Friday, September 29, 2017

Self-Employment Tax on Farm Rental Income – Is the Mizell Veneer Cracking?

Overview

Self-employment tax applies to income that is derived from a “trade or business.”  That’s a fact-based determination.  In addition, by statute, “rentals from real estate and from personal property leased with the real estate” are excluded from the definition of net earnings from self-employment. I.R.C. §1402(a)(1).  Likewise, income from crop share and/or livestock share rental arrangements for landlords who are not materially participating in the farming or ranching operation will not be classified as self-employment income.  Only if the rents are produced under a crop or livestock share lease where the individual is materially participating under the lease does the taxpayer generate self-employment income.  Income received under a cash rental arrangement is not subject to self-employment tax.

But, what is “material participation”?  A lease is a material participation lease if (1) it provides for material participation in the production or in the management of the production of agricultural or horticultural products, and (2) there is material participation by the landlord.  Both requirements must be satisfied. While a written lease is not required, a written lease certainly makes a material participation arrangement easier to establish (or not established, if that is desired).

But, what about leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity?  Does the real estate exemption from the definition of net earnings from self-employment apply in that situation?  Does the type of lease or the rate of rent charged under the lease matter?  In 1995, the Tax Court rendered an important decision on the first question that, apparently, also answered the second question.  Mizell v. Comr., T.C. Memo. 1995-571.  Later, the U.S. Court of Appeals for the Eighth Circuit carved out an exception from the 1995 Tax Court decision for fair market leases.  McNamara, et al. v. Comr., 263 F.3d 410 (8th Cir. 2000), rev’g., T.C. Memo 1999-333.  Now, the Tax Court, in a full Tax Court opinion, has applied the Eighth Circuit’s analysis and holding to a case with similar facts coming from Texas – a jurisdiction outside the Eighth Circuit.  Martin v. Comr., 149 T.C. No. 12 (2017). 

The Mizell Case

In Mizell, the petitioner was a farmer who, in 1986, structured his farming operation to become a 25 percent co-equal partner in an active farming partnership with his three sons. In addition, in 1988, leased about 730 acres of farmland to the farm partnership.  The lease called for the petitioner to receive a one-quarter share of the crop, and the partnership was responsible for all expenses.  The petitioner reported his 25 percent share of partnership income as self-employment earnings. However, the crop share rent on the land lease was treated as rents from real estate that was exempt from self-employment tax.

The IRS disagreed with that tax treatment of the land rent, assessing self-employment tax on the crop share lease income for the years 1988, 1989 and 1990.  The parties agreed that he materially participated in the agricultural production of his farming operation.  The IRS took the position that the crop share rental and the farming partnership constituted an “arrangement” that needed to be considered in light of the entire farming enterprise in measuring self-employed earned income.  Thus, the IRS position was that the landlord role could not be separated from the employee or partner role.  That meant that any employee or partner-level participation by the landowner triggered self-employment tax on the rental income. On the other hand, the petitioner, argued that the crop share lease did not involve material participation and that the crop share rental income should be exempt from self-employment tax.  In other words, the IRS looked to the overall farming arrangement to find a sufficient level of material participation on the petitioner’s part, but the petitioner confined the analysis to the terms of the lease which wasn’t a material participation lease.

While, rents from real estate, whether cash rent or crop share, are excluded from the definition of self-employment income, there is an exception, however, if three criteria are met:

  • The rental income is derived under an arrangement between the owner and lessee which provides that the lessee shall produce agricultural commodities on the land;
  • The arrangement calls for the material participation of the owner in the management or production of the agricultural commodities; and
  • There is actual material participation by the owner.. R.C. §1402(a)(1)(A); Treas. Reg. §1.1402(a)-4(b)(1).

The Tax Court, agreeing with the IRS, focused on the word "arrangement" in both the statute and the regulations, noting that this implied a broader view than simply the single contract or lease for the use of the land between the petitioner and the farming partnership.  By measuring material participation with consideration to both the crop share lease and the petitioner’s obligations as a partner in the partnership, the court found that the rental income must be included in the petitioner’s net earnings for self-employment purposes.

Following its win in Mizell, the IRS privately ruled in 1996 that a married couple who cash-rented land to their agricultural corporation were subject to self-employment tax on the cash rental income, because both the husband and wife were employees of the corporation. T.A.M. 9637004 (May 6, 1996).

Implications of Mizell.  The Mizell decision was a landmine that posed a clear threat to the common set-up in agriculture where an individual leases farmland to an operating entity in which the individual is also a material participant.  Importantly, the type of lease was apparently immaterial to the court.  On that point, the wording of Treas. Reg. § 1.1402(a)-4(b)(2) appears to be broad enough to include income in any form, crop share or cash, if received in an arrangement that contemplates the material participation of the landowner.

Exception to the Mizell “Arrangement” Theory 

The Tax Court, in 1998, decided three more Mizell-type cases.   In Bot v. Comr., T.C. Memo. 1999-256, the court determined that rental income (at the rate of $90 per acre) received by a wife for 240 acres of land, paid to her by her husband’s farm proprietorship, was subject to self-employment tax. The wife also received an annual salary from the proprietorship of approximately $15,000, and the court said that the rental amount and the salary amounted to a single arrangement.   In Hennen v. Comr., T.C. Memo1999-306, the court again held that self-employment tax applied to rental income that a wife received on land leased to her husband’s farming business.  Like Mrs. Bot, Mrs. Hennen worked for the farming business and was paid a salary ($3,500/year).  McNamara v. Comr., T.C. Memo. 1999-333, also involved a husband and wife who owned land that they leased to their farming C corporation under a written, cash rent lease. The rent payment averaged about $50,000 per year.  The husband was employed full time by the corporation, and the wife was employed doing part-time bookkeeping and farm errand duties.  She was paid a nominal amount – about $2,500 annually.  The court again determined that the rental arrangement and the wife’s employment were to be combined, which meant that the rental income was subject to self-employment tax.

All three cases were consolidated on appeal to the U.S. Court of Appeals for the Eighth Circuit.  The Eighth Circuit, reversing the Tax Court, determined that the lessor/lessee relationship was to be analyzed separate and distinct from the employer-employee relationship. The Eighth Circuit interpreted I.R.C. §1402(a)(1) as requiring material participation by the landlord in the rental arrangement itself in order to subject the arrangement to self-employment tax. The court stated that, “The mere existence of an arrangement requiring and resulting in material participation in agricultural production does not automatically transform rents received by the landowner into self-employment income. It is only where the payment of those rents comprise part of such an arrangement that such rents can be said to derive from the arrangement.”

The Eighth Circuit remanded the case to the Tax Court for the purpose of giving the IRS an opportunity to illustrate that there was a connection between the rental amount and the labor arrangement. The IRS could not establish a connection.  The rents were cash rents that were at or slightly below fair market value.  However, the IRS later issued a non-acquiescence to the Eighth Circuit’s decision.  A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003).   That meant that the IRS would continue to litigate the issue outside of the Eighth Circuit.

More Litigation

As the non-acquiescence indicated, the IRS continued to litigate the matter and two more cases found their way to the Tax Court.  In Johnson v. Comr., T.C. Memo. 2004-56, the petitioners verbally cash leased 617 acres of land to their farm corporation.  They also had a verbal employment agreement with the corporation and received a nominal salary.   The farming operation was located within the Eighth Circuit, which meant that the if the land rental and the employment agreement were two separate arrangements the land rental income would not be subject to self-employment tax.  Ultimately, the Tax Court determined that the rental amount under the lease was representative of a fair market rate of rent, and the rental payments were not tied to any services the petitioners provided to the farming corporation.  The compensation paid to the petitioners was also not understated.

However, in Solvie v. Comr., T.C. Memo. 2004-55, the Tax Court reached a different conclusion on a set of facts similar to those involved in Johnson.   In Solvie, the petitioners leased real estate to their controlled corporation and also received compensation as corporate employees.  Later, an additional hog barn was constructed which increased the total rent paid to the petitioners which the IRS claimed was subject to self-employment tax.  The Tax Court agreed because the additional rent was much greater than the rental amounts the received from the corporation for the other hog buildings even though the new building had a smaller capacity.  In addition, the court noted that the petitioners’ wages did not increase even they overall hog production increased, and the additional rent was computed on a per-head basis which meant that no building rent would be paid if there was no hog production. 

The Downfall of Mizell?

In Martin v. Comr., 149 T.C. No. 12 (2017), the Tax Court (in an opinion authored by Judge Paris) delivered its most recent opinion concerning the self-employment tax treatment of leases of farmland to an operating entity in which the lessor is also a material participant in the operating entity.  Under the facts of the case, the petitioners, a married couple, operated a farm in Texas – a state not located within the Eighth Circuit’s jurisdiction.  In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator.  The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services.  They also pegged their salaries at levels consistent with other growers.  The wife provided bookkeeping services and the husband provided labor and management.  In 2005, they assigned the balance of their contract to the S corporation.  Thus, the corporation became the “grower” under the contract.  In 2005, the petitioners entered into a lease agreement with the S corporation.  Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period.  The court noted that the rent amount was consistent with other growers under contract with the integrator.  The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an “arrangement” that required their material participation in the production of agricultural commodities on their farm.

The Tax Court noted that the IRS agreed that the facts of the case were on all fours with McNamara.  In addition, the court determined that the Eighth Circuit’s rationale in McNamara was persuasive and that the “derived under an arrangement” language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the “arrangement” that required their material participation.  In other words, there must be a tie between the real property lease agreement and the employment agreement.  The court noted the petitioners received rent payments that were consistent with the integrator’s other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners’ investment in their facilities.  Similarly, the employment agreement was appropriately structured as a part of the petitioners’ conduct of a legitimate business.  Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara and relying on the court to broadly interpret “arrangement” to include all contracts related to the S corporation.  Accordingly, the court held that the petitioner’s rental income was not subject to self-employment tax.

A dissenting judge complained that the IRS should not have the burden of producing evidence of establishing a nexus between the land lease and the employment agreement once the petitioner establishes that the land lease is a fair market lease.  Another dissenter would have continued to apply the Mizell arrangement theory outside of the Eighth Circuit.

Implications

The cases point out that leases should be drafted to carefully specify that the landlord is not providing any services or participating as part of the rental arrangement.  Services and labor participation should remain solely within the domain of the employment agreement.  In addition, leases where the landlord is also participating in the lessee entity must be tied to market value for comparable land leases.  If the rental amount is set too high, the IRS could argue that the lease is part of “an arrangement” that involves the landlord’s services.  If lessor does provide services, a separate employment agreement should put in writing the duties and compensation for those services. 

Conclusion

The Martin decision, a full Tax Court opinion, is a breath of fresh air for agricultural operations that are structured with leases of farmland to an operating entity in which the lessor is also a material participant.  Proper structuring of the land lease and a separate employment agreement can provide protection from an IRS claim that self-employment tax applies to the land rental income.  Now there is substantial authority for that proposition outside the Eighth Circuit.  

September 29, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Wednesday, September 27, 2017

Fall Tax Schools

Overview

I have received numerous emails and calls from practitioners wondering where they can catch me this fall at a tax school.  You can find my CE speaking schedule on WALTR’s homepage – www.washburnlaw.edu/waltr.  Tomorrow, the teaching teams for the fall tax schools that will be held in Kansas on behalf of Kansas State University will be meeting at Washburn Law School to organize and plan the teaching of the material for both days of each of the eight schools across Kansas.  The schools have a long history in Kansas – the schools this year will be the 69th year of their presentation across the state. 

The tax schools are a primary source of continuing education and research material for practitioners that prepare tax returns for clients.  Of course, in Kansas, a significant part of a portion of one day at each teaching location focuses on agricultural tax issues.  If you haven’t ever attended one of these schools, either in-person or via the web, I would encourage you to try it out. 

Teaching Material

The material taught at the schools is contained in a workbook produced by the University of Illinois Tax School - https://taxschool.illinois.edu/.  It is an outstanding workbook that is developed by numerous authors with many years of experience in the particular topics that they are writing.  The material goes through an extensive review process and is current through approximately mid-August annually.   It contains examples, problems, solutions, sample IRS forms, and lots of reference material.   

2017 Topics

The topics that are taught at the schools generally vary from year-to-year, but some are constant each year, such as those concerning ag tax, and recent developments/new legislation.  The topics to be covered this year are as follows:

New Developments

New Rulings and Cases

Investments
Employment Issues
Agricultural Issues

Individual Taxpayer Issues
Small Business Issues
Installment Sales
Partnership Issues
IRS Update
State of Kansas (Dept. of Revenue)

Partner Issues
Beneficiary and Estate Issues
                

I also teach from the Illinois workbook at schools this fall in North Dakota.  If you can’t attend in person, one school in Kansas will be simulcast over the internet.  That simultaneous broadcast will be of the tax school on December 13-14.  The two-day seminar in Fargo, North Dakota, will also be live simulcast over the internet on November 14-15.  For those interested in attending from other parts of the country, Kansas City is relatively easy to fly into.  One of the Kansas schools is in Overland Park, Kansas, a southern suburb of the Kansas City metropolitan area.

Instructors

In Kansas, the instructors along with myself are Paul Neiffer of CliftonLarsonAllen and author of the FarmCPA Today blog - http://blogs.claconnect.com/agribusiness/ ; Andrew Morehead, an accountant from Eaton, CO, Bill Parrish, an accounting from Kansas City, Felecia Dixson, an enrolled agent from Rolla, Missouri and Ross Hirst, former IRS Practitioner Liaison for Kansas.  All have many years in presenting tax seminars and representing tax clients.  In North Dakota, my teaching partner is Chris Province, a CPA with many years of practice and teaching experience.

Registration Information

You can find registration information links on WALTR or here:   https://und.edu/academics/extended-learning/conference-services/nd-tax-institute/register-here.cfm or here:  https://commerce.cashnet.com/cashnetg/selfserve/BrowseCatalog.aspx?CNAME=AGECON-5++++

Conclusion

I hope to see you at one of the locations this fall or online.  As we prepare for the schools, if you have particular issues that you would like to make sure get addressed, please drop me an email and we will do our best to get that issue researched and addressed.

September 27, 2017 in Income Tax | Permalink | Comments (0)

Monday, September 25, 2017

The Prior Converted Cropland Exception From Clean Water Act Jurisdiction

Overview

The federal government’s jurisdiction over “wetlands” continues to be a contentious issue.  In 2015, the U.S. Environmental Protection Agency (EPA) and the United States Army Corps of Engineers (Corps) jointly published a regulation (known as the “Clean Water Rule”) in an attempt to “clarify” the scope of federal jurisdiction over “waters of the United States.”  80 Fed. Reg. 37053 (Jun. 29, 2015).  The rule was immediately contested in court, its implementation stayed, and the U.S. Circuit Court of Appeals determined that it had jurisdiction to hear the challenge to the rule.  Murray Energy Corp. v. United States Department of Defense, 817 F.3d 261 (6th Cir. 2016).  In early, 2017, the Trump Administration indicated its intent to review, revise or rescind the rule.    82 Fed. Reg. 12532 (Mar. 6, 2017).   

Various exemptions can potentially apply to exclude “wetlands” from the federal government’s jurisdiction under the Clean Water Act (CWA).  One of those is for “prior converted cropland.”  That exemption stems from the “Swampbuster” provisions of the 1985 Farm Bill that were later adopted by the EPA and the Corps. 

How does the exception apply?  When does it not apply?  What’s the history behind the exception?  What have the courts had to say about it?  Is there a better way for the federal government to regulate prior converted cropland than the present manner?  A recent Illinois federal court decision involved the prior converted cropland exemption from CWA jurisdiction.  It didn’t turn out well for the landowner, however. 

The prior converted cropland exemption from CWA, that’s today’s topic.

Swampbuster

The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “swampbuster.”  Swampbuster was introduced into the Congress in January of 1985.  Later, in 1985, the Swampbuster provisions were introduced into the House Agriculture Committee as an amendment to Title XII resource conservation, to deny federal farm program benefits to persons planting agricultural commodities for harvest on converted wetlands. 16 U.S.C. § 3821(a)-(b) (2008).  The USDA defines “converted wetland” as a wetland that has been drained, dredged, filled, leveled, or otherwise manipulated (including…the removal of woody vegetation or any activity that results in impairing or reducing the flow and circulation of water) for the purpose of or to have the effect of making possible the production of an agricultural commodity without further application of the manipulations described herein if: (i) such production would not have been possible but for such action, and (ii) before such action such land was wetland, farmed wetland, or farmed-wetland pasture and was neither highly erodible land nor highly erodible cropland. 7 C.F.R. § 12.2(a) (2008).

The report of the conference committee a week before the 1985 Farm Bill was signed into law stated that wetland conversion was considered to be “commenced” when a person had obligated funds or begun actual modification of a wetland.

The final Swampbuster rules were issued in 1987 and greatly differed from the interim rules.  The final Swampbuster rules eliminated the right to claim prior investment as a commenced conversion.  Added were farmed wetlands, abandoned cropland, active pursuit requirements, FWS concurrence, a complicated “commenced determination” application procedure, and special treatment for prairie potholes. Under the “commenced conversion” rules, an individual producer or a drainage district is exempt from Swampbuster restrictions if drainage work began before December 23, 1985 (the effective date of the 1985 Farm Bill).  This is the genesis of the “prior converted cropland” exemption.    

The final rules defined “farmed wetlands” as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics.  Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b).  Prior converted wetlands can be farmed, but they revert to protected status once abandoned. Abandonment occurs after five years of inactivity and can happen in one year if there is intent to abandon.  A prior converted wetland is a wetland that was totally drained before December 23, 1985.  If a wetland was drained before December 23, 1985, but wetland characteristics remain, it is a “farmed wetland” and only the original scope and effect of the drainage of the affected land can be maintained.

Clean Water Act

In 1993, the COE and EPA adopted new regulations clarifying the application of the permit requirement of §404 of the CWA to land designated as wetland.  Section 404 of the CWA makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” without obtaining a permit from the Secretary of the Army acting through the Corps.  The regulations specifically exempt prior converted wetlands from the definition of “navigable waters” for CWA purposes. 58 Fed. Reg. 45,008-48,083 (1993); 33 C.F.R. §328.3(a)(8).  Thus, prior converted cropland is not subject to the permit requirements of § 404 of the CWA.  Indeed, the Corps stated clearly that the only method for prior converted cropland to return to the Corps’ jurisdiction under the regulation was for the cropland to be “abandoned” – cropland production ceases with the land reverting to a wetland. 

In early 2009, the Corps prepared an Issue Paper announcing for the first time that prior converted cropland that is shifted to non-agricultural use becomes subject to regulation by the Corps. See Issue Paper Regarding "Normal Circumstances" (ECF No. 18-22).  The paper was the Corps’ response to five pending applications for jurisdictional determinations involving the transformation of prior converted cropland to limestone quarries. The paper concluded that the transformation would be considered an "atypical situation" within the meaning of the Corps’ Wetlands Manual and, thus, subject to regulation.  The paper further found that active management, such as continuous pumping to keep out wetland conditions, was not a "normal condition" within the meaning of 33 C.F.R. § 328.3(b).  However, no APA notice-and-comment period occurred (as required by the Administrative Procedure Act (APA) – Pub. L. 79-404, 69 Stat. 237, enacted Jun. 11, 1946)) before the Corps issued the memorandum.  Even so, the Corps implemented and enforced the rules nationwide.  The rules were challenged and in New Hope Power Company, et al. v. United States Army Corps of Engineers, 746 F. Supp.2d 1272 (S.D. Fla. Sept. 2010), the court held that the Corps had improperly extended its jurisdiction over the prior converted croplands that were converted to non-agricultural use and where dry lands were maintained using continuous pumping.  Under the Corp’s new rule, wetland determinations were being made based on what a property’s characteristic would be if pumping ceased.  The court noted that the rules effectively changed the regulatory definition of prior converted cropland without the new definition being subjected to notice and comment requirements.  Accordingly, the court invalidated the Corp’s new rule.

Illinois Case

Facts.  In Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017), the plaintiff was a developer that obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995.  The local town then passed a zoning ordinance allowing development of the property.  The tract was divided into three sections - 25 acres were to be developed into 168 townhomes; 61 acres to be developed into 169 single-family homes; and 14 acres in between the other acreages to function as a stormwater detention area.  The townhomes and water detention area was to be developed first and then the single-family housing.  Construction of the townhomes began in 1996, and the single-family housing development was about to begin when the defendant designated about 13 acres of the undeveloped property as “wetlands” and asserted regulatory jurisdiction under the CWA.

Administrative process.  The defendant claimed jurisdiction on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S.   The plaintiff administratively appealed the defendant’s jurisdictional determination to the Division Engineer who agreed that the District Engineer failed to properly interpret and apply applicable the U.S. Supreme Court decision in Rapanos v. United States, 547 U.S. 715 (2006)On reconsideration, the District Engineer issued a second approved jurisdictional determination in 2010 concluding that the tract had a significant nexus to the navigable river.  The plaintiff appealed, but the Division Engineer dismissed the appeal as being without merit.  In 2011, the plaintiff sought reconsideration of the defendant’s appeal decision because of a 1993 prior converted cropland designation that excluded a part of the 100-acres from CWA jurisdiction.  Upon reconsideration, the District Engineer issued a third jurisdictional determination in 2012 affirming its prior determination noting that farming activities had ceased by the fall of 1996 and wetland conditions had returned.  The plaintiff appealed on the basis that the “significant nexus” determination was not supported by evidence.  The Division Engineer agreed and remanded the matter to the District Engineer for supportive documentation and to follow the defendant’s 2008 administrative guidance.  The District Engineer issued a new jurisdictional determination with supportive evidence, including an 11-page document that had previously not been in the administrative record.  This determination, issued in 2013, constituted a final agency determination, from which the plaintiff sought judicial review. 

Court opinion.  In court, the plaintiff claimed that the defendant didn’t follow its own regulations, disregarded the instructions of the Division Engineer, and violated the Administrative Procedures Act (APA) by supplementing the record with the 11-page document.  However, the court noted that existing regulations allowed the Division Engineer, on remand, to instruct the District Engineer to supplement the administrative record on remand and that the limitation on supplementing the administrative record only applied to the Division Engineer.  The court also determined that the supplemental information did not violate the Division Engineer’s remand order, and that the supplemental information had been properly included in the administrative record and was part of the basis for the 2013 reviewable final agency determination.  The court also upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. 

The court also determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned.  The court noted that the defendant and the EPA had jointly adopted a rule in 1993 adopting the Natural Resources Conservation Service (NRCS) exemption for prior converted cropland.  While the joint regulation did not refer to the abandonment exception, the defendant and EPA did explain in the Federal Register that they would use the NRCS abandonment provisions such that prior converted cropland that is abandoned and exhibits wetland characteristics are jurisdictional wetlands under the CWA.  The court noted that prior caselaw had held that the CWA’s exemption of “prior converted croplands” included the abandonment provision (see, e.g., Huntress v. United States Department of Justice, No. 12-CV-1146S, 2013 U.S. Dist. LEXIS 73805 (W.D. N.Y. May 24, 2013); United States v. Righter, No. 1:08-CV-0670, 2010 U.S. Dist. LEXIS 64686 (M.D. Pa. Jun. 30, 2010)), and that it would apply the same rationale in this case.  The court noted that the specific 13-acre parcel at issue in the case had not been farmed since 1996, and that conversion to a non-ag use did not remove the abandonment provision.  The plaintiff also claimed that the wetlands at issue were “artificial” wetlands (created by adjacent development) under 7 C.F.R. §12.2(a) that were not subject to the defendant’s jurisdiction.  However, the court noted that the defendant never adopted the “artificial wetland” exemption of the NRCS and, therefore, such a classification was inapplicable.  The court granted the defendant’s cross motion for summary judgment. 

Conclusion

A good case can be made that agricultural wetlands should be removed from Corps jurisdiction.  The Corps appears to lack the experience and the local staff needed to ably administer the regulation of continuously cropped, partially drained farmed wetlands.  The Corps regulates all wetlands in the same way irrespective of whether the wetland is agricultural, previously manipulated or something else.  In addition, the Corps will not allow drainage with compensatory mitigation without the applicant sequentially proving that drainage cannot be avoided or minimized.  Also, while the USDA and the Corps use the same wetland definition, the Corps refuses to rely upon USDA wetland determinations. This needlessly confounds agricultural property owners in the management, use and marketing of properties containing NRCS-certified farmed wetland and prior converted crop land.  Conversely, an NRCS-certified prior converted cropland determination increases the value of a property. 

In situations where a property owner has installed drainage features, and is responsible for a share of the maintenance costs of common drains built by a drainage district, a clear vested right has been established. A change in land use does not erase that vested right.  Viewed in that light, the Corps’ refusal to accept a USDA prior converted cropland determination could constitute a regulatory taking.

Perhaps a better approach would be to vest sole regulatory authority over prior converted cropland with the USDA.  With 30 years of experience and an office in practically every rural county, it would seem to make more sense that regulatory authority of prior converted wetlands rest solely with the USDA. 

With a change in Administration in the White House and new direction at the top of the EPA and the Corps, perhaps there will be a change in the way the federal government views wetlands, and the prior converted cropland exception.  These issues are very important to agriculture producers and rural landowners that own the estimated 53 million acres of prior converted cropland scattered across the U.S.

September 25, 2017 in Environmental Law, Regulatory Law | Permalink | Comments (0)

Thursday, September 21, 2017

Ag Contracts and Express Warranties

Overview

Understanding warranties with respect to contracts is important.  One important aspect concerns their creation.  There are various types of warranties that are recognized by the law.  One type, an express warranty, generally results from explicit statements made by the seller and are the most common way of imposing liability on sellers of agricultural products.  Once an express warranty has been made, it is very difficult to disclaim and, in general, an express warranty cannot be limited.  Under the Uniform Commercial Code (UCC), an express warranty can be created in three ways.  In each case, it is important that the event creating the express warranty occur at a time when the buyer could have relied upon it.

Today’s post looks at express warranties and ag contracts.

Creation

The first way an express warranty can be created is for the seller to make “ any affirmation of fact or promise” that relates to the goods and becomes part of the basis of the bargain.  The warranty is that the goods will conform to the affirmation or promise.  Oral or written statements concerning the goods that the buyer relies on in purchasing the goods can create an express warranty. In agricultural sales, express warranties usually involve the seller’s oral or written statements concerning the goods.  If the statements become “part of the basis of the bargain,” that is, if they tend to induce the buyer to make the purchase, they may be considered express warranties.   But, statements do not create an express warranty if they are statements of opinion, honestly held, or merely commendation of the goods (“puffing talk”).  See, e.g., American Italian Pasta Co. v. New World Pasta Co., 371 F.3d 387 (8th Cir. 2004)For example, in a South Dakota case, a seller’s statement that allegedly defective seeds were “good seed” created no express warranty. Schmaltz v. Nissen, 431 N.W.2d 657 (S.D. 1988)Similarly, in a North Carolina case a seller’s statement that a herbicide would “do a good job” also did not create an express warranty. Tyson v. Ciba-Geigy Corp., 82 N.C. App. 626, 347 S.E.2d 473 (1986).  Also, in a Wisconsin case, Fulton v. Vogt, 583 N.W.2d 673 (Wis. Ct. App. 1998), a broker’s statement that “there is no reason that this property cannot be a successful sod farm” did not create an express warranty.

However, at some point a statement moves from being merely an opinion and becomes an express warranty because the buyer reasonably understands that only an opinion is involved.  For example, a statement by the seller that “all of my cows are bred,” or “all of my hay is of the highest quality” creates an express warranty that the goods (cows or hay) will conform to the particular affirmation or promise. See, e.g., Smith v. Bearfield, 950 S.W.2d 40 (Tenn. Ct. App. 1997); Reilly Construction Co., Inc. v. Bachelder, Inc., 863 N.W.2d 302 (Iowa Ct. App. 2016); Smith v. Penbridge Associates, Inc., 440 Pa. Super. 410, 655 A.2d 1015 (1995).  Likewise, statements contained in product labels may be deemed to create express warranties. 

An express warranty can also be created if the seller provides “any description of the goods” that becomes part of the basis of the bargain.  The warranty is that the goods will conform to the description.  Similarly, an express warranty can be created if the seller displays a “sample or model” of the goods.  If the sample or model becomes part of the basis of the bargain, the warranty is that all of the goods will conform to the sample or model. See, e.g., Dakota Grain Co., Inc. v. Ehrmantrout, 502 N.W.2d 234 (N.D. 1993).  The UCC creates a presumption that any sample or model is intended to become a basis of the bargain.  UCC §2-313, Comment 6.  To prevent a sample or model from creating an express warranty, the presumption must be rebutted by the seller.  See, e.g., Sylvia Coal Co. v. Mercury & Coke Co., 151 W. Va. 818, 156 S.E.2d 1 (1967).

In general, express warranties are not subject to exclusion or modification and, once made, are very difficult to disclaim or limit.  The UCC requires that “[w]ords or conduct relevant to the creation of an express warranty [be construed as consistent with] words or conduct tending to negate or limit warranty...wherever reasonable...[and] negation or limitation is inoperative to the extent that such construction is unreasonable.  UCC § 2-316(1). 

Disclaiming An Express Warranty

While it is difficult for an express warranty to be disclaimed once created, it may not be created if it doesn’t become a basis of the bargain between the parties.  For example, the statement by a tractor seller that the tractor was in “excellent condition” and “field ready” did not become a basis of the bargain with the buyer because the buyer inspected the tractor, determined it was in need of some repairs and was familiar with tractors based on his experience.

Other Related Issues

Parties to sales contracts should exercise caution when reducing oral agreements to writing with the intent of making the written contract the final agreement between the parties.  Oral statements may inadvertently be omitted from a later writing, but could have served as the basis of the bargain.  As such, an express warranty could have been created orally, but eliminated by a subsequent writing omitting the relied upon oral statements.  The best approach may be to ensure that all previously negotiated terms are included in any subsequent written agreement.

Any representations made by a company, its employees, consultants or agents pertaining to a product, whether oral or written, can potentially be treated as express warranties.  Thus, an important part of any loss prevention program is to closely monitor any representations made and provide training concerning appropriate representations.

Conclusion

When entering into contracts for ag products, statements and conduct can create an express warranty.  That can have legal implications.  Care must be taken to make sure only what is intended to be warrantied occurs.  It can be easy to create an express warranty, but difficult to disclaim.  Take care when contracting.

September 21, 2017 in Contracts | Permalink | Comments (0)

Tuesday, September 19, 2017

South Dakota Attempts To Change Internet Sales Taxation – What Might Be The Impact On Small Businesses?

Overview

The South Dakota Supreme Court has given the South Dakota legislature and Governor what it wanted – a ruling that a recently enacted South Dakota law was unconstitutional.  Confused?  It is strange.  But South Dakota’s insatiable thirst for additional revenue led it to enact a law imposing sales tax on businesses that have no physical presence in the state.  That’s something that the U.S. Supreme Court first said 50 years ago that a state cannot do.  Accordingly, the South Dakota Supreme Court struck the law down as an unconstitutional violation of the Commerce Clause.   

So why did the South Dakota legislature deliberately enact a law that it knew was unconstitutional?  South Dakota is a state without a state income tax, and wants to grab sales tax from (primarily internet) sales to South Dakota residents by businesses without any physical presence in the state. They also enacted the law so that it would be challenged as unconstitutional in order to set up a case in hopes that the U.S. Supreme Court would review it and reverse its longstanding position on the issue.  However, if that happens or the Congress takes action to allow states to impose sales (and/or use) tax on businesses with no physical presence in the state, that would not be good news for small businesses, including home-based business and small agricultural businesses.  It would also raise serious questions about how strong the principle of federalism remains.

U.S. Supreme Court Precedent

In 1967, the U.S. Supreme Court determined that the Commerce Clause grants “exclusive authority [to] Congress to regulate trade between the States” in holding that Illinois could not subject a mail order seller located in Missouri to use tax where the seller had no physical presence in Illinois.  National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967).  In holding the law unconstitutional, the Court reasoned that subjecting the seller’s interstate business to local “variations in rates of tax…and record-keeping requirements” would violate the purpose of the Commerce Clause “to ensure a national economy free from…unjustifiable local entanglements.” 

Twenty-five years later, the Court reaffirmed the limitations of the Commerce Clause on state regulatory authority in Quill Corporation v. North Dakota, 504, U.S. 298 (1992).  In Quill, the Court held that a mail order house with no physical presence in North Dakota was not subject to North Dakota use tax for “property purchased for storage, use, or consumption within the State.”  The Court followed closely its holding in National Bellas Hess, Inc. because doing so “encourage[d] settled expectations and …foster[ed] investment by businesses and individuals.”   As applied to internet sales, Quill (which predated the internet) does not exempt all internet sales from state sales taxes – just sales by sellers who don’t have a physical presence in a particular state.  National retailers have a presence in many states.

More recently, in 2015, the Court examined a Colorado “tattletale” law that required out-of-state sellers with no physical presence in the state “to notify…customers of their use tax liability and to report” sales information back to Colorado.  Direct Marketing Association v. Brohl, 135 S. Ct. 1124 (2013).  The trial court enjoined enforcement of the law on Commerce Clause grounds.  On appeal, the Tenth Circuit held that it couldn’t hear the challenge to the law because the Tax Injunction Act (28 U.S.C. §1341) divested it of jurisdiction and the matter belonged in state court and, ultimately, the U.S. Supreme Court.  The Tenth Circuit remanded the case for dismissal of the Commerce Clause claims and dissolution of the permanent injunction.  The U.S. Supreme Court reversed and remanded the decision of the Tenth Circuit on the jurisdiction issue and, on remand, the Tenth Circuit, invalidated the Colorado law on Commerce Clause grounds.  Direct Marketing Association v. Brohl, 814 F.3d 1129 (10th Cir. 2016). 

In the U.S. Supreme Court’s reversal and remand of the Tenth Circuit’s decision in Direct Marketing Association, Justice Kennedy wrote a concurring opinion that essentially invited the legal system to find an appropriate case that would allow the Court to reexamine the Quill and National Bellas Hess holdings.  Hence, the South Dakota legislation. 

South Dakota Legislation and Litigation

S.B. 106 was introduced in the 2016 legislative session of the South Dakota legislature.  It requires the collection of sales taxes from certain remote sellers – those with “gross revenue” from sales in South Dakota of over $100,000 per calendar year or with 200 or more “separate transactions” in the state within the same timeframe.  Interestingly, S.B. 106 authorized the state to bring a declaratory judgment action in circuit court against any person believed to be subject to the law.  The law also authorized a motion to dismiss or a motion for summary judgment in the court action, and provided that the filing of such an action “operates as an injunction during the pendency of the” suit that would bar South Dakota from enforcing the law. 

S.B. 106 was signed into law on March 22, 2016, and the state Department of Revenue soon thereafter began issuing notices to sellers that it thought were in violation of the law.  Several out-of-state sellers that received notices did not register for sale tax licenses as the law required.  Consequently, the state brought a declaratory judgment action against the sellers in circuit court, and sought a judicial declaration that the S.B. 106 requirements were valid and applied to the sellers.  The state also sought an order enjoining enforcement of S.B. 106 while the action was pending in court, and an injunction that required the sellers to register for licenses to collect and remit sales tax. 

The sellers tried to remove the case to federal court based on federal question jurisdiction, but the federal court rejected that approach and remanded the case to the South Dakota Supreme Court.  South Dakota v. Wayfair, Inc., 229 F. Supp. 3d 1026 (D. S.D. Jan. 17, 2017).  On remand, the South Dakota Supreme Court invalidated S.B. 106 on Commerce Clause based on the U.S. Supreme Court precedent referenced above.  State v. Wayfair, Inc., et al., No. 28160, 2017 S.D. LEXIS 111 (S.D. Sup. Ct. Sept. 13, 2017).  The state of South Dakota announced shortly after the South Dakota Supreme Court’s decision that it would file a petition for certiorari with the U.S. Supreme Court by mid-October.

Taxing Out-of-State Sellers

The Congress, in recent years, has made attempts to allow states to apply sales/use tax to out-of-state (primarily internet-based) sales.  In 2013, the Senate passed the Marketplace Fairness Act in an attempt to override the U.S. Supreme Court’s Quill decision.  The legislation went nowhere in the House.  The bill would have required that retail sellers identify and collect sales taxes for the thousands of jurisdictions in which their customers purchase products.  That would have been a nightmare for businesses, particularly smaller and home-based ones.   

In 2016, draft legislation (Online Sales Simplification Act of 2016) was released that again would have allowed states to subject out-of-state businesses with no physical presence in a state to sales and/or use taxes (sales and use taxes are often complementary).  See, e.g., South Dakota Codified Laws 10-46-2).  The bill was an improvement on the 2013 Marketplace Fairness Act because it based taxation on the rules that apply to the tax base of the seller’s home state.  Thus, the actual rate of tax would be required to be set by the seller’s home state.  But, it still mandates that states impose a tax in situations where they have chosen not to do so. 

The South Dakota development is just the most recent attempt to give states the power to tax out-of-state businesses that sell products in the non-home jurisdiction.  Apparently, South Dakota reasoned that if the Congress couldn’t get the job done, it would take the matter into its own hands in an attempt to generate more revenue.

What could be wrong with states taxing businesses that don’t have a physical presence in their state?  For starters, a law that requires a business that is located only in Kansas, for example, to collect and remit taxes to any other state is synonymous with regulation without representation.  The whole notion is incompatible with the principles of federalism that bar states from taxing (whether income, property or sales tax, for instance) non-resident individuals or businesses (with few, minor exceptions).  In addition, such taxes are not just a tax on the individuals in a particular state that buy products from an out-of-state seller.  Those out-of-state sellers would have to calculate, charge and remit the taxes on behalf of a political jurisdiction (state and local government) that they have no connection with.  In essence, a state that imposes such a taxing regime would be able to generate revenue from taxpayers who use none of the services provided by the taxing jurisdiction. 

Another problem with allowing states to tax out-of-state businesses with no physical presence in the state is where the line will ultimately be drawn.  If the Congress or the Supreme Court allows states to tax the sales of out-of-state businesses, they likely won’t stop there.  Will they then go after a portion of business income of the out-of-state business via income tax?  That seems plausible.  However, the Interstate Income Act of 1959 (15 U.S.C. §381-384), requires that a business have some sort of connection with a state before its income can be taxed (at least with respect to the solicitation of orders for tangible personal property).  The law was enacted to overturn the U.S. Supreme Court’s decision in Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 (1959).  However, the law may not apply to bar a state from taxing receipts, as opposed to income. 

From a practical standpoint, the burden of compliance and associated costs would fall disproportionately on small businesses.  In the United States, there are over 10,000 sales/use tax jurisdictions.  Tracking all of those various taxing schemes and staying current would be incredibly time consuming.  In addition, the accounting for the collection and remission of sales/use tax would be nightmarish.  All of this would fall disproportionately heavy upon smaller businesses and home-based internet businesses. 

Conclusion

It will be interesting to see if the U.S. Supreme Court decides to grant certiorari in the South Dakota case.  If so, will the Court distance itself from 50 years of jurisprudence on the Commerce Clause analysis at issue?  If so, what will the Congress do?  Many states are desperate for revenue and don’t seem able to control spending.  But, will the Constitution remain as a bar to states getting revenue from taxpayers that can’t vote the politicians out of office that enact the taxes?    These are all important questions.       

September 19, 2017 in Income Tax | Permalink | Comments (0)

Friday, September 15, 2017

Alternatives to Like-Kind Exchanges of Farmland

Overview

Farmers who sell farmland (or other real estate) have the option to defer gain under I.R.C. §1031.  Most farmers will reinvest sold farmland into other farmland or real estate.  But, with the talk in Washington, D.C. appearing to get serious about discussion among federal legislators and the Administration about limiting the scope and effect of tax-deferred exchanges, there will be interest in alternative strategies to avoid gain on the transfer of farming or ranching real estate that is commonly characterized by a low tax basis. 

What other options are available?  Possibilities include the Real Estate Investment Trust (REIT), the Umbrella Partnership REIT, and the Delaware Statutory Trust (DST).

REITs in General

REITs were initially authorized by the REIT Act title of the Cigar Excise Tax Extension Act of 1960.  Pub. L. 86-779, Sept. 14, 1960.  The purpose of a REIT is to provide a real estate investment structure similar to what mutual funds provide for investment in stocks.  A REIT allows investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate in the same way they typically invest in other types of assets

A REIT is a company that owns, and usually operates, income-producing real estate.  Sometimes a REIT finances real estate.  The definition of a REIT contained in I.R.C. §856 illustrates that a REIT is any corporation, trust or association that essentially acts as an investment agent specializing in real estate and real estate mortgages.  Consequently, REITs own many types of commercial real estate as well as agricultural land.  In addition, some REITs engage in financing real estate.

Basic Tax Rules

A REIT must annually distribute at least 90 percent of its taxable income to shareholders in the form of dividends. I.R.C. §857(a)(1). Thus, a REIT is a strong income vehicle for its shareholders.  A REIT is also entitled to deduct dividends paid to shareholders.  As a result, a REIT often avoids incurring all or a part of its federal income tax liability.  In order to achieve the result of reducing or eliminating corporate income tax, a REIT must elect REIT tax treatment by filing Form 1120-REIT (and satisfying certain other requirements).  I.R.C. §856(c)(1);  Treas. Reg. §1.856-2(b).

The key characteristics of a REIT can be summarized as follows:

  • Be structured as a corporation, trust, or association;
  • Be managed by one or more directors or trustees;
  • Issue transferable shares or transferable certificates of interest;
  • Be taxable as a domestic corporation;
  • Not be a financial institution or a domestic corporation;
  • Have the shares or certificates owned by 100 persons or more (no attribution rules apply); R.C. §856(h). This rule does not apply in the REIT’s first tax year.  I.R.C. §856(h)(2).
  • Have 95 percent of its gross income derived from dividends, interest and property income; R.C. §856(c)(2).
  • Pay dividends of at least 90 percent of the REIT’s taxable income (excluding net capital gain);
  • Have no more than 50 percent of the shares held by five or fewer individuals during the last half of each tax year;
  • Have no more than 50 percent of the shares held by five or fewer individuals (attribution rules apply) during the last half of each taxable year;
  • Have at least 75 percent of its total assets invested in real estate, cash and cash items, and government securities;
  • Derive at least 75 percent of its gross income from “rents” from real property, “interest” from loans secured by real property or interests in real property, gain from the sale of investment real property, REIT dividends, income from “foreclosure” property,” “qualified temporary investment income,” and other specified sources;
  • Maintains the statutorily required records; and
  • Have no more than 25 percent of its assets invested in taxable REIT subsidiaries.

Timber gain is included under I.R.C. §631(a) as a category of statutorily recognized qualified real estate income of a REIT if the cutting is provided by a taxable REIT subsidiary, and also includes gain recognized under I.R.C. §631(b).  The otherwise applicable one-year holding period does not apply.  Also, for sales to a qualified organization for conservation purposes, the holding period is two years under I.R.C. §857(b)(6)(D), which provides a safe harbor from prohibited transaction treatment for certain timber property sales. 

REITs are potentially subject to tax at corporate rates on undistributed REIT taxable income, undistributed net capital gain, income from foreclosure property, the income “shortfall” in failing to meet the 75 percent or 95 percent tests, income from prohibited transactions and income from redetermined rents.  From taxable income is deducted an amount for dividends paid and specified other items.  Shareholders are taxed on REIT dividends received to the extent of the REIT’s earnings and profits.  In addition, REIT dividends of capital gain are taxable to the shareholders in the year received as long-term capital gain, regardless of holding period.  I.R.C. §857(b)(3)(B).

The UPREIT

In General

An UPREIT is an “Umbrella Partnership REIT”.  In the UPREIT format, instead of the REIT owning property directly, all of the REIT’s assets are indirectly owned through an umbrella partnership (the “operating partnership”) of the REIT and the REIT directly owns only interests in the operating partnership (“Unit”). 

Structure

Typically, the REIT contributes cash to the operating partnership in exchange for Units and the real estate owners (farmers) contribute properties to the operating partnership in exchange for Units that are convertible into REIT shares at the option of the Unit-holder at a rate of one Unit per one REIT share.

Since the contributors are transferring their property to a partnership, these contributions are generally tax-free under I.R.C. §721 at the time of the contribution.  However, the contributors will recognize any built-in gain in the future upon exercising their right to convert their Units into REIT shares. 

If there is debt on the property contributed and the amount of debt allocated to the taxpayer decreases, gain may result from the transaction.  Usually the UPREIT will allocate the same amount of debt back to the taxpayer as was transferred into the UPREIT.

A “lockout” period is usually negotiated as part of the deal structure.  This lockout period prevents the UPREIT from selling the contributed property for a certain term.  Without this lockout period, the UPREIT could sell the property contributed which would result in the gain being recognized by the taxpayer under I.R.C. §704(c).  If the UPREIT sells the property during the lockout period, the UPREIT will usually provide an indemnity payment to the taxpayer.  The UPREIT is allowed to dispose of the property in a tax-free exchange.

The UPREIT provides diversification to the taxpayer by allowing a farmer to pool his farmland with the farmland of other farmers or other real estate investments.  Several public and private REITS have been formed over the last several years and the use of an UPREIT has allowed taxpayers with large farm real estate holdings to diversify their holdings and provide more liquidity without incurring an immediate tax liability.

Delaware Statutory Trusts (DST)

In Rev. Rul. 2004-86, I.R.B. 2004-33, the IRS allowed for the creation of a Delaware Statutory Trust to hold real estate.  These trusts are structured as “securities” which allows the taxpayer to purchase interests in the trusts, which holds title to property.  Investment in the real estate is shared amongst many investors.

The property sponsors, who are Trustees of the DSTs, are national real estate developers who purchase the property and structure it as a securities DST.  There is a written offering document that provides very detailed information on tenants/leases, area demographics, financial projections, etc.  The annualized income offered by the DST is usually in the 5-7% range depending on investment opportunities

There are drawbacks to the DST as follows:

  • The pre-packaged trust structure and property management make this is an extremely passive investment to the taxpayer.
  • The holding period for these DSTs are normally in the 2-10-year period, therefore, the taxpayer will need to “roll-over” their investment at a later time and this roll-over period will be out of their control.
  • Investment returns are usually capped at the 5-7% range. An individual taxpayer who reinvests into other farmland or real estate may be able to generate a greater return on their own.

The positives of a DST are as follows:

  • Exit strategies are good for the investor. When the transfer of ownership occurs, the banks are usually not involved.
  • Good diversification options during the 45-day identification period.
  • There can be offerings to 100 or more investors, with the minimum investment amounts in a more reasonable range of $100,000 to $250,000.
  • No need to set up individual single member limited liability companies. The DST itself shields investors from any liability.

Conclusion

When tax legislation moves through the Congress it will move quickly.  It’s not likely that tax-deferred exchanges will remain fully available, especially if full expensing of assets is allowed or expense method depreciation remains at its present high level.  If the tax-deferred exchange rules are modified with respect to real estate, then the REIT, UPREIT and DST will continue to gain in popularity.   

September 15, 2017 in Income Tax | Permalink | Comments (0)

Wednesday, September 13, 2017

New Partnership Audit Rules

Overview

Under the Balanced Budget Act of 2015 (BBA), P.L. 114-74, section 1101(a), 129 Stat. 584 (2015), as amended by P.L. 114-113, new partnership audit rules take effect for tax returns filed for tax years beginning on or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any partnership return filed after the date of enactment, November 2, 2015).

The new rules, make it easier for the IRS to audit large partnerships by making a determination of taxes at the partnership level, ensuring that a partner's return is consistent with the partnership return.  They also allow for the designation of a partnership representative.  In essence, the rules allow the IRS to audit partnerships, make a tax adjustment in the year in which the audit is done, and have the general partner have the income flow through to the partners.

The IRS had been pushing for the change to a centralized partnership audit regime for some time.  In general, the new process will result in the assessment and collection of tax at the partnership level and could result in more partnership audits.

One reason the new rules matter and should be paid attention to is that they could require the modification/amendment of partnership operating agreements. 

Today’s post takes a brief look at the new partnership audit rules and their impact. 

What is Changing?

1982 rules.  The current partnership audit rules date back to 1982 and the Tax Equity and Fiscal Responsibility Act (TEFRA).  Under those rules, for partnerships with 10 or fewer partners, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately.  For partnerships with 11 to 100 partners, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Once the audit is completed and the resulting adjustments are determined, the IRS recalculates the tax liability of each partner in the partnership for the particular audit year. 

For partnerships with 100 or more partners that elect to be treated as Electing Large Partnerships (ELPs) for reporting and audit purposes, partnership adjustments generally flow through to the partners for the year in which the adjustment takes effect, rather than the year under audit.  As a result, the current-year partners’ share of current-year partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior-year audit that take effect in the current year.  The adjustments generally do not affect prior-year returns of any partners (except in the case of changes to any partner’s distributive share).

BBA provision.  Under the BBA provision, the current TEFRA and ELP rules are repealed, and the partnership audit rules are streamlined into a single set of rules for auditing partnerships and their partners at the partnership level.  Similar to the current TEFRA rule excluding small partnerships, the BBA provision allows partnerships with 100 or fewer qualifying partners to opt out of the new rules, in which case the partnership and partners would be audited under the general rules applicable to individual taxpayers.

The new rules allow a partnership to pay a computed tax at the end of any partnership examination rather than a tax being assessed at the partnership level.  This tax will be assessed to the partnership in the year that the audit is completed (the adjustment year), rather than the year of the examination (the reviewed year).  The tax will be computed at the highest income tax rate applicable to corporations and individuals (currently the individual rate, at 39.6%). I.R.C. §6221(a).

The partnership is permitted to issue adjusted Schedules K-1 to the partners of the reviewed year.  The recomputed tax for the reviewed year is paid in the adjustment year.  The partners take the adjustment into account on their individual returns in the adjustment year (not the reviewed year).  I.R.C. §6226(b)(1).

In addition, rather than amending the partnership tax return, partnerships will have the option of initiating an adjustment for a reviewed year.  The adjustment could be taken into account at the partnership level or the partnership could issue adjusted information return to each partner of the reviewed year.

A “partnership representative” replaces the former “tax matters partner.”  The representative has more authority to act on the partnership’s behalf without involving the partners.  The “partnership representative,” a person (or entity) must have a “substantial presence” in the United States.  If it is an entity, the partnership must identify and appoint an individual to act on the entity’s behalf.  While the representative doesn’t have to be a partner of the partnership, they do have the sole authority to settle any disputes with the IRS and agree to a final adjustment.  The representative also can make the election to shift the tax liability to the partners, and extend the statute of limitations on assessment.   But, under the proposed regulations, the representative doesn’t have to communicate with the partners or get consent from the partners before the representative acts on behalf of the partnership.  Also, if the partnership does not have a representative designation in effect, the IRS can pick who the representative will be.

A “small partnership” can elect out of the new rules.  A “small partnership” is one that is required to furnish 100 or fewer Schedules K-1 for the year.  In addition, the partnership must have partners that are individuals, corporations or estates.  If a partnership fits within the definition and desires to be excluded from the BBA provisions, it must make an election on a timely filed return and include the name and identification number of each partner. If the election is made, the partnership will not be subject to the BBA audit provisions and the IRS will apply the audit procedures for individual taxpayers.   There are more specifics on the election in the regulations, but a drawback of the election might be that a small partnership electing out of the BBA audit provisions could be at a higher audit risk. IRS has seemingly indicated that this could be the case.

Proposed regulations.   Proposed regulations were issued in January to replace the 1982 unified audit rules and implement the new rules, but never were published in the Federal Register because of the regulatory freeze that the White House imposed.  They were reissued in June.  REG-136118-15. 

Needed Action?

So, what do partnerships need to do in light of the new audit rules?  One consideration might be to amend an existing partnership agreement to establish a procedure to be used when the IRS determines that the partnership has a deficiency and partners might be able to do something to reduce the tax burden.  I am thinking here of situations where individual partners might have information or could take steps might be helpful to the partnership in dealing with the IRS audit of the partnership and reducing the ultimate tax burden of an additional assessment.  Related to that, partnership agreements commonly include notice and consent procedures for various aspect of partnership business, so it may be beneficial to add in notice and consent language that specifically pertains to IRS audit matters under the new rules.  As a caveat, however, it’s not likely that a court would determine that the IRS is bound by such language.  But, the language might provide more clarity and guidance for the partnership and its partners.

Conclusion

The new audit rules that take effect on January 1, 2018, change the landscape for partnership audits.  In some respects, the audit process will be simpler and more streamlined.  In addition, the vast majority of farming and ranching partnerships will be able to elect out of the new rules.  But, the election must be affirmatively made, and the proposed regulations provide detail on making the election.  In any event, now is the time for partnership agreements to be amended where necessary to take into account the coming new rules. 

September 13, 2017 in Business Planning, Income Tax | Permalink | Comments (0)

Monday, September 11, 2017

Right-To-Farm Laws

Overview

Every state has enacted a right-to-farm law that is designed to protect existing agricultural operations by giving farmers and ranchers who meet the legal requirements a defense in nuisance suits that are brought against them. 

These laws have become more important in recent years because of increasing rural/urban land use conflicts.  Today’s post takes a look at right-to-farm laws – the type of farming operations they are designed to protect and how they work

What Is “Farming”?

The general idea of a particular state's right-to-farm law is that it is unfair for a person to move to an agricultural area knowing the conditions which might be present and then ask a court to declare a neighboring farm a nuisance.  Thus, the basic purpose of a right-to-farm law is to create a legal and economic climate in which farm operations can be continued.  Right-to-farm laws can be an important protection for agricultural operations, but, to be protected, an agricultural operation must satisfy the law's requirements.

To be granted the protection of a statute, the activity at issue must be a farming activity.  While the laws commonly apply to traditional farming activities, sometimes state provisions take a more expansive definition of “farming” to cover more than just row crop and livestock operations.  For example, the Washington statute applies to “forest practices” which has been held to not be limited to logging activity, but include the growing of trees.  Alpental Community Club, Inc. v. Seattle Gymnastics Society, 86 P.3d 784 (Wash Ct. App. 2004). Similarly, in Hood River County v. Mazzara, 89 P.3d 1195 (Or. Ct. App. 2004), the court held that state statutes protecting farms against nuisance actions barred a lawsuit against a farmer for noise from barking dogs because the court determined that the use of dogs to protect livestock constituted a farming practice.  Also, in Vicwood Meridian Partnership, et al. v. Skagit Sand and Gravel, 98 P. 3d 1277 (Wash. Ct. App. 2004), the court held that an indoor composting facility for a mushroom farm qualified as a “farm” under state right-to-farm law.  The compost was produced for use in growing mushrooms and the composting activity was held to be an agricultural activity.

Types of Statutes

Right-to-farm laws are of three basic types: (1) nuisance related; (2) restrictions on local regulations of agricultural operations; and (3) zoning related.  While these categories provide a method for identifying and discussing the major features of right-to-farm laws, any particular state's right-to-farm law may contain elements of each category.

The most common type of right-to-farm law is nuisance related.  This type of statute requires that an agricultural operation will be protected only if it has been in existence for a specified period of time (usually at least one year) before the change in the surrounding area that gives rise to a nuisance claim.  These types of statute essentially codify the “coming to the nuisance defense,” but do not protect agricultural operations which were a nuisance from the beginning or which are negligently or improperly run.  For example, if any state or federal permits are required to properly conduct the agricultural operation, they must be acquired as a prerequisite for protection under the statute.

A second type of right-to-farm statute is designed to prevent local and county governments from enacting regulations or ordinances that impose restrictions on normal agricultural practices.  This type of statute is usually contained in the state's agricultural districting law.  Under this type of a statute, agricultural operations are required to be located within a designated agricultural district in order to be protected from nuisance suits. However, agricultural activities, even though they may be located in an agricultural district, must be conducted in accordance with federal, state and local law or rules in order to take advantage of the statute's protections.  Some courts have held that state law pre-empts local governments from making siting decision for confined animal feeding operations.  See, e.g. Worth County Friends of Agriculture v. Worth County, 688 N.W.2d 257 (Iowa 2004); Adams v. State of Wisconsin Livestock Facilities String Review Bd., No. 2009AP608, 2012 Wisc. LEXIS 381 (Wisc. Sup. Ct. Jul. 11, 2012).

A third type of right-to-farm statute exempts (at least in part) agricultural uses from county zoning ordinances.  The major legal issue involving this type of statute is whether a particular activity is an agricultural use or a commercial activity.  In general, “agricultural use” is defined broadly.  For example, the Illinois Court of Appeals has interpreted the Illinois statute such that the use of seven acres to board 19 show horses constitutes an agricultural use, Tuftee v. Kane Co., 76 Ill. App. 3d 128, 394 N.E.2d 896 (1979).  The same conclusion was reached with respect to a poultry hatchery on a three-acre tract, Lake County v. Cushman, 40 Ill. App. 3d 1045, 353 N.E.2d 399 (1976). and a 60-acre tract used for the temporary storage of sewage sludge for spreading on land as fertilizer. Soil Enrichment Materials Corp. v. Zoning Board of Appeals of Grundy County, 15 Ill. App. 3d 432, 305 N.E.2d 521 (1973).  The court has also held that the “rearing and raising of hogs, in any quantity, constitutes an agricultural purpose” under the statute. Knox County v. The Highlands, L.L.C., 302 Ill. App. 3d 342, 705 N.E.2d 128 (1998), aff’d, 723 N.E.2d 256 (Ill. 1999).  However, the same court has held that the right-to-farm statute does not prevent the application of county zoning laws to a mobile home placed on agricultural land. People v. Husler, 34 Ill. App. 3d 977, 342 N.E.2d 401 (1975). The Iowa statute, even though essentially identical to the Illinois statute, has not been interpreted as broadly.

In some states, agricultural activities receive nuisance-type protection through zoning laws wholly separate from the protections of a right-to-farm statute.  For instance, the Iowa Supreme Court, in a case predating the Iowa right-to-farm statute, held that the use of a four-acre tract as the site for two 40,000 capacity chick-growing houses was not “agricultural” but was “commercial” and not exempt from county zoning. Farmegg Products, Inc. v. Humboldt County, 190 N.W.2d 454 (Iowa 1971).   In 1995, the Iowa Supreme Court followed its earlier analysis, but held that the proposed construction of a hog confinement facility was associated with an existing farming operation and was exempt from county zoning. Thompson v. Hancock County, 539 N.W.2d 181 (Iowa 1995).  However, in 1996, the court overturned its previous decisions concerning the agricultural use exemption from county zoning.  Kuehl v. Cass County, 555 N.W.2d 686 (Iowa 1996).   The 1996 case, involved a hog confinement facility in contract production with a Pennsylvania company.  The court determined that the facility was exempt from county zoning even though the proposed facility was separate from any traditional farming operation carried on by the hog farmers.  As such, the case reflects an acknowledgement of the changes in present-day agricultural business structures.

What’s Not Protected

Subsequent changes.  While right-to-farm laws try to assure the continuation of farming operations, they do not protect subsequent changes in a farming operation that constitute a nuisance after local development occurs nearby.  For example, in Davis, et al. v. Taylor, et al., 132 P.3d 783 (Wash. Ct. App. 2006), the state’s right-to-farm law was held to be inapplicable where the increased noise caused by a farmer’s use of propane cannons and cherry guns to scare birds from a cherry orchard began after homeowners built their house and an adjoining residential neighborhood was well-established.  The orchard had previously been quiet and pastoral, and the farmer’s use of cherry guns and propane cannons was held to be a nuisance.  Similarly, in Trickett v. Ochs, 838 A.2d 66 (Vt. 2003), the Vermont right-to-farm statute was inapplicable where the nature of an apple farming operation changed after the plaintiffs moved into a nearby home.  However, some states may allow increased agricultural activity on property that is used for agricultural use without substantial interruption if the agricultural use began before the plaintiff began using the neighboring land.  See, e.g., Wis. Stat. §823.08.

 

Nuisances.  Right-to-farm laws don’t protect nuisances.  In other words, a farmer has the right to continue farming without being sued for being a nuisance (if the statutory requirements are satisfied), but if the farming operation constitutes a nuisance after conditions have changed around the operation, the statute may not protect the farming operation.  For instance, in Flansburgh v. Coffey, 370 N.W.2d 127 (Neb. 1985), the plaintiffs purchased a 1.67-acre home site from the defendant in 1980.  After the plaintiffs moved to the location, the defendant allowed his tenant to construct a 400-head hog facility within 100 feet of the plaintiff's land.  The plaintiffs filed a nuisance action, and the defendants raised the Nebraska right-to-farm law as a defense.  The court held that the right-to-farm law did not bar an action for a change in operations when a nuisance is present.  If a nuisance cannot be established, a right-to-farm law can operate to bar an action when the agricultural activity on land changes in nature.  For instance, in Dalzell, et al. v. Country View Family Farms, LLC, No. 1:09-cv-1567-WTL-MJD, 2012 U.S. Dist. LEXIS 130773 (S.D. Ind. Sept. 13, 2012), the land near the plaintiffs changed hands. The prior owner had conducted a row-crop operation on the property.  The new owner continued to raise row crops, but then got approval for a 2800-head sow confinement facility.  The defendant claimed the state (IN) right-to-farm law as a defense and sought summary judgment.  The court held that state law only allows nuisance claims when “significant change” occurs and that transition from row crops to a hog confinement facility did not meet the test because both are agricultural uses.  The court noted that an exception existed if the plaintiffs could prove that the hog confinement operation was being operated in a negligent manner which causes a nuisance, but the plaintiffs failed to prove that the alleged negligence was the proximate cause of the claimed nuisance.  Thus, the exception did not apply and the defendant’s motion for summary judgment was granted.  The court’s decision was affirmed on appeal. Dalzell, et al. v. Country View Family Farms, LLC, et al., No. 12-3339, 2013 U.S. App. LEXIS 13621 (7th Cir. Jul. 3, 2013).   Similarly, in Parker v. Obert’s Legacy Dairy, LLC, No. 26A05-1209-PL-450, 2013 Ind. App. LEXIS 203 (Ind. Ct. App. Apr. 30, 2013), the defendant had expanded an existing dairy operation from 100 cows to 760 cows by building a new milking parlor and free-stall barn on a tract adjacent to the farmstead where the plaintiff’s family had farmed since the early 1800s.  The plaintiff sued for nuisance and the defendant asserted the state (IN) right-to-farm statute as a defense.  The court determined that the statute barred the suit.  Importantly, the court determined that the expansion of the farm did not necessarily result in the loss of the statute’s protection.  The expanded farm remained covered under the same Confined Animal Feeding Operation permit as the original farm.  In addition, the conversion of a crop field to a dairy facility was protected by the statute because both uses simply involved different forms of agriculture.  The court noted that the statute protected one farmer from suit by another farmer for nuisance if the claim involves odor and loss of property value.  But, it is important to note that not all state statutes will protect a farmer from nuisance suits brought by other farmers. 

Conclusion

The increasing interactions between non-farmers farmers in rural areas makes understanding the importance and operation of right-to-farm laws important.  Do you know how your state provisions operate?

September 11, 2017 in Civil Liabilities | Permalink | Comments (0)

Thursday, September 7, 2017

Commodity Credit Corporation Loans and Elections

Overview

The Commodity Credit Corporation (CCC) is the USDA’s financing institution with programs administered by the Farm Service Agency (FSA).  Among other things, the CCC makes commodity and farm storage facility loans to farmers where the farmers’ crops are pledged as collateral. These loans are part of the price and income support system of the federal farm programs. 

How is the loan reported for tax purposes?  What happens when the loan is paid back?  What are the particular IRS rules that apply?  These questions are the focus of today’s post.

Tax Reporting Options

When a farmer seals grain (places it in storage and pledges it as collateral to secure a CCC loan), the farmer retains the ability to forfeit the grain in the future if the loan value exceeds commodity prices.  Because most CCC loans are nonrecourse, upon maturity, if the loan plus interest is not paid, the forfeiting of the commodity to the CCC as full payment for the loan effectively establishes a minimum price.  Why?  Because the farmer can forfeit the grain if prices drop below the loan value, and still retain the ability to market the grain later if the commodity price increases.  The forfeiting of the loan to the CCC as full payment is known as “redemption.”  Once redemption occurs, the farmer can then sell the grain, feed it to livestock or store it. 

How are CCC loan proceeds handled for tax purposes?  There are two possible methods.

Loan method.  By presumption, every farmer treats CCC loans as loans for tax purposes.  Thus, for a farmer on the cash method of accounting, there is no taxable income from the loan until the year in which the commodity is sold or the crop is forfeited to CCC in full satisfaction of the loan.  If grain is forfeited to the CCC in satisfaction of the loan, the taxpayer will receive a Form 1099-A from the USDA.  The amount of the loan forfeited is reported on line 5b of Schedule F with the same amount entered as taxable income on line 5c. 

Farmers using the loan method (and their tax preparers) should recognize that the loan method can create a high income with no cash flow in the year the grain is sold.  That’s because the loan amount was received in the prior year. 

Income method.  CCC loans may, by election (and without IRS permission), be treated as income in the year the proceeds of the loan are received. I.R.C. §77.  The election can be made at any time (I.R.C. §77(a)), but the IRS has ruled that, if a farmer elects to treat CCC loans as income, it applies to all loans originating that year.  Priv. Ltr. Rul. 8819004 (Jan. 22, 1988).  Actually, the CCC loan is not income.  Rather, the amount reported as income is the cash proceeds of the CCC loan which then serves as the grain’s income tax basis.  I.R.C. §1016(a)(8).  The amount of the income is entered on line 5a of Schedule F.  The election constitutes an adoption of an accounting method and is binding for future years.  Treas. Reg. §1.77-1.  An election statement reporting the details of the loan must be attached to the farmer’s return for the year the election is made.  See IRS Pub. 225 and the Instructions to Schedule F.  Also, the election to treat CCC loans as income applies to all commodities for that taxpayer.  Treas. Reg. § 1.77-1. 

In addition, a taxpayer reporting CCC loans as income can switch automatically to treating CCC loans as loans. Rev. Proc. 2002-9, I.R.B. 2002-3, Section 1.01(1).  Loans taken out previously continue to be treated as if the election to report loans as income was still in effect.  Under the IRS guidance, the change is made on a “cut-off” basis.  In other words, when a taxpayer changes CCC loan reporting methods, the new method applies to current year and subsequent loans.  That means that a farmer could be reporting on both methods until prior loans are satisfied.  In addition, even if a farmer had made the election to report the CCC loan as income within the past five years, the farmer is still eligible to switch to the loan method.  The IRS, in Rev. Proc. 2015-13, Appendix Sec. 2.01(2), waives that five-year prohibition. But, Form 3115 must be attached to the return noting that the change is being made under the automatic consent procedures of Rev. Proc. 2015-14.  Also, a copy of Form 3115 must be sent to the IRS in Washington, D.C.

Tax Planning Issues 

It is important to understand the tax ramifications of making or not making the election to treat CCC loans as income.  For example, assume a farmer is participating in a three-year farmer loan reserve program.  If a year of high prices occurs and all of the grain under the three-year loan reserve program is sold, the result is a spike in the taxpayer's income for that year.  That is because the grain is income in the year that it is disposed of if an election has not been made to treat the loan as income.  In order avoid that result, the farmer is permitted to treat the loans as income. This means the farmer will report the crop into income in the year it was placed under loan.  This has the favorable result of evening out year-to-year income by offsetting the income from the crop with the expenses of raising the crop.  When the crop is eventually sold, there will be taxable income only to the extent that the sale price exceeds the loan amount.

However, there is an advantage in not paying tax any sooner than required and, therefore, farmers (particularly those in higher brackets) may not want to treat CCC loans as income.  The preference may be to roll the income as far as possible without paying tax on it.  Thus, it is an important consideration for tax planning purposes to consider whether to treat CCC loans as income or as loans.  The point is that a choice is available.          

As a summary of the income tax treatment of various dispositions of CCC loans and commodities, consider the following:

  • If the loan is paid by forfeiting the commodity to the CCC, no income is reported if an election has been made to treat the loan as income upon receipt. The farmer’s basis in the grain offsets the loan liability.  But, there could be either a gain or loss on the farmer’s Schedule F if the farmer’s liability on the loan is more or less than the farmer’s basis in the grain.  However, if no election is made, the amount of the loan is reported as income upon forfeiture (redemption).
  • If the commodity is redeemed by paying off the loan with cash, the farmer has a basis in the commodity equal to the loan amount if an election has been made to treat the loan as income. If no election was made, the farmer has a zero basis in the commodity.
  • If the redeemed commodity is sold, the farmer has income (or loss) equal to the sale price of the commodity less the amount of the loan (which is the basis in the commodity), if an election to treat the loan as income was made. If not, the farmer has income equal to the selling price of the commodity.
  • If the redeemed commodity is fed to livestock, the farmer has a feed deduction equal to the amount of the loan (which is the basis in the feed), if an election has been made to treat the loan as income. If no election was made, the farmer does not get a feed deduction. 
  • Regardless of whether the CCC loan is treated as a loan or as income, interest that the farmer pays to the CCC on the loan is deductible in the year it is paid for a cash-basis farmer.

What if the CCC Loan Is Redeemed in the Same Year It Is Taken Out?

As noted above, normally the repayment of a CCC loan has no tax impact.  That’s the case regardless of whether or not the taxpayer has made an election to treat the loans as income.  But if a farmer has elected to treat CCC loans as income, the courts are divided as to the outcome if the loans are redeemed in the same year they are taken out.  The Fifth Circuit Court of Appeals has held that no income is realized from the loan on a crop redeemed in the same year. Thompson v. Comm’r, 322 F.2d 122 (5th Cir. 1963), aff'g and rev'g, 38 T.C. 153 (1962).  On the other hand, the Ninth Circuit Court of Appeals has taken the position that the loan triggers income even though it is redeemed in the same year. United States v. Isaak, 400 F.2d 869 (9th Cir. 1968).

What About Market Gains on CCC Loans?

Similar rules to those discussed above apply to market gains triggered under the CCC nonrecourse marketing assistance loan program.  The amount that a farmer has to repay for a loan that is secured by an eligible commodity is tied to the lower of the loan rate or the world market price for the commodity on the loan repayment date.  If repayment occurs when the world price is lower than the loan rate, the farmer has “market gain” on the difference.  For repayment in cash, the gain is reported on a CCC-1099-G.  But, if a CCC certificate is used to repay the loan, there is no Form 1099 reporting.  In addition, the farmer’s tax treatment of the market gain is tied to how the farmer treats CCC loans for tax purposes.  For farmers that treat CCC loans as loans, the market gain is reported on line 4a of Schedule F and taxable income is reported on line 4b.  If the farmer made an election treat CCC loans as income, the market gain is not taxable income.  Instead, it reduces the basis in the commodity and defers income until the sale of the grain occurs. 

Conclusion

CCC loans are another illustration of how agricultural tax is different from tax for non-farmers.  It’s a unique aspect of tax law that is particular to farmers.  This is another area of the law that makes having a practitioner that specializes in ag tax of great value.

September 7, 2017 in Income Tax | Permalink | Comments (0)

Tuesday, September 5, 2017

Department of Labor Overtime Rules Struck Down – What’s the Impact on Ag?

Overview

The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§201, et seq.) as originally enacted, was intended to alleviate some of the more harmful effects of the Great Depression.  In particular, the Act was intended to raise the wages and shorten the working hours of the nation's workers.  Since 1938, the FLSA has been amended frequently and extensively.  While the FLSA is very complex, not all of it is pertinent to agriculture and agricultural processing.

One aspect of the FLSA that does apply to agriculture are the wage requirements of the law, both in terms of the minimum wage that must be paid to ag employment and overtime wages.  With respect to overtime wages, the Department of Labor (DOL) proposed a significant expansion of overtime eligibility effective December 1, 2016.  A court enjoined nationwide enforcement of the expanded rules before they took effect, and just recently the court invalidated the rules.

As a result of the DOL rules being invalidated, what is the future of the DOL’s attempt to increase compensation to covered workers?  What’s the impact on agricultural businesses and their employees?

Wage Requirements 

Minimum wage.  The FLSA requires that agricultural employers who use 500 “man-days” or more of “agricultural labor” in any calendar quarter of a particular year must pay the agricultural minimum wage to certain agricultural employees in the following calendar year.  Man-days are those days during which an employee performs any agricultural labor for not less than one hour.  The man-days of all agricultural employees count in the 500 man-days test, except those generated by members of an incorporated employer's immediate family29 U.S.C. § 203(e)(3).  Five hundred man-days is roughly equivalent to seven workers working five and one-half days per week for thirteen weeks (5.5 x 7 x 13 = 501 man-days). Under the FLSA, “agriculture” is defined to include “among other things (1) the cultivation and tillage of the soil, dairying, the production, cultivation, growing and harvesting of any agricultural or horticultural commodities; (2) the raising of livestock, bees, fur-bearing animals, or poultry; and (3) any practices (including any forestry or lumbering operations) performed by a farmer or on a farm as an incident to or in conjunction with such farming operations, including preparation for market, delivery to storage or to market or to carriers for transportation to market.”  29 U.S.C. § 203(f). For related entities, where not all of the entities involve an agricultural trade or business, the question is whether the business operations are so intertwined that they constitute a single agricultural enterprise exempt from the overtime rules.  See, e.g., Ares v. Manuel Diaz Farms, Inc., 318 F.3d 1054 (11th Cir. 2003).

The minimum wage must be paid to all agricultural employees except: (1) members of the employer's immediate family, unless the farm is incorporated; (2) local hand-harvest, piece-rate workers who come to the farm from their permanent residences each day, but only if such workers were employed less than 13 weeks in agriculture in the preceding year; (3) children, age 16 and under, whose parents are migrant workers, and who are employed as hand-harvest piece-rate workers on the same farm as their parents, provided that they receive the same piece-rate as other workers; and (4) employees engaged in range production of livestock. 29 U.S.C. § 213(a)(6).  A higher monthly wage rate applies to a “ranch hand” who does not work in a remote location and works regular hours.  See, e.g., Mencia v. Allred, 808 F.3d 463 (10th Cir. 2015).  Where the agricultural  minimum  wage  must  be  paid  to   piece-rate employees, the rate of pay for piece-rate work must be sufficient to allow a worker reasonably to generate that rate of hourly income. When the minimum wage must be paid, the FLSA allows the employer to include, as part of the compensation paid, the reasonable cost of meals, housing and other perquisites actually provided, if they are customarily furnished by the employer to the employees. Also, the costs of employee travel, visa cost and immigration costs that are incurred for the employer’s benefit cannot be shifted to the employee if that would result in the employee’s net gain from the employment being less than the FLSA minimum wage.  See, e.g., Arriaga v. Florida Pacific Farms, L.L.C., 305 F.3d 1228 (11th Cir. 2002).

Overtime.  The FLSA requires payment of an enhanced rate of at least one and one-half times an employee’s regular rate for work over 40 hours in a week.  However, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. § 213(b)(12). The agricultural exemption is broad, defining “agriculture” to include “farming in all its branches [including] the raising of livestock, bees, fur-bearing animals, or poultry,…and the production, cultivation, growing, and harvesting of...horticultural commodities and any practices performed by a farmer or on a farm as an incident to or in conjunction with farming operations.”  The 500 man-days test is irrelevant in this context. In addition, there are specific FLSA hour exemptions for certain employment that is not within the FLSA definition of agriculture.

Thus, an agricultural worker is not entitled to be paid overtime wages, but they must be paid for hours that they work.  There are also certain workers that are exempt from being paid for hours worked that exceed 40 hours in a week.  Included in this category are those “executive” workers whose primary duties are supervisory and the worker supervises 2 or more employees.  Also included are workers that fall in the “administrative” category who provide non-manual work related to the management of the business.  Also exempt are those workers defined as “professional” whose job is education-based and requires advanced knowledge.  Many larger farming and ranching operations have employees that will fit in at least one of these three categories.

DOL Proposal

For ag employees that are exempt from the overtime wage payment rate because they occupy an “executive” position, they must be paid a minimum amount of wages per week.  Until December 1, 2016, the minimum amount was $455/week ($23,660 annually).  Under the DOL proposal, however, the minimum weekly amount was to increase to $913 ($47,476 annually).  Thus, an exempt “executive” employee that is paid a weekly wage exceeding $913 is not entitled to be paid for any hours worked exceeding 40 in a week.  But, if the $913 weekly amount was not met, then the employee would generally be entitled to overtime pay for the hours exceeding 40 in a week.  Thus, the proposal would require farm businesses to track hours for those employees it historically has not tracked hours for – executive employees such as managers and those performing administrative tasks.  But, remember, if the employee is an agricultural worker performing agricultural work, the employee need not be paid for the hours in excess of 40 in a week at the overtime rate.  The proposal also imposes harsh penalties for noncompliance.

Nationwide injunction. Before the new rules went into effect, many states and private businesses sued to block them.  The various lawsuits were consolidated into a single case, and in November of 2016, the court issued a temporary nationwide injunction blocking enforcement of the overtime regulations.  Nevada v. United States Department of Labor, 218 F. Supp. 3d 520 (E.D. Tex. 2016). 

Summary judgment ruling.  On Aug. 31, 2017, the court entered summary judgment for the plaintiffs in the case thereby invalidating the regulations.  Nevada v. United States Department of Labor, No. 4:16-cv-731, 2017 U.S. Dist. LEXIS 140522 (E.D. Tex. Aug. 31, 2017).  In its ruling, the court focused on the congressional intent behind the overtime exemptions for “white-collar” workers as well as the authority of the DOL to define and implement those exemptions.  The court determined that the Congress clearly intended to exempt overtime wages for work that involved “bona fide executive, administrative, or professional capacity duties.”  Consequently, the DOL did not have regulatory authority to use a “salary-level test that will effectively eliminate the duties test” that the Congress clearly established.  The court also concluded that the DOL did not have any authority to categorically exclude workers who perform exempt duties based on salary level alone, which is what the court said that the DOL rules did.  The court noted that the rules more than doubled the required salary threshold and, as a result, “would essentially make an employee’s duties, functions, or tasks irrelevant if the employee’s salary falls below the new minimum salary level.”  The court went on to state that the overtime rules make “overtime status depend predominantly on a minimum salary level, thereby supplanting an analysis of an employee’s job duties.”  The court noted that his was contrary to the clear intent of the Congress and, as a result, the rules were invalid. 

The Future of the FLSA Overtime Rules

The DOL overtime rules were a product of the Obama Administration.  With the Trump Administration now in place, a question is raised as to what the future holds with respect to the overtime rules of the FLSA.  Will the DOL appeal the trial court’s ruling?  That’s doubtful in my view.  The current DOL Secretary has stated that the Obama Administration exceeded its FLSA authority in developing the (now invalidated) rules.  But, that doesn’t necessarily mean that the waters are calm on the issue.  While the court’s injunction order was being appealed, the Trump Administration’s DOL did defend the DOL’s authority to include a salary test in the overtime regulations.  They simply believed that the Obama Administration’s DOL had set the thresholds too high. 

In addition, the DOL put out a request for information (RFI) on July 21 noting that it would be opening a 60-day comment period on the white-collar exemptions. https://s3.amazonaws.com/public-inspection.federalregister.gov/2017-15666.pdf  That comment period began on July 26 and continues through September 24.  One of the issues that the DOL solicited comment on was whether the present threshold of $23,660 (annually) needed changed, perhaps by indexing it to inflation.  The DOL was also asking comment on whether salary thresholds should be tied to the size of a business, and whether the salary threshold should be tied to where a business is located, and the type of industry the business is involved in.  In addition, the DOL sought input from commentators on whether the overtime rule had a negative impact on small businesses, and whether the sole focus of the overtime rules should be on job duties of an employee (the current approach) in lieu of a salary threshold.

Conclusion

The court’s ruling invalidating the overtime rules is an important victory for many agricultural (and other) businesses.  It alleviates an increased burden to maintain records for employees in executive positions (e.g., managers and administrators), and the associated penalties for non-compliance.  However, the future of the FLSA overtime rules is not clear at the present time.  It remains to be seen the course that the Trump Administration’s DOL and, perhaps, the Congress, will take.

This issue and many other key issues in agricultural law and taxation are addressed in my treatise in my textbook on agricultural law, Principles of Agricultural Law, just out with its 41st Release.  You can find out more information about the book here:  http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/principlesofagriculturallaw/index.html

September 5, 2017 in Regulatory Law | Permalink | Comments (0)

Friday, September 1, 2017

Selling Collateralized Ag Products – The “Farm Products” Rule

Overview

When a farmer sells farm products such as crops and livestock in the normal course of the farming business, those products often are also serving as collateral for a lender’s security interest.  So what are the rights of the buyer in that instance?  Does the buyer take the goods subject to a pre-existing security interest created by the farmer-seller?  That’s an important question for both farmer-sellers and buyers of farm products to know the answer to.  Fortunately, there is a special rule that governs in such situations – the farm products rule.

The Farm Products Rule

Original rule.  There is a long history behind the farm products rule.  Prior to a change in the law that was contained in the 1985 Farm Bill, the majority rule was that a buyer in the ordinary course of business (BIOC) from a seller engaged in farming operations did not take free of a perfected security interest unless evidence existed of a course of past dealing between the secured party and the debtor from which it could be concluded that the secured party gave authority to the debtor to sell the collateral. UCC § 9-307(1).  Thus, a farmer's sale of secured farm products did not cut off the creditor's right to follow farm products into the hands of buyers, such as grain elevators.  This meant that when a farmer failed to settle with secured parties, buyers of farm products sometimes had to pay twice unless the buyer could show that the secured party gave the debtor authority to sell the collateral

Under the farm products rule, farm products were not considered “inventory” to a farmer.  Instead, “farm products” were defined as crops, livestock (including, apparently, fowl) or supplies used or produced in farming operations and products of crops or livestock in their unmanufactured states if they were in the possession of a debtor engaged in the raising, fattening, or grazing of livestock or other farming operations.  The holder of the perfected security interest could recover farm products subject to the interest from a bona fide purchaser purchasing watermelons from a roadside stand, steers in carload lots, or a load of corn, if the purchase was from a seller engaged in farming operations.  However, crops, livestock, or the products of crops or livestock if in the possession of one not engaged in farming cease to be farm products and are inventory.  Similarly, if farm products pass to one engaged in marketing for sale or a manufacturer or processor, they become inventory.

As can be surmised, the farm products rule was highly protective of secured parties.  Purchasers of farm products had to be cautious in all transactions and were given strong incentive to always check the record for filed financing statements, and to have checks made payable jointly to the seller and the lender.  However, creditors secured by farm products still needed to have a properly perfected security interest in the crops or livestock and include a specific provision in the security agreement specifying whether the debtor could sell the collateral.  If sales were allowed, the lender needed to state clearly how payment was to be made, whether checks were to be sent directly to the lender, whether the debtor and lender were to be joint payees, or, whether a specified percentage of the proceeds was to be remitted directly to the lender.  In any event, the provisions on sale and payment of proceeds had to be consistently enforced.

From the mid-1970s until the mid-1980s, several states amended the UCC farm products rule to allow, in various circumstances, purchasers of farm products from a person engaged in farming operations to take free of a perfected security interest.  By the end of 1985, about 40% of the states had modified the general rule discussed above. 

New rule.  Effective December 23, 1986, the 1985 Farm Bill “federalized” the states' farm product rules.  This gave the states two options - adopt a prescribed central filing system or follow an “actual notice” rule.  Thus, under the federal rule, if a BIOC buys a farm product that has been “produced in a state” from a seller engaged in farming, the BIOC takes the farm product free of any security interest created by the seller unless:

  • Within one year before the sale of the farm products, the buyer has received written notice of the security interest from the secured party (the direct notice exception);
  • The buyer has failed to pay for the farm products; or
  • In states which have established a central filing system (all states now have adopted central filing), the buyer has received notice from the Secretary of State of an effective filing of a financing statement (EFS) or notice of the security interest in the farm products and has not obtained a waiver or release of the security interest from the secured party (the central filing exception).

To comply with the direct notice exception, a secured creditor had to send the farm products purchaser a written notice listing (1) the secured creditor’s name and address; (2) the debtor’s name and address; (3) the debtor’s social security number or taxpayer identification number; (4) a description of the farm products covered by the security interest and a description of the property; and (5) any payment obligations conditioning the release of the security interest.  The description of the farm products had to include the amount of the farm products subject to the security interest, the crop year, and the counties in which the farm products are located or produced.

Under central filing, the secured creditor must file a financing statement containing the same information as required in the written notice under the direct notice exception, except the secured creditor need not include crop year or payment obligation information.  Also, notwithstanding errors contained in the financing statement, a financing statement in a central filing state remains effective so long as the errors “are not seriously misleading.”  However, the general rule is that there is no “substantial compliance” rule with respect to the direct notice exception.  A secured creditor must comply strictly with the requirements of the direct notice exception.  See, e.g., State Bank of Cherry v. CGB Enterprises, Inc., 984 N.E.2d 449 (Ill. 2013), aff’g., 964 N.E.2d 604 (Ill. Ct. App. 2012).  However, the Kansas Supreme Court has applied a substantial compliance rule to the direct notice exception.  First National Bank & Trust v. Miami County Cooperative Assoc., 257 Kan. 989, 897 P.2d 144 (1995).

Key question.  Under the farm products rule, a question arises as to whether a buyer in a direct notice state that buys farm products that were produced in a central filing state is subject to a filing in an EFS central notice state.  7 U.S.C. §1631 says the answer to that question is “yes” but does not define what “produced in” means.  Is the phrase restricted in meaning only to production activities or does it also include marketing of the farm products?  One court has held that “produced in” means “the location where farm products are furnished or made available for commerce.”  The court believed that “such an interpretation allowed lenders to discern where they must file notice of their security interests and ensures a practical means for buyers to discover otherwise unknown security interests in farm products.”  Great Plains National Bank v. Mount, 280 P.3d 670 (Colo. Ct. App. 2012). 

2002 Farm Bill

The 2002 Farm Bill made several changes in the federal farm products rule.  Under the legislation, a financing statement is effective if it is signed, authorized or otherwise authenticated by the debtor.  A financing statement securing farm products needs to describe the farm products and specify each county or parish in which the farm products are produced or located.  Also, the required information on the security agreement must include a description of the farm products subject to the security interest created by the debtor, including the amount of such products where applicable, crop year, and the name of each county or parish in which the farm products are produced or located.           

Revised Article 9

Secured transactions under Article 9 of the Uniform Commercial Code (UCC) involve personal property and fixtures including loans on crops, livestock, inventories, consumer goods and accounts receivable.  Effective in 2001, Article 9 was revised such that “farm products” means goods, other than standing timber, with respect to which the debtor is engaged in a farming operation and which are:

  • Crops grown, growing or to be grown, including crops produced on trees, vines and bushes; and aquatic goods produced in aquacultural operations;
  • Livestock, born or unborn, including aquatic goods produced in aquacultural operations;
  • Supplies used or produced in a farming operation; or
  • Products of crops or livestock in their unmanufactured states.

“Farming operation” means raising, cultivating, propagating, fattening, grazing or any other farming, livestock or acquacultural operation.  As such, the revised definition of “farm products” eliminates the provision explicitly requiring the collateral to be in the possession of a person engaged in a farming operation.

Conclusion

In difficult financial times, understanding the rights of creditors of agricultural products is important.  The specific rules surrounding the sale of farm products are important to understand.

September 1, 2017 in Secured Transactions | Permalink | Comments (0)