Thursday, August 10, 2017

When Is A Farmer Not A “Qualified Farmer” For Conservation Easement Donation Purposes?


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.     

Planning Implications

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.

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