also creates a ready market for an owner’s interest, easing the liquidity problems created by the ownership of a block of closely-held business interests at the owner’s death. In addition, if the buy-sell is drafted properly, it can help establish the value of the business interests if drafted properly.
Cons. On the downside, a hybrid or redemption type of buy-sell agreement may not yield favorable tax consequences upon the purchase of business interests in accordance with the agreement. This is typically not a problem with a cross-purchase agreement. The basic problem is that a corporate distribution in a redemption of stock is taxed as a dividend (i.e., taxed as ordinary income to the extent of earnings and profits, without recovery of basis), unless it meets the technical requirements of I.R.C. §302(b) or §303.
As discussed further below, the parties to the agreement must have funds available to buy the stock at the time the agreement is triggered. Typically, life insurance is purchased for each business owner to cover the total purchase price (or at least the down payment). However, the premiums on such policies are not deductible (see I.R.C. §264) and can create a substantial ongoing expense.
Estate Planning Implications
The purchase of a deceased shareholder’s stock can deprive the estate of the advantage of certain post-mortem estate planning techniques such as special use valuation and installment payment of federal estate tax under. As for the installment payment provision, the sale of all or a substantial part of the shares during the deferral period accelerates the deferred taxes. I.R.C. §6166 (g)(1)(B). Thus, it may be a good strategy to plan a series of redemptions or purchases in amounts equal to the taxes that must be paid in each of the fifteen years of the deferral period.
If a buy-sell is not planned well, the agreement can cause a gift of stock to a trust for the surviving spouse not to qualify for the estate tax marital deduction. In Estate of Rinaldi v. United States, 38 Fed. Cl. 341 (1997), aff’d., 178 F.3d 1308 (Fed. Cir. 1998), cert. den., 526 U.S. 1006 (1999), a purchase option was created in the decedent’s will for a son that was named as trustee of a QTIP trust for the decedent’s surviving spouse. The court determined that the marital deduction was not available because the son could purchase the stock at book value by ceasing active management in the company. That result would have been the same had the option been included in an independent buy-sell agreement.
Life insurance is often the preferred means of funding the testamentary purchases of stock pursuant to a buy-sell agreement because the death benefit is financed by a series of smaller premium payments, and because the proceeds are received by the beneficiary without income tax liability. See I.R.C. §101. But, there can be traps associated with life insurance funding. For instance, proceeds received by a C corporation can increase the corporation’s AMT liability by increasing its adjusted current earnings (even if the proceeds are to be used to redeem the stockholder’s shares). See IRC §56(g). Also, life insurance may be sufficient to fund the buyout of a deceased owner’s interest, but may be insufficient to fund the lifetime redemption occasioned by the owner’s disability or retirement.
Other observations. The cash value of a permanent life insurance policy may be withdrawn by loan or surrender of the policy, but the value may be a very small percentage of the death benefit, inadequate to finance the buy-out. Disability insurance may be used to finance a purchase occasioned by an owner’s disability, but it can be quite expensive, and cannot be applied toward the purchase of an interest of an owner who is retiring or used to prevent the sale of an interest in the business to a buyer outside the family unit.
It is possible to use accumulated earnings of the business to fund a redemption. But, such a strategy may not be treated as a “reasonable need of the business” with the result that the business (if it is a C corporation) could be subject to the accumulated earnings tax. I.R.C. §531. However, corporate accumulations used to pay off a note given a stockholder for a redemption is a reasonable need of the business, as a debt retirement cost. But see Smoot Sand & Gravel Corp. v. Comr., 274 F.2d 495 (4th Cir. 1960), cert. denied, 362 U.S. 976 (1960).
A well-drafted buy sell agreement can be a very useful document to assist in the transitioning of a family business from one generation to the next. It can also be a useful device for assisting in balancing out inheritances among heirs by making sure the heirs interested in running the family business end up with control of the business and other heirs end up with non-control interests. A buy-sell agreement - a critical part of a family business succession plan. Does your family business need one?
Friday, August 4, 2017
My blog post of July 27 concerning the failure of a grain elevator struck a chord by pointing out a difference between grain stored in the elevator under a warehouse receipt or scale ticket, and grain that is sold to the elevator on contract. I received numerous comments from readers that hadn’t realized that difference. Many of those were also asking about the proper structuring of a deferred payment contract.
That’s the focus of today’s blog – the proper structuring of deferred payment contracts.
A cash-basis taxpayer accounts for income in the tax year that it is either actually or constructively received. The constructive receipt doctrine is the primary tool that the IRS uses to challenge deferral arrangements. Under the regulations (Treas. Reg. §1.451-2(a)), a taxpayer is deemed to have constructively received income when any of the following occurs.
- The income has been credited to the taxpayer’s account.
- The income has been set apart for the taxpayer.
- The income has been made available for the taxpayer to draw upon it, or it could have been drawn upon if notice of intent had been given, unless the taxpayer’s control of the receipt of the income is subject to substantial limitations or restrictions.
However, income received under a deferred payment contract is taxed under the installment payment rules. IRC §§453(b)(2); 453(l)(2)(A).
Basic Deferral Arrangements
The most likely way for a farmer to avoid an IRS challenge of a deferral arrangement is for the farmer to enter into a sales contract with a buyer that calls for payment in the next tax year. This type of contract simply involves the buyer’s unsecured obligation to purchase the agricultural commodities from the seller on a particular date. Under this type of deferral contract, the price of the goods is set at the specified time for delivery, but payment is deferred until the next year. If the contract is bona fide and entered into at arm’s length, the farm seller has no right to demand payment until the following year, and the contract (as well as the sale proceeds) is non-assignable, nontransferable and nonnegotiable, the deferral will not be challenged by the IRS.
The following criteria for a deferred payment contract should be met in order to successfully defer income to the following year.
- The seller should obtain a written contract that under local law binds both the buyer and the seller. A note should not be used;
- The contract should state clearly that under no circumstances would the seller be entitled to the sales proceeds until a specific date (i.e., a date in a future tax year). The earliest date depends on the farmer’s tax yearend.
- The contract should be signed before the seller has the right to receive any proceeds, which is normally before delivery. That means that the contract should have been executed before the first crop delivery. If the contract was not executed until after the crop proceeds were delivered, IRS can argue that the farmer actually had the right to the income, but later chose not to take possession of it until the next calendar year. An oral agreement to the contrary can be difficult to prove.
- The buyer should not credit the seller’s account for any goods the seller may want to purchase from the buyer during the year of the deferred payment contract (such as seed and/or fertilizer). Instead, such transactions should be treated separately when billed and paid.
- The contract should state that the taxpayer has no right to assign or transfer the contract for cash or other property.
- The contract should include a clause that prohibits the seller from using the contract as collateral for any loans or receiving any loans from the buyer before the payment date;
- The buyer should avoid sales through an agent in which the agent merely retains the proceeds. Receipt by an agent usually is construed as receipt by the seller for tax purposes.
- Price-later contracts (where the price is set in a later year) should state that in no event can payment be received prior to the designated date, even if a price is established earlier.
- The contract may provide for interest. Interest on an installment sale is reported as ordinary income in the same manner as any other interest income. If the contract does not provide for adequate stated interest, part of the stated principal may be recharacterized as imputed interest or as interest under the original issue discount rules, even if there is a loss. Unstated interest is computed by using the applicable federal rate (AFR) for the month in which the contract is made.
Is There a Way To Provide Security?
As noted in that July 27 post, after an agricultural commodity is delivered to the buyer but before payment is made, the seller is an unsecured creditor of the buyer. In an attempt to provide greater security for the transaction, a farmer-seller may use letters of credit or an escrow arrangement. This could lead to a successful challenge by the IRS on the basis that the letters of credit or the escrow can be assigned, with the result that deferral is not accomplished.
Although the general rule is that funds placed in escrow as security for payment are not constructively received in the year of sale, it is critical for a farmer-seller to clearly indicate that the buyer is being looked to for payment and that the escrow account serves only as security for this payment. In addition, any third-party guarantee or standby letter of credit should be nonnegotiable and set up so that it can only be drawn upon in the event of default. If the escrow account is set up properly, the funds held in escrow, and the accrued interest on those funds, is taxable as income in the year that it provides an economic benefit to the taxpayer.
For deferred sales that are structured properly and achieve income tax deferral, installment reporting is automatic unless the taxpayer makes an election not to use it. An installment sale is a sale of property with the taxpayer receiving at least one payment after the tax year of the sale. Thus, if a farmer sells and delivers grain in one year and defers payment until the next year, that transaction constitutes an installment sale. If desired, the farmer can elect out of the installment-sale method and report the income in the year of sale and delivery.
The election must be made by the due date, including extensions, of the tax return for the year of sale and not the year in which payment is to be received. The election is made by recognizing the entire gain on the taxpayer’s applicable form (i.e., Schedule D or Form 4797), rather than reporting the installment sale on Form 6252, Installment Sale Income.
Because of the all-or-nothing feature (on a per-contract basis) of electing out of installment reporting, it may be advisable for farm taxpayers to utilize multiple deferred payment sales contracts in order to better manage income from year to year. The election out is made by simply reporting the taxable sale in the year of disposition. But, when the election out of the installment method is made by reporting the income in the year of the sale, the seller must be careful to make sure that the gain recognized is also not recognized in the following year. A way to make sure that is done is to record a receivable for the amount of the accelerated sales, with the entry reversed after yearend.
Generally, if the taxpayer elects out of the installment method, the amount realized at the time of sale is the proceeds received on the sale date and the fair market value of the installment obligation (future payments). If the installment obligation is a fixed amount, the full principal amount of the future obligation is realized at the time of the acquisition.
What About An Untimely Death?
If a seller dies before receiving all of the payments under an installment obligation, the installment payments are treated as income in respect of a decedent (IRD). I.R.C. §691(a)(4). Therefore, the beneficiary does not get a stepped-up basis at the seller’s death. The beneficiary of the payments includes the gain on the beneficiary’s return subject to tax at the rate applicable to the beneficiary. The character of the payments is tied to the seller. For example, if the payments were long-term capital gain to the seller, they are long-term capital gain to the beneficiary.
Grain farmers often carry a large inventory that may include grain delivered under a valid deferred payment agreement. Grain included as inventory but more properly classified as an installment sale may not qualify for stepped-up basis if the farmer dies after delivering the grain but prior to receiving all payments.
The only way to avoid possible IRD treatment on installment payments appears to be for the seller to elect out of installment sale treatment. IRD includes sales proceeds “to which the decedent had a contingent claim at the time of his death.” Treas. Reg. §1.691(a)-1(b)(3). The courts have held that the appropriate inquiry regarding installment payments is whether the transaction gave the decedent at the time of death the right to receive the payments. See, e.g., Estate of Bickmeyer v. Comm’r, 84 TC 170 (1985). This means that the decedent holds a contingent claim at the time of death that does not require additional action by the decedent. In that situation, the installment payments are IRD.
Chapter 9 of the IRS Farmers Audit Technique Guide (ATG) provides a summary of income deferral and constructive receipt rules. The ATG provides a procedural analysis for examining agents to use in evaluating deferred payment arrangements. The ATG is available https://www.irs.gov/businesses/small-businesses-self-employed/farmers-atg.
Agricultural producers typically have income streams that are less consistent from year to year than do nonfarm salaried individuals. Because of this, agricultural producers often try to structure transactions to smooth out income across tax years and for other tax-related purposes. One technique used to accomplish these goals involves the use of deferral arrangements. But, it’s important to make sure they are structured properly to produce the desired tax results.
Wednesday, August 2, 2017
We are now into August and we don’t really have a good fix on where tax legislation might be headed, if anywhere. A little over a year ago, a House committee set forth a “Blueprint” for tax reform, and there have been some comments from legislators here and there that have discussed various aspects of what might end up as a part of an overall bill. But, it still remains to be seen where the Congress might be headed with tax reform.
Today’s post takes a look at what some of this tax talk has been, where it might be headed, how the process might unfold and the expiring/expired provisions that might be on the immediate “to do” list.
The Political Process and Realities
Of course, any tax legislation must work its way through the political process. While the Republicans control both the House and Senate, the margin of their Senate majority is razor-thin in that they only hold 52 seats. That’s problematic in the Senate because of a Senate rule that requires a 60-vote supermajority. However, if tax legislation happens as part of the budget reconciliation process only a simple majority is necessary. That would make any tax legislation “filibuster proof.” But, it would come at a price – it would have to “sunset” in 10 years unless it is deemed to be revenue neutral.
So, what is the reality of getting 60 votes to pass a straight-up tax bill? My view is that it’s next to none – at least for any type of comprehensive reform. 60 votes might be obtained for provisions that “nibble on the corners,” but I just don’t see any type of significant reform garnering 60 votes at this time – or at any time in the near future.
Tax Reform in General
Individual taxes. In 2016, the Republicans in the House produced a tax plan that would decrease individual tax rates and also reduce the number of brackets. The top rate would be cut to 33 percent on the individual income tax, and the capital gain rate would also be reduced for all taxpayers regardless of their ordinary income tax bracket. The top capital gain rate would be 16.5 percent. The House proposal is slightly different from what the President has proposed, so there would have to be some sort of compromise reached. That’s true for both individual rates and capital gain rates. Both the House and the President would also repeal the 3.8 percent net investment income tax. But, that provision was recently proposed to remain in the Code as part of the on-going negotiations over what to do with Obamacare.
It also appears on the individual income tax side of things that the personal exemption would rise under the House GOP proposal and the President’s proposal. However, negotiations will need to occur concerning differences over whether the personal exemption should be eliminated, the level of the child tax credit, and what itemized deductions would be retained or eliminated. But, at this point in time, it looks as if the mortgage interest deduction and the deduction for gifts to charity will be retained under their existing rules. As for the alternative minimum tax (AMT), there appears to be general agreement on the Republican side that it should be eliminated. This is something that Senator Grassley has pushed for some time.
Transfer taxes. There seems to be a consensus that the federal estate tax should be eliminated. That’s not a big deal for most people given that the current level of the exclusion eliminates federal estate tax on a gross estate of up to $5.49 million. However, the big question for far more people is whether the rule allowing an heir to receive an income tax basis in inherited property equal to the fair market value of the property at the time of the decedent’s death will be retained. That’s a big deal. If the rule is eliminated, what will replace it? Will there be a capital gains tax when property is gifted or inherited, which would create a basis step-up” rule. Will there be an exemption up to a certain amount? Will the federal gift tax be retained? These are all important questions for which there really aren’t clear answers to right now.
Payroll tax. Under current rules, owners of their own businesses and those receiving flow-through income from an entity pay a 15.3 percent maximum tax (FICA and Medicare) on the first $127,200 of income. Above $127,200, the rate is either 2.9 percent or 3.8 percent. With adjustments, that $127,200 could easily exceed $200,000 in another 10 years or so. One proposal that’s been discussed is to have at least a portion of all flow-through income be subjected to these payroll taxes with no income threshold. In addition, it may no longer be limited to the taxpayer’s active business income.
Corporate and business-related tax. This is one area that I believe something will get done. The President would like to cut the corporate tax rate to 15 percent to make the U.S. rate more in-line with the major countries around the world. The GOP House plan is a bit different – a “destination-based cash flow tax” at a flat 20 percent. That’s basically a value-added tax (VAT) with a deduction allowance for wages that are paid. In addition, business interest would be deductible against business income, with any excess being allowed to be carried forward. Costs associated with imported goods wouldn’t be deductible under such a plan, but costs for exporting goods could be deducted. In addition, this type of a VAT tax would eliminate the corporate AMT, and would also allow a net operating loss to be carried forward indefinitely (but not back) with an inflation adjustment. The current domestic production activities deduction would be eliminated.
Also, being discussed is the immediate deduction of the cost of business assets. If that occurs, that would eliminate the need for like-kind exchanges (except for land exchanges). It would also eliminate the need for expense method depreciation. But, would the sale of these business assets generate ordinary income, or would it be capital gain? What about the sales of breeding stock? Will that generate ordinary income? Questions also remain over the handling of pre-productive costs, deferred payment contracts, pre-paid feed expense, business interest expense and the treatment of state income and personal real estate taxes.
An extender bill should address certain specific items, including:
- The definition of “specified plant” for purposes of the provision that allows bonus depreciation to be claimed for fruit/nut plants at the time of planting/grafting instead of waiting until the plant become productive.
- The provision that allows the exclusion from gross income discharge of debt associated with a principal residence. The current provision expired at the end of 2016. The same can be said the provision that allows mortgage insurance premiums to be treated as qualified residence interest, and the above-the-line deduction for qualified tuition and related expenses. Both of these provisions also expired at the end of 2016.
At the present time, it appears that tax reform is in line behind the repeal of Obamacare. It may finally be dawning on the Republicans in Congress that the President won’t accept their inability (so far) to take action on that front. That reality delays tax reform. So, it may be September or October until tax reform really begins to take serious shape. This process can be frustrating to watch, but it is the present reality.
Clients will begin (if they haven’t already) asking questions about tax policy and where things might be headed. Hopefully today’s post will provide some guidance that can assist in advising clients on what is being considered and what, if anything, they can do from a planning standpoint.