Tuesday, October 31, 2017
Sometimes, I receive questions about the deductibility of interest. Often, the question comes up when money is borrowed. However, regardless of what the question relates to, the answer of whether interest is deductible can be complicated. That’s because the answer depends on how the taxpayer plans on using the borrowed funds. Are they used for business purposes? Investment? Or will the use of the borrowed funds be solely for personal purposes?
The issue has also gotten attention lately because of discussions by some on the tax writing committees in the Congress about eliminating interest deductibility.
Interest deductibility, that’s the topic of today’s post.
Personal interest (such as that associated with car loans, home appliances and credit cards) is not deductible unless the debt is secured by a mortgage on the principal residence. This exception for “qualified residence interest” applies for interest associated with the taxpayer's principal residence and one other residence selected by the taxpayer. To qualify, the residence must be used by the taxpayer or a member of the family for more than the greater of two weeks or 10 percent of the number of days when the residence is rented for a fair rent to persons other than family members. The maximum mortgage amount that interest can be claimed on is $1,000,000 of acquisition indebtedness. In addition, an interest deduction is available for home equity indebtedness up to a $100,000 loan amount. The deductions are on a per mortgage basis.
Investment interest is deductible (for those taxpayers that itemize deductions) to the extent of the taxpayer's net investment income. However, interest on debt associated with tax-free investments is not deductible. Also, interest on debt associated with land used by a farmer or rancher for agricultural purposes is not investment interest – it’s business interest. Similarly, the investment interest rules do not apply to any interest resulting from passive activities. The term “passive activities” means any activity involving the conduct of a trade or business in which the taxpayer does not materially participate and includes any rental activity. Crop share and livestock share leases with substantial involvement in decision making should be deemed businesses for this purpose.
Business interest is interest on debt associated with a business activity in which the taxpayer materially participates. Business interest is fully deductible, and if it is associated with the farm or ranch, it should be taken as a deduction. In 1993, the United States District Court for the District of North Dakota held that interest paid on an income tax deficiency attributable to income reported on Schedule F was business interest deductible on the Schedule F for the year it was paid. Miller v. United States, 841 F. Supp. 305 (D. N.D. 1993). However, the trial court’s decision was overturned on appeal, and numerous federal courts have since upheld the IRS regulations that disallow the interest deduction in such situations.
Passive Activity Interest
Interest on debt associated with a business (or other income-producing activity) in which the taxpayer doesn’t “materially participate” is deductible only if the income from passive activities exceeds expenses from those activities. This can be an issue for taxpayers that are engaged in rental real estate activities. There are special passive loss allowance rules that apply, but for interest on debt associated with these activities to be deductible, the income from the activity must exceed expenses.
Classification of Interest
Given the different categories of interest and the various rules of deductibility associated with each category, it is crucial to properly classify interest in order to determine which rules of deductibility apply. In general, the nature of interest is determined by examining of the use of the borrowed funds. This is known as the “tracing rule.” For example, if the use of the borrowed funds is for personal purposes, the interest is personal. Similarly, if borrowed funds are used to purchase a tractor, the interest is deductible business interest if the tractor is used in the taxpayer's farming or ranching business. If funds are borrowed as a second loan for the purpose of paying interest on a prior debt, interest on the second loan is allocated to the same purposes as the first loan. For example, if a second loan is contracted to pay the interest on a debt incurred to purchase the farm, the interest on the second loan is allocated to the purchase of the farm and is business interest. Any compound interest is allocated in accordance with the original interest to the uses of the original debt.
Segregation of Interest
As a matter of planning, it is important for farmers borrowing funds to maintain separate bank accounts for the business and for family expenditures. To maintain deductibility, loan proceeds should not be deposited in accounts from which non-business expenditures are paid.
Prepayment of Interest
Similar to the prepayment of inputs for the farming operation, the prepayment of interest used to be quite common. Indeed, it was common for farmers and ranchers in the past to go to the bank or the Production Credit Association at the end of December and line up their credit for the following year and, at the same time, prepay a year's worth of interest or even more. This is no longer permissible as interest cannot be prepaid. Cash basis taxpayers of all types are essentially placed on accrual accounting for deducting prepayments of interest. Interest is deductible in the year it is earned as the payment for borrowed funds. Distortion of income is no longer a relevant consideration.
Deductibility of Points
While the general rule is that interest paid in advance must be deducted over the life of the loan, exception exists for points paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer's principal residence. “Points” on indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence continue to be deductible in the year of payment if it is an established business practice in the community to pay points on such loans and the amount of the payment does not exceed the amount generally charged in the area. One “point” equals one percent of the loan. A deduction may be claimed for points if paid by the seller. An amount is considered paid by the seller if the buyer provides, from funds not borrowed, an amount at least equal to the points in the form of down payment, escrow deposits, earnest money or other funds paid at the closing. However, this rule does not apply to refinancing loans or home improvement loans on the principal residence and to all loans that involve a residence other than the principal residence, although one court permitted a deduction for points paid in conjunction with refinancing a home mortgage. Huntsman v. Comm’r, 905 F.2d 1182 (8th Cir. 1990).
Proper Handling of Year-End Interest Payments and Loan Rollovers
Late year-end payments pose special problems where interest is paid from proceeds of a new loan and the indebtedness continues. An important factor in determining if interest payments to a lender are “paid” is whether the borrower exercised unrestricted control over the loan proceeds. Interest is generally considered to be paid if the borrower has unrestricted control over the loan funds. However, a taxpayer should avoid borrowing funds for interest payments from the same lender that furnished the original loan even if unrestricted control is maintained over the loan proceeds. See, e.g., Davison v. Comm’r, 141 F.3d 403 (2d Cir. 1998). The IRS has indicated that an interest deduction will be denied if the taxpayer borrows funds from the same lender for the purpose of satisfying the interest obligation to that lender. I.R.S. News Release IR 83-93 (July 6, 1983).
For loans of more than one year, the “original issue discount” rules authorize an interest deduction evenly over the life of the loan.
The proper characterization of interest is critical to understanding whether interest is deductible. Have you been handling interest deductibility properly?
Friday, October 27, 2017
In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules. That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011.
Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction? Only time will tell, but the issue is important for LLC and LLP members.
Passive Loss Rules
The passive loss rules (I.R.C. §469) can have a substantial impact on farmers and ranchers as well as investors in farm and ranch land. The effect of the rules is that deductions from passive trade or business activities, to the extent the deductions exceed income from all passive activities may not be deducted against other income.
The proper characterization of the loss depends on whether the taxpayer is materially participating in the business. I.R.C. §469(h). But, I.R.C. §469(h)(2) creates a per-se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. The statute was written before practically all state LLC statutes were enacted and before the advent of LLPs, and the Treasury has never issued regulations to detail how the statue is to apply to these new types of business forms.
A few years ago, the issue of how losses incurred by taxpayers that are members of LLCs (and LLPs) are to be treated under the passive loss rules surfaced in four court opinions - three by the U.S. Tax Court and one by the U.S. Court of Federal Claims. In the cases, IRS stood by its long-held position that the per-se rule of non-material participation applies to ownership interests in LLCs because of the limited liability feature of the entity.
Material Participation Tests - Passive Losses
The key question presented in the cases was whether the taxpayer satisfied the material participation test. As mentioned above, a passive activity is a trade or business in which the taxpayer does not materially participate. Material participation is defined as “regular, continuous, and substantial involvement in the business operation.” I.R.C. §469(h)(1). The regulations provide seven tests for material participation in an activity. Temp. Treas. Reg. §1.469-5T(a)(1)-(7). The tests are exclusive and provide that an individual generally will be treated as materially participating in an activity during a year if:
- The individual participates more than 500 hours during the tax year;
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the tax year;
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of anyone else (including non-owners) for the tax year;
- The activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities during the tax year exceeds 500 hours;
- The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the tax year at issue;
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years preceding the tax year at issue; or
- Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year
As noted, if the taxpayer is a limited partner of a limited partnership, the taxpayer is presumed to not materially participate in the partnership’s activity, “except as provided in the regulations.” I.R.C. §469(h)(2). The regulations provide an exception to the general presumption of non-material participation of limited partners in a limited partnership if the taxpayer meets any of one of three specific material participation tests that are included in the seven-part test for material participation under Treas. Reg. 1.469-5T(a)(1)-(7). Those three tests are:
- The 500 hour test;
- The five out of 10 year test; and
- The test involving material participation in a personal service activity for any three years preceeding the tax year at issue.
Thus, the standard of “material participation” for a limited partner is higher than that for a general partner, and the question presented in the cases was whether the more rigorous standard for material participation for limited partners in a limited partnership under I.R.C. §469(h)(2) applied to the taxpayers (who held membership interests in LLCs and LLPs) with the result that their interests were per-se presumptively passive.
Garnett v. Com’r, 132 T.C. No. 19 (2009)
Facts. The taxpayers, a married couple residing in Nebraska, owned interests in various LLCs and partnerships that were organized under Iowa law as well as certain tenancy-in-common interests that were all engaged in agricultural production activities. They held direct ownership interests in one LLP and and LLC and indirect interests in several other LLPs and LLCs. Their ownership interests were denoted as “limited partners” in the LLP and “limited liability company members” in the LLC – which did have a designated manager. The interests that they held in the two tenancies-in-common were also treated similarly. For tax years 2000-2002, the taxpayers ran up large losses and treated them as ordinary losses.
The IRS claimed that an LLC member is always treated as a limited partner because of limited liability under state law and because the Code specifies that a limited partnership interest never counts as an interest with respect to which the taxpayer materially participates. I.R.C. §469(h)(2). Thus, the IRS characterized the losses as passive, basing their position on the regulation which, for purposes of I.R.C. §469, treats a partnership interest as a limited partnership interest if “the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount.” Temp. Treas. Reg. §1.469-5T(e)(3)(i)(B). On the other hand, the taxpayers argued that the Code and regulations did not apply to them because none of the entities that they had interests in were limited partnerships and because, in any event, they were general partners rather than limited partners. The taxpayers also pointed out that the Federal District Court for Oregon had previously ruled that, under the Oregon LLC Act, I.R.C. §469(h)(2) did not apply to LLC members. Gregg v. United States, 186 F. Supp. 2d 1123 (D. Ore. 2000).
Analysis. The Tax Court first noted that I.R.C. §469(h)(2) was enacted at a time when LLCs and LLPs were either new or nonexistent business entities and, as such, did not make reference to those entities. The court also pointed out that the regulations did not refer explicitly to LLPs or LLCs. Accordingly, the court rejected the IRS argument that a limitation on liability automatically qualifies an interest as a limited partnership interest under I.R.C. §469(h)(2). On the contrary, the court held that the correct analysis involved a determination of whether an interest in a limited partnership (or LLC) is, based on the particular facts, actually a limited partnership interest. That makes a state’s LLC statute particularly important. Does it grant LLC and LLP members power and authority beyond those that limited partners have traditionally been allowed.? The IRS conceded that the statute at issue in the case did just that. Other distinguishing features were also present. The court noted that limited partnerships have two classes of partners, one of which runs the business (general partners) and the other one which typically involves passive investors (limited partners). The limited partners enjoy limited liability, but that protection can be lost by participating in the business. By comparison, an LLP is essentially a general partnership in which the general partners have limited liability even if they participate in management. Likewise, the court noted that LLC members can participate in management and retain limited liability.
The court made a key point that it was not invalidating the temporary regulations, but was simply declining to write a regulation for the Treasury that applied to interests in LLCs and LLPs. Importantly, the court refused to give deference to the Treasury’s litigating position in absence of such a regulation.
Thompson v. United States, 87 Fed. Cl. 728 (2009)
Facts. The taxpayer held a 99 percent interest in an LLC that was formed under the Texas LLC statute. He held the other one percent interest indirectly through an S corporation. The LLC’s articles of organization designated the taxpayer as the manager. The LLC did not make an election to be taxed as a corporation and, thus, defaulted to partnership tax status. The LLC, which provided charter air services, incurred losses in 2002 and 2003 of $1,225,869 and $939,878 respectively which flowed through to the taxpayer. The IRS disallowed most of the losses on the basis that the taxpayer did not meet the more rigorous test for material participation that applied to limited partners in limited partnerships. The taxpayer paid the additional tax of $863,124 and filed a refund claim for the same amount. The IRS denied the refund claim and the taxpayer sued for the refund, plus interest. Both the taxpayer and the IRS moved for summary judgment.
The IRS stood by its position that the more rigorous material participation test applied because the taxpayer enjoyed limited liability by owning the interests in the LLC just like he would if he held limited partnership interests. Thus, according to the IRS, the taxpayer’s interest was identical to a limited partnership interest and the regulation applied triggering the passive loss rules.
The court disagreed with the IRS. While both parties agreed that the statute and regulations trigger application of the passive loss rules to limited partnership interests, the taxpayer pointed out that he didn’t hold an interest in a limited partnership. The court noted that the language of the regulation (Treas. Reg. § 1.469-5T(e)(3)) explicitly required that the taxpayer hold an interest in an entity that is a partnership under state law, and that the Treasury had never developed a regulation to apply to LLCs. It was clear that the taxpayer’s entity was organized under Texas law as an LLC. In addition, the court pointed out that the taxpayer was a manager of the LLC, and IRS had even conceded at trial that the taxpayer would be deemed to be a general partner if the LLC were a general partnership. The court noted that the position of the IRS that an LLC taxed as a partnership triggers application of the Treas. Reg. §1.469-5T(e)(3)(ii) was “entirely self-serving and inconsistent.” The court also stated that it was irrelevant whether the taxpayer was a manager of the LLC or not – by virtue of the LLC statute, the taxpayer could participate in the business and not lose the feature of limited liability.
Hegarty v. Comr., T.C. Sum. Op. 2009-153
In this summary opinion, the Tax Court reiterated its position that the reliance by IRS on I.R.C. § 469(h)(2) to treat members of LLCs as automatically limited partners for passive loss purposes is misplaced. Instead, the general tests for material participation apply and the petitioners in the case (a married couple) were determined to have materially participated in their charter fishing activity for the tax year at issue. They participated more than 100 hours and their participation was not less than the participation of any other individual during the tax year.
Newell v. Comr., T.C. Memo. 2010-23
In this case, the taxpayer’s primary business activity was managing various real estate investments. He spent more than one-half of his time and more than 750 hours annually in real property trade or business activities. During the years at issue, the taxpayer was the sole owner of an S corporation that manufactured and installed carpentry items, and his participation is that business qualified as a significant participation activity for purposes of the passive loss rules. He also owned 33 percent of the member interests in a California-law LLC engaged in the business of owning and operating a golf course, restaurant and country club. The LLC was treated taxwise as a partnership. It was undisputed that the taxpayer was the managing member of the LLC. For tax years 2001-2003, IRS claimed that the losses the taxpayer incurred from both the S corporation and the LLC were passive losses that were not currently deductible. While the parties agreed that the taxpayer’s participation in both the S corporation and the LLC satisfied the significant participation activity test under the passive loss rules, IRS again asserted its position that I.R.C. §469(h)(2) required that the taxpayer’s interest in the LLC be treated as a passive limited partnership interest, even though IRS conceded that the taxpayer held the managing member interest in the LLC.
The Tax Court rejected the IRS’ argument, noting again that the general partner exception of Treas. Reg. §1.469-5T(e)(3)(ii) was not confined to the situation where a limited partner also holds a general partnership interest. Under the exception, an individual who is a general partner is not restricted from claiming that the individual materially participated in the partnership. Here, it was compelling that the taxpayer held the managing member interest in the LLC. As such, the taxpayer’s losses were properly deducted.
Chambers v. Comr., T.C. Sum. Op. 2012-91
Here, the taxpayer owned rental property with his spouse that produced a loss. The taxpayer was also a managing member of an LLC that owned rental properties. The LLC also owned rental property, and produced losses with one-third of the losses allocated to the taxpayer. The taxpayer was also employed by the U.S. Navy. He deducted his rental losses in full on the basis that he was a real estate professional. In order to satisfy the “more than 50 percent test,” he combined his hours spent on his personally-owned rental activity with his management activity for the LLC. The IRS invoked I.R.C. §469(h) to disallow the taxpayer’s LLC managerial hours, but the court disagreed. The court held that the taxpayer’s LLC interest was not defacto passive. Thus, his hours spent in LLC managerial activities counted toward his total “real estate” hours. However, he still failed to meet more than 50 percent test. In addition, the court noted that the fallback test of active participation allowing $25,000 of rental real estate losses was not available because the taxpayer’s AGI exceeded $150,000 for the year in issue.
The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership. That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities.
As noted above, in late 2011, the Treasury Department proposed regulations defining “limited partner” for purposes of the passive loss rules. Notice of Proposed Rulemaking REG-109369-10 (Nov. 28, 2011). The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue. Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement. Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.
But, with the recent statement in the 2017-2018 Priority Guidance Plan, is the IRS going to finalize the proposed regulations as written or will there be modifications? What will the standard be for material participation? It’s an important issue for farmers, ranchers and others that utilize the LLC or LLP form of structure, of which there are many.
Wednesday, October 25, 2017
Next week begins the first of the fall tax schools that I will be a part of this fall. The schools start in western Kansas and cover the state with eight two-day schools sponsored by Kansas State University. I also participate in two schools in North Dakota sponsored by the University of North Dakota.
Of course, what’s happening on the legislative front in D.C. will be discussed. As of right now, that discussion will be rather short. Talk of tax reform started in August of 2016 with the release of the “House Blueprint” and many of the reforms enumerated in that document continue to be discussed under the banner of “tax reform.” However, in my view, prospects for something coming into form and passing the Congress by the end of the year look slim. If there are any developments, I will be covering those at the schools.
Of course, detailed coverage and analysis will be provided on numerous topics. Included in the coverage will be tax issues associated with employment, including the tax difference between an employee and an independent contractor; Section 530 relief; taxation of fringe benefits; household employees and foreign workers. Also on the agenda are investment tax issues (information reporting; covered and noncovered securities; associated IRS forms; interest on loans; and issues associated with puts, calls, options, and short sales of securities.
A full update of what’s happening within the IRS will be provided. On that note, I observed earlier this week that IRS listed in its Priority Guidance List that it plans on finalizing regulations associated with I.R.C. §469(h)(2). That’s the code provision that deals with material participation by a limited partner. The IRS lost several cases a few years ago on the issue and I suspect it will take a position in the final regulations that sets forth the IRS position that the courts disagreed with.
Of course, a full update on ag tax issues will be provided with a specific look at audit issues, C corporation penalty taxes, cash method issues, indirect production costs, depreciation strategies and planning opportunities, loss issues, farm income averaging and tax issues associated with financial distress.
The latest significant IRS rulings and court cases will be addressed and their relevance to tax practice explained. Also, an in-depth discussion of installment sales will occur getting into associated issues such as electing out, handling the receipt of payments, escrow arrangements, depreciation recapture, like-kind exchanges, sale of a business, disposition of the obligation, repossession and SCINS. Other issues that will be discussed include crowdfunding, self-directed IRAs, fantasy sports and legal fees.
Particular issues associated with small businesses will also be covered, including: small business stock; health plans; bonus depreciation; recapture on sale of business assets; correcting depreciation errors and how to handle the sale of an asset that is acquired in a like-kind exchange.
Partners and partnership tax issues will be discussed in detail. The tricky issue of inside and outside basis will be covered as will distributions and guaranteed payments and self-employment taxes. Also, loans by partners and income from the discharge of debt and the disposition of a partnership interest. As for partnership issues, the key issues will be addressed – electing out of partnership taxation; capital accounts; liabilities; the I.R.C. §754 election; allocations; and distributions, dispositions and terminations.
Tax issues associated with estates and beneficiaries will also be covered. The discussion of these issues will also include pointers on estate planning under the current transfer tax system. Of course, estate planning could change significantly if the estate tax is eliminated and/or the stepped-up basis rule is modified or eliminated.
On the whole, each of the two-day seminars is packed with information that can be used by practitioners in preparing returns for the upcoming tax season after the start of the year. The educational information will also include a state income tax update for the respective state.
A separate ethics session is provided after the first day of each of the North Dakota schools, and after the last of the Kansas schools. I will participate in the ethics session in Kansas with Prof. Lori McMillan who is also of Washburn Law School.
The North Dakota school in Fargo will also be webcast live on November 14 and 15. The last of the Kansas schools, in Pittsburg, will also be simulcast over the web on December 13-14, as will the ethics session on December 15. For those interested in attending in-person from further away, flights into Kansas City will put you within an hour of the Topeka tax school on November 27-28 and about 40 minutes from the Overland Park tax school on November 20 and 21, as well as about a two-hour drive from the Pittsburg tax school on December 13-14. Also, Fargo and Mandan are easily accessible by flights from Minneapolis, MN.
For those in Iowa, I will be opening the Iowa Bar Bloethe Tax School on December 6 in Des Moines with an hour session providing an update on federal tax issues. The tax manual for that school is also an excellent set of materials that can be used during tax season and beyond.
All told, the tax seminars that are about to begin provide excellent opportunities for tax practitioners and their staff to get prepared for the next tax season that will soon be upon us. For more information on the schools, the teaching teams, dates and locations, and accommodations you can find more at the following links:
Monday, October 23, 2017
The death of a family member or other loved-one is often difficult circumstance for the family and other close ones that are left behind. From a financial and tax standpoint, however, proper and thorough estate planning is the key to minimizing and potentially eliminating more distress associated with the decedent’s passing.
One aspect of estate planning that does not involve technical tax planning or entity structuring or other crucial legal aspects involves cataloguing where the decedent’s important documents are located and who has access to them. In the past, that has often involved counseling clients to make sure that they have a filing system for key items such as insurance policies, contact information for utility companies, and contracts and warranty information for equipment and appliances, etc. In addition, a safety deposit box and/or safe has commonly been suggested for the storage of critical documents such as a will, power of attorney, or trust as well as real estate deeds and similar items.
But, in recent years a new issue has arisen in the estate planning realm. This issue involves the decedent’s digital assets such as electronic mail (email) accounts, bank accounts, credit cards, mortgages, and any other type of digital record as well as electronically stored information and social media accounts. Even business assets have become digitized. Depending on the decedent’s type of business, the extent of digitization of business records and information can be quite large.
So, what is the big estate planning issue with digital assets? It involves who has access to those assets upon death and whether appropriate language is included in estate planning documents to provide that access. A recent court decision in Massachusetts brings the issue front and center.
That’s the topic of today post – digital assets and estate planning.
Interestingly, federal law governing privacy rights to electronic communications goes back over 30 years. The Stored Communications Act (SCA) was included as part of the Electronic Communications Privacy Act of 1986. 18 U.S.C. §§2701-2712. That SCA created privacy rights to particular electronic communications and associated files from disclosure by online service providers. However, with the development of the internet and email communication that started in the mid-1990s, the SCA created a significant problem for fiduciaries and family members that needed access to the decedent’s online records and accounts. The SCA bars an online service provider from disclosing the decedent’s files and/or accounts to the estate fiduciaries or others unless the requirements for an exception contained in 18 U.S.C. §2702(b) are satisfied. But, even if an exception is satisfied, the service provider is not required to provide access to or otherwise disclose the contents of the decedent’s digital files or online accounts. Voluntary disclosure is the rule upon “lawful consent” of the “originator” or “subscriber.” 18 U.S.C. §2702(b)(3). In addition, the statute does not clearly state whether an estate fiduciary (e.g., executor or personal representative) can give the required “lawful consent.”
Facts. In a recent decision, the highest court in Massachusetts held that “…the personal representatives may provide lawful consent on the decedent’s behalf to the release of the contents of the Yahoo email account.” Ajemian v. Yahoo!, Inc., 478 Mass. 169 (2017). The facts of the case indicate that the decedent died intestate in 2006 as the result of a bicycle accident. The decedent had, at the time of death, an email account. However, he didn’t leave any instructions regarding how to handle the account after his death. Two of his siblings were appointed the personal representatives of his estate, and sought access to the contents of the email account. But, the service provider refused to provide access on the basis that it was barred from doing so by the SCA. The service provider also claimed that the terms of service that governed the email account gave the service provider the discretion to reject the personal representatives’ request.
Court determinations. The personal representatives sued, and the probate court granted the service provider’s motion to dismiss the case. On appeal, the appellate court vacated that judgment and remanded the case for a determination of whether the SCA barred the service provider from releasing the contents of the decedent’s email account to the personal representatives. On remand, the service provider claimed that the SCA prevented disclosure and, even if it did not, the terms-of-service agreement gave the service provider the right to deny access to (and even delete the contents of) the account. The appellate court granted summary judgment for the service provider on the basis that the SCA prohibited disclosure (but not on the basis of the terms of service contract).
On further review at the Massachusetts Supreme Judicial Court, the personal representatives claimed that they were the decedent’s agents for purposes of the exception of 18 U.S.C. §2702(b)(1) which gave the service provider the ability to disclose the contents of the decedent’s email account to them. However, the Supreme Judicial Court did not buy that argument, determining instead that a person appointed by a court does not fall within the common law meaning of “agent” citing Restatement (Third) of Agency §1.01 comment f. As to whether the personal representatives “stepped into the shoes” of the decedent as the originator of the account and, thus, could lawfully consent to the release of the contents of the email account under 18 U.S.C. §2702(b)(3), the Supreme Judicial Court held that they could, reasoning that there was nothing in the statutory definition or legislative history that indicated an intent to preempt state probate and/or common law allowing personal representatives to provide consent on a decedent’s behalf. The Supreme Judicial Court vacated the appellate court’s judgment and remanded the case to the probate court.
Revised Uniform Fiduciary Access To Digital Assets Act
While the Ajemian decision holds that a personal representative can meet the “lawful consent” exception of the SCA, a service provider is still not required to provide the desired access to digital records. However, under the Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA), a state law procedure is provided that fiduciaries can use to get access to online accounts (or other digital assets) of a decedent. The RUFADAA defines a “fiduciary” as a person appointed to manage the property of another person in that other’s person’s best interest. In essence, the RUFADAA empowers a fiduciary to manage another person’s “digital assets.” However, under the RUFADAA, the fiduciary must still get consent from the “owner” to be able to manage certain digital assets such as electronic communications and social media accounts unless the original user consented in a will, trust, power of attorney, or other record. Once that consent is obtained for digital assets that require it, if the service provider doesn’t comply with a disclosure request, §16(a) of the RUFADAA allows the personal representative to file a legal action seeking a court order requiring the service provider to comply with the personal representative’s request.
The majority of states have enacted the RUFADAA (or a substantially similar version thereof). Those that haven’t are: CA, DE, GA, KY, LA, MA, ME, MO, NH, OK, PA, RI, WV and the District of Columbia. Some of these states may enact the law in the near future. 2017 saw action in numerous state legislatures. As noted, MA has not enacted the RUFADAA, so a question is raised as to whether the court’s analysis in Ajemian would have differed, as well as how the RUFADAA would have impacted the SCA.
Digital Asset Planning Suggestions
What needs to be considered with respect to digital assets and an estate plan? The access question looms large. Who is to have access to digital assets and information post-death? From a will drafting standpoint, if a specific gift of digital assets is not made, the digital assets will be disposed of under the will’s residuary clause (“all the rest, residue and remainder of my estate”). Also, what type of access is the estate fiduciary to have? The type of access (such as the ability to read the substance of electronic communications) should be clearly specified in the owner’s will or trust. If access to digital assets and information is to be granted to a third party before death, the type and extent of access should be set forth in a power of attorney. On this point, the type of power of attorney matters.
Even with the authority to act as provided in a will, trust or power of attorney, it is likely that a service provider (or similar “custodian”) will require that the fiduciary obtain a court order before the release of any digital information or the granting of access.
While many people do not have estate planning documents in place at death, a very high percentage of decedents have at least some digital assets and/or accounts at the time of death. Some may have significant value. Others may have significant sentimental worth (such as photos). Thus, the ability to deal with and manage those assets post-death is very important. Technology has created additional legal and planning issues that should be accounted for.
The RUFADAA contains many associated comments that answer a lot of questions. To learn more, click on http://www.uniformlaws.org. Under the “Acts” tab, click on “Fiduciary Access To Digital Assets Act.”
Thursday, October 19, 2017
It can be beneficial (for business and tax purposes) for a farmer that utilizes the cash method of accounting to prepay for supplies. It’s one method to reduce a current years’ tax burden - simply purchase next year's fertilizer, feed, seed, chemicals and other inputs without near the end of the year and deduct all of that expense against that year's income.
As I have noted in prior posts, the IRS has mounted an attack on farmers’ use of the cash method of accounting. One avenue of attack has been its attempt to deny the use of pre-paid expenses. Thus, it’s imperative for a farmer to properly pre-pay expenses to be able to claim the deduction in the year of the pre-payment. As we get closer to the end of the year, and the timeframe during which many pre-payments occur, it’s a good idea to review the rules and get pre-payment arrangements properly structured so that deductions can be taken in the year of the payment, favorable prices can be received for input supplies and planting can be made more efficient due to having adequate input supplies on hand.
The pre-paid expense rules. That’s the topic of today’s post.
The IRS issued a revenue ruling in 1979 that identified three conditions that must be satisfied for pre-paid expenses for inputs such as fertilizer, seed and chemicals to successfully generate a deduction in the year of pre-payment. Rev. Rul. 79-229, 1979-2 C.B. 210. Failure to meet any one of these conditions results in an allowable deduction only when the input is used or consumed.
Binding contract. The first condition requires the pre-purchase to be an actual purchase evidenced by a binding contract for specific goods (of a minimum quantity) that are deductible items that will be used in the taxpayer’s farming business over the next year. An absence of specific quantities or a right to a refund of any unapplied credit are indicative of a deposit. Likewise, if the farmer retains the right to substitute other goods or services for those denoted in the purchase contract, a deposit is indicated. For example, a 1982 case from the Fifth Circuit Court of Appeals involved a Texas farmer who went to the local elevator near year's end, wrote a check for $25,000, and told the elevator operator that he would be back sometime in the following year to pick up $25,000 worth of supplies. The farmer then deducted those expenses for that tax year and the IRS challenged the deductions. The farmer lost because the transaction looked like a mere deposit. Schenk v. Comr., 686 F.2d 315 (5th Cir. 1982).
While the IRS thinks that how the seller of the inputs characterizes the transaction on its books matters, that should be immaterial as to the characterization of the transaction for the farmer’s tax purposes. That’s particularly the case because of Treas. Reg. §1.451-5(c) which allows the seller to treat the transaction as a deposit without affecting the farmer’s ability to deduct for the amount of the pre-paid expenses. In addition, the farmer has no control over how an input seller treats the transaction on its books and deductibility should not turn on the seller’s characterization.
So, if a written contract is entered into for specific goods that are otherwise deductible items that will be used in the farming business within the next year, and the payment does not exceed (in total) the price and quantity established in the contract, the first condition is satisfied and the transaction is a pre-payment rather than a deposit.
Business purpose. The second IRS condition that is used to determine whether pre-purchased items are deductible is whether the transaction has a business purpose or was entered into solely for tax avoidance purposes. This is the easiest of the three tests because if a taxpayer is not pre-purchasing to assure the taxpayer a set price, the taxpayer is pre-purchasing to assure supply availability. Another legitimate business purpose associated with pre-purchasing include avoiding a feed shortage. Thus, in practically all conceivable transactions, it is fairly easy to think of a business reason for what the taxpayer is doing. But see, Peterson v. United States, 6 Fed. Appx. 547 (8th Cir. 2001).
Material distortion of income. The third condition requires that the transaction must not materially distort income. While pre-purchasing distorts income, the key is whether the distortion is “material.” There is no bright-line test to determine whether income has been materially distorted in any particular case. The IRS, however, gets most upset when a taxpayer's pattern of pre-purchases bears a suspicious tandem relationship to income. For example, if a taxpayer's income goes up in one year and the level of pre-purchases also rises, and in a subsequent year, income goes down along with the level of pre-purchases, the IRS could question the transaction. In addition, the IRS will likely examine the relation of the purchase size to prior purchases and the time of year payment was made. Thus, it’s important for a farmer to stay consistent with their customary business practices in buying supplies and the business purpose(s) for the pre-payment. Also, the pre-payment transaction should not provide a tax benefit that extends longer than 12 months. See Treas. Reg. §1.162-3(c)(1)(iii).
Some courts have approved deductions for prepaid inputs if the expenditure was made in the course of prudent business practice unless a gross distortion of income resulted. However, recent cases have found material distortion of income and disallowed the deduction even though a legitimate purpose existed. In any event, a survey of the decisions indicates that for year-end purchases of the next year's supplies, a taxpayer should try to take delivery or at least enter into a binding, no refund, no substitutes contract. Likewise, it appears that if a taxpayer stays within the confines of the IRS rulings, the deduction will be allowed. See, e.g., Comr. v. Van Raden, 650 F.2d 1046 (9th Cir. 1981).
There is an overall limitation on the amount of deduction for pre-paid expenses. The limit is 50 percent of total deductible farming expenses excluding prepaid expenses. This is largely drawn right off of Schedule F (including current year depreciation expense). The taxpayer simply takes into account all of the expenses and is eligible to deduct up to 50 percent on a prepaid basis. Thus, if a taxpayer has total deductible farming expenses for the year of $80,000, and has prepaid an additional $50,000, the most the taxpayer could deduct would be $40,000 which means the other $10,000 is carried over and deducted the following year.
Exceptions. There are two exceptions to the 50 percent test. One of these exceptions is for a change in business operations caused by extraordinary circumstances. A farmer is permitted to continue to deduct prepaid expenses even though the prepaid expenses exceed 50 percent of the deductible farming expenses for that year if the failure to meet the 50 percent test was because of a change in business operations directly attributable to extraordinary circumstances. If the reason for a taxpayer's reduced level of inputs was because of something extraordinary such as a major change in federal farm programs, like a 1983-style payment-in-kind program that idled a lot of land, or because of a big casualty loss, or because of a disease outbreak in livestock or something of that nature, that constitutes an extraordinary circumstance and removes the taxpayer from the 50 percent rule.
The second exception permits a “qualified farm-related taxpayer” to meet the 50 percent test over the last three years (computed on an aggregate basis) rather than the last one year. A “qualified farm-related taxpayer” is a taxpayer whose principal residence is on a farm or whose principal occupation is farming or who is a member of the family of a taxpayer whose principal residence is on a farm or who has a principal occupation of farming. A corporation carrying on farming operations can qualify as a “farm-related taxpayer.” See Golden Rod Farms, Inc. v. United States, 115 F.3d 897 (11th Cir. 1997).
If the aggregate prepaid farm supplies for the three taxable years preceding the taxable year are less than 50 percent, then there is no limitation on deductibility of prepaid expenses. There is a question, however, concerning how the expenses over the past three years are to be aggregated. Guidance is needed as to whether carry-over expenses to or from the three-year period are ignored, or whether the 50 percent test applies each year with the excess carried over to the following year.
The ability of a cash method farmer to pre-pay and deduct expenses is a critical tax management tool. A typical famer’s amount of pre-payments can easily exceed $100,000. In addition, it should be noted that rent can also be pre-paid (and currently deducted) if it doesn’t extend beyond 12 months. Treas. Reg. §1.263(a)-4(f)(8), Example 10. But, for pre-paid rent, the potential application of §467 will need to be considered.
Have you been following the rules and structuring pre-payment transactions properly?
Tuesday, October 17, 2017
A popular tax technique for certain taxpayers, including farmers and ranchers, involves the donation of a permanent conservation easement. A conservation easement is a voluntary restriction on the use of land that a landowner negotiates with a private charitable conservation organization (commonly referred to as a "land trust") or government agency that the landowner chooses to "hold" the easement. That means that the donee organization has the right to enforce the restrictions that the easement imposes.
Normally, the donation of a partial interest in property does not generate a tax deduction for the donor. However, a deduction can be obtained for a “qualified conservation contribution.” I.R.C. §170(f). Thus, a donor can receive a charitable deduction for the donation if the transaction is structured properly. But, those rules must be strictly satisfied to get the desired tax benefit. Numerous cases have been litigated that illustrate how closely the rules must be followed. Indeed, in Notice 2004-1, 2004-28, IRB 31, the IRS announced that it was increasing its scrutiny of conservation easement transactions. The audit activity and the litigated cases have picked up steam since that time
Today’s post summarizes some of the most recent cases involving donated easements and one particular issue – the need that the easement be protected in perpetuity. That’s what a “permanent” easement donation means.
For qualified conservation contributions (i.e., contribution of a qualified real property interest to a qualified organization exclusively for conservation), a 50 percent limit on the contribution base, less all other contributions, applies, and the carryforward period is 15 years. I.R.C. §170(b)(1)(E)(ii). However, for qualified farmers and ranchers (as defined by I.R.C. §2032A(e)(5) – see I.R.C. §170(b)(1)(E)(v)) the limit is 100 percent of the contribution base less all other contributions. For property in agriculture or livestock production to be eligible for the 100 percent limit, the qualified real property interest has to include a restriction that the property remains generally available for such production.
A qualified conservation contribution is one that is of a “qualified real property interest” donated to a “qualified organization” exclusively for “conservation purposes” where the donee is barred from making certain transfers. I.R.C. §170(h)(1)(A-C). In addition, as noted above, the donated easement must also be perfected in perpetuity. If these requirements are satisfied, the starting point for determining the deductible amount of the donation is determined by the difference between the value of the burdened property before and after the donation.
But, as noted above, the IRS requires strict compliance to all of the rules governing the donated easement so as to generate a deduction. Recent cases highlight the need to protect the easement in perpetuity.
The Perpetuity Requirement
Under I.R.C. §170(h)(2) and (h)(5)(A), to be deductible, the donated easement must be granted in perpetuity. These perpetuity Code sections have been at issue in a few recent cases.
Subordination requirement. The easement must be granted in perpetuity at the time of the grant. The Tax Court made that point clear in Mitchell v. Comr., 138 T.C. 324 (2012). In that case, the petitioner did not subordinate an underlying mortgage on the property until two years after the easement grant. That fact, the Tax Court held in a case of first impression, barred a charitable contribution deduction. The Tenth Circuit later affirmed the Tax Court’s decision. Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015)
In a more recent case, the Tax Court continued to strictly apply the subordination requirement. In Palmolive Building Investors, LLC v. Comr., 149 T.C. No. 18 (2017), the petitioner transferred a façade easement via deed to a qualified charity. The easement deed placed restrictions on the petitioner and its successors with respect to the façade easement and the building. The building was subject to two mortgages, but before executing the easement deed, the petitioner obtained mortgage subordination agreements from banks holding the mortgages. But, the easement deed provided that if the easement were eliminated due to the government’s exercise of its eminent domain power, the banks would have claims to any condemnation award in order to satisfy the underlying mortgage before the charity had any rights to the award.
The petitioner claimed a charitable contribution deduction for the tax year of the easement contribution. The IRS disallowed the deduction, claiming that the easement deed failed to satisfy the perpetuity requirements of I.R.C. §170 and Treas. Reg. §1.170A-14(g)(6)(ii) because it provided the mortgagees with prior claims to the extinguishment proceeds in preference to the donee. Specifically, the lender had agreed to subordinate the debt to the charity’s claims, but the easement deed said that the lender would have priority access to any insurance proceeds on the property to the extent that the donor had insurance on the property. The easement deed also said that the lender would have priority to any condemnation proceeds.
The petitioner claimed that the First Circuit’s decision in Kaufman v. Comr., 687 F.3d 21 (1st Cir. 2012) applied. In that case, the First Circuit rejected the view that a subordination agreement must remove any preferential treatment of the lender in all situations. Instead the First Circuit created an exception for “unusual situations” that had the potential to occur at some future point. The First Circuit claimed that the Tax Court’s strict reading of what is necessary to grant a perpetual easement would eliminate easement donations because an easement represented only a partial interest in property. In addition, the First Circuit reasoned that the Tax Court’s rationale was improper because, for example, a tax lien could arise if the donor failed to pay property tax when they became due.
However, in the present case, the Tax Court rejected the First Circuit’s view, noting that the Tax Court’s decision in the present case would be appealable to the Seventh Circuit. That meant that the Tax Court was not bound by the First Circuit’s decision. The Tax Court reasoned that because the lender had superior rights in certain situations, the mortgages did not meet the subordination requirement of Treas. Reg. §1.170A-14(g). Thus, the donated easement did not meet the perpetuity requirement of I.R.C. §170(h)(5).
The Tax court also pointed out that other Circuits did not agree with Kaufman, and noted a difference concerning what must be done to subordinate an existing liability at the time of the donation (such as a mortgage) as opposed to a possible future liability that was not yet in existence. The Tax Court also noted that the Treasury Regulations specifically mentioned mortgages in the list of requirements necessary to satisfy the perpetuity requirement, but made no mention of tax liens.
The subordination requirement was also at issue in RP Golf, LLC v. Comr., 860 F.3d 1096 (8th Cir. 2017), aff’g., T.C. Memo. 2016-80. In this case, the petitioner made a charitable contribution of a permanent conservation easement on two private golf courses in the Kansas City area in 2003 valued at $16.4 million. The IRS challenged the charitable contribution deduction on numerous grounds, and in an earlier action, the petitioner conceded that the donation did not satisfy the open space conservation test, granting the IRS summary judgment on that issue, with other issues remaining in dispute. At the time of the donation, two banks held senior deeds of trust on the land at issue.
Subordination agreements were not recorded until approximately three months after the donation stating that they were effective at the time of the donation. In addition, the petitioner had no power or authority to enforce the easement with respect to a portion of the property due to its lack of ownership of the property. The Tax Court cited Mitchell v. Comr., 775 F.3d 1243 (10th Cir. 2015) and Minnick v. Comr., 796 F.3d 1156 (9th Cir. 2015) as precedent on the issue that the donor must obtain a subordination agreement from the lender at the time the donation is made. Here, the court held that the evidence failed to establish that the petitioner and the lenders entered into any agreements to subordinate their interests that would be binding under state (MO) law on or before the date of the transfer to the qualified charity. As a result, the donated easement was not protected into perpetuity and failed to qualify as a qualified conservation contribution.
Deed recordation. Failure to record the deed can also result in the easement not being protected in perpetuity. In Ten Twenty Six Investors v. Comr., T.C. Memo. 2017-115, the petitioner owned an old warehouse and executed a “Conservation Deed of Easement” that granted a façade easement on the warehouse to the National Architectural Trust (NAT). The deed was accepted in late 2004, but was not recorded until late in 2006. On its 2004 tax return, the petitioner, claimed a noncash charitable deduction of $11.4 million in accordance with an appraisal. The IRS disallowed the deduction in its entirety, and imposed a 40 percent gross valuation misstatement penalty or, alternatively, the 20 percent accuracy-related penalty. To support the deduction, it is imperative that the donee have a legally enforceable right under state law. However, because the deed was not recorded until late 2006, the perpetuity requirement could not be satisfied in 2004. Citing prior caselaw based on New York (NY) law, the Tax Court determined that the deed was effective only upon recording and that a deed to create an easement must be recorded to be effective. Thus, the Tax Court upheld the IRS determination.
Similarly, in Carroll, et al. v. Comr., 146 T.C. 196 (2016), the Tax Court determined that a conservation easement was not protected in perpetuity with the result that the deduction was limited. The petitioner contributed a conservation easement on a tract of land to two qualified organizations. The easement provided that if the conservation purpose was extinguished because of changed circumstances surrounding the donated property, the that donees were entitled to a proportionate share of extinguishment proceeds. If extinguishment occurred, the donees were entitled to receive at least the amount allowed as a deduction to the donor for federal income tax purposes over the fair market value of the property at the time of the contribution. The plaintiff claimed a charitable contribution for the year of the contribution and carried forward the remaining balance to tax years 2006-2008. Under Treas. Reg. §1.170A(g)(6)(i), when a change in conditions extinguishes a perpetual conservation restriction, the donee, on later sale, exchange or conversion of the property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction. Because the easement at issue provided that the value of the contribution for purposes of the donees’ right to extinguishment proceeds is the amount of the petitioner’s allowable deductions rather than the fair market value of the easement, the court determined that the easement violated the Regulation and was not protected in perpetuity under I.R.C. §170(h)(5)(A). The court also imposed an accuracy-related penalty.
The IRS takes a close look at donated conservation easements. It simply does not like the granting of a significant tax deduction while the donor continues to use the underlying property in largely the same manner as before the easement on the property was donated. Thus, all of the requirements necessary to obtain the deduction must be followed. That includes satisfying the perpetuity requirement.
The IRS has also produced an audit technique guide concerning the donation of permanent conservation easements. That guide should be reviewed by parties interested in donating permanent easements. It is accessible here: https://www.irs.gov/pub/irs-utl/conservation_easement.pdf
Friday, October 13, 2017
Cash is often inconvenient as a payment medium in transactions that involve large sums of money or where an ordinary promise to pay is unsuitable. A “negotiable instrument” is a document that guarantees that payment will be made of a certain sum of money. Payment will be made either upon demand or at a specified time by the person (or entity) named on the document. A check, for example, is considered to be a negotiable instrument.
Essentially, a negotiable instrument is a contract that promises the payment of money. That means, therefore, that rights and liabilities attach to a transaction involving a negotiable instrument. The law of negotiable instruments arose, at least in part, to provide a convenient and safe substitute for cash in these types of situations. Presently, Article 3 of the Uniform Commercial Code (UCC) governs negotiable instruments, and Article 4 (concerning bank deposits and collections) specifies the rules regarding bank processing of negotiable instruments.
The rights and liabilities of the parties to a negotiable instrument – that’s the focus of today’s post.
Types of Liability
Once an instrument is determined to be negotiable, it is necessary to determine whether or not a particular person is liable on the instrument and, if so, the nature of that liability. Liability can be based on contract principles involving a person's transfer of property related to the instrument, or on a tort theory relating to a breach of warranty on the instrument that intentionally or negligently causes loss to others.
Contract liability. The contract liability of the maker (also known as the issuer) of a note is based on that person's promise to pay. Article 3 requires the maker of a note, cashier's check or other draft to pay the instrument “according to its terms” either at the time of issue or at the time it first comes into possession of the holder. UCC § 3-413. The maker's promise is unconditional, and the maker owes the obligation “to a person entitled to enforce the instrument.” That includes the holder of the instrument, a non-holder in possession of the instrument who has the rights of a holder, or a person not in possession of the instrument who is entitled to enforce the instrument. UCC § 3-301. Thus, only two parties can be primarily liable - the maker and the acceptor. However, a person can still be entitled to enforce the instrument even though such person does not own the instrument or is in wrongful possession of the instrument.
A party that receives a check in payment of a debt expects the bank on which the check is drawn to pay the specified amount. However, until the bank accepts the check, the bank is not obligated to pay anything on the check. UCC § 3-411(2), Comment 2. Even if the bank arbitrarily dishonors a check, the payee or holder ordinarily has no cause of action against the bank on the instrument. As such, a payee may wish to obtain assurance that the bank will carry out the drawer's order. In particular, the payee or other holder may demand that the bank “accept” the draft and thus become primarily liable on the instrument. When a bank upon which a check is drawn accepts the check (usually by signing vertically across the face of the instrument), the bank is said to have certified the check. Once a bank accepts a check, it becomes primarily liable to all subsequent holders and the drawer of the check is discharged. UCC § 3-411(1).
The drawer of a draft drawn on a bank or other party is only “secondarily” liable on the instrument. Someone other than the drawer is expected to pay. The holder must make an attempt to collect elsewhere before the drawer must pay. While the drawer of a check, like the issuer of a note, signs the instrument in the lower right-hand corner, the drawer's contract is unlike the issuer's in that the drawer orders another to make payment and promises to pay only if the order bears no fruit. The holder of a draft looks first to the bank for payment and if it cannot be had there, to the drawer. If an unaccepted draft is dishonored, the drawer is obliged to pay the draft according to its terms at the time it was issued or if it was not issued, at the time it first came into possession of the holder. UCC § 3-413(2). With the 1990 changes to Article 3, it is no longer necessary that a holder give the drawer notice of the dishonor.
Article 3 frees a drawer from an obligation to pay a check if the check is not presented for payment within 30 days or given to a depository bank for collection within that time. However, this rule applies only where the drawee bank fails and because of the delay, the drawer is deprived of funds. In that event, the drawer is discharged, but only to the extent that the drawer is deprived of funds. On this point, consider the following example:
Example: Sam bought a rare Arabian quarter horse from Kenny, and wrote Kenny a check for $265,000 drawn against Sam's account at Wea Cheatum State Bank. Kenny misplaced the check and found it four months later under a stack of papers in his office. In the meantime, Wea Cheatum State Bank failed. If the bank was federally insured, Sam would collect $250,000 in federal bank deposit insurance, and his obligation to pay Kenny the remaining $15,000 would be discharged because Sam would otherwise be deprived of funds that he could have withdrawn from the bank before it failed. Sam would assign to Kenny his drawer's rights against the drawee, and it would be up to Kenny to try to collect the $15,000 balance.
An indorser of a negotiable instrument is also secondarily liable. Indorsement is the formal act that passes title to the indorser's transferee and obligates the indorser on the contract. Indorsement can also serve as a means of protecting against conflicting claims later on by restricting payment of the instrument. For example, the indorsement “for deposit only” not only serves to pass title or incur a guarantor's liability, it also prevents a party that accepts a stolen check from later claiming HDC status.
An indorsement can accomplish three functions: (1) negotiating the instrument; (2) restricting payment of the instrument; or (3) incurring an indorser's liability on the instrument. Thus, every signature that satisfies one or more of the above functions is an indorsement. This is true even if the indorsement is not in its usual place on the back of the instrument, but even in that event indorsers are normally liable in the order in which their names appear on the instrument.
All indorsements fall into three broad categories: special, blank and qualified. A special indorsement is an indorsement that identifies a person to whom the instrument is payable. A negotiable instrument that has been specially indorsed becomes payable to the identified person and may be negotiated only by the indorsement of that person. For example, “pay to the order of John Doe, \s\ Jim Jones” is a special indorsement that converts the negotiable instrument into an “order instrument” if the instrument is not already an order instrument. A blank indorsement converts a negotiable instrument into a “bearer instrument” and the instrument becomes payable to bearer and may be negotiated by transfer of possession alone until it is specially indorsed. For example, a blank indorsement “\s\ John Doe” makes the instrument bearer paper and is payable to anyone, with negotiation occurring solely by delivery (or possession for lost or stolen bearer paper).
A qualified or restrictive indorsement is utilized by individuals that want to limit their liability if the instrument is dishonored. Restrictive indorsements such as “for deposit only,” “pay any bank,” and similar phrases establish the terms for further negotiation of the instrument. Most often, their main purpose is to prevent thieves and embezzlers from cashing checks, but some phrases may constitute offers or terms of underlying agreements between the parties (i.e. “in full satisfaction of all claims”). If an indorser adds the words “without recourse” to its indorsement, the indorsement is qualified and the indorser transfers title to the instrument, but does not promise to pay should the instrument be dishonored upon presentation.
In one prominent Kansas case, a co-op employee forged customer signatures on co-op checks made payable to the customers and absconded with the funds. The co-op sued the bank for not honoring the restrictive indorsement on the checks which specified that the checks were for deposit only. Instead, the bank paid the cash amounts directly to the co-op employee. The bank was held liable for breach of the express contract with its depositor. Cairo Cooperative Exchange v. First National Bank of Cunningham, 620 P.2d 805 (Kan. 1980).
A tort is a civil wrong for which a court will award recovery. The essence of a tort case is that the defendant owed a duty to the plaintiff that was breached, with the breach constituting the proximate cause of the plaintiff's damage. All of the elements must be present before the plaintiff can recover. As applied in the negotiable instrument context, if a bank wrongfully dishonors a customer’s check, and the wrongful discharge proximately causes the customer’s damages, tort liability may apply. See, e.g., Maryott v. First National Bank of Eden, 624 N.W.2d (S.D. 2001).
Article 3 also imposes tort liability for actions grounded in negligence and conversion. For example, if a check is altered and the alteration should be obvious upon reasonable inspection, a bank making payment on such check may be deemed to have not paid the check in good faith for failing to exercise reasonable care, and may be liable to the drawer to the extent the drawer is damaged by the alteration, unless the drawer's negligence, such as not adequately safeguarding checks and embossing equipment, substantially contributed to the alteration. See, e.g., Commercial Credit Corp. v. First Alabama Bank, 636 F.2d 1051 (5th Cir. 1981).
Banking transactions are often straightforward. However, when a transaction doesn’t turn out as expected, or fraudulent conduct is involved, or a bank fails, it’s helpful to know the applicable rules.
Wednesday, October 11, 2017
Many legal cases are settled out-of-court. Cases could involve divorce, wrongful death, securities fraud, false advertising, civil rights, sexual harassment, product liability, reverse discriminations, or damages for a spilled cup of hot coffee just to name a few. But, if a recovery from a lawsuit or out-of-court settlement is obtained, the tax consequences must be considered.
The tax treatment of settlements and court judgments, that’s today’s topic.
Recoveries from out-of-court settlements or as a result of judgments obtained may fall into any one of several categories. Quite clearly, damages received on account of personal physical injury or physical sickness are excluded from income. I.R.C. §104(a)(2). Thus, amounts received on account of sickness or mental distress may be received tax-free if the sickness or distress is directly related to personal injury. For instance, settlement proceeds from a wrongful termination suit that are allocable to mental distress are excludible from income where the mental distress is caused directly by the wrongful termination. See, e.g., Barnes v. Comr., T.C. Memo. 1997-25. Those amounts that are allocated to punitive damages are not excludible. Id.
As the regulations point out, nontaxable damages include “an amount received (other than workmen's compensation) through prosecution of a legal suit or action based on tort or tort-type rights, or through a settlement agreement entered into in lieu of such prosecution.” Treas. Reg. § 1.104-1 (1970). The IRS has determined, for example, that excludible damages include damages for wrongful death (Priv. Ltr. Rul. 9017011 (Jan. 24, 1990)); payments to Vietnam veterans for injuries from Agent Orange (Priv. Ltr. Rul. 9032036 (May 16, 1990)); and damages from gunshot wounds received during a robbery (Priv. Ltr. Rul. 8942083 (Jul. 27, 1989)).
Categorization of a settlement or award is also highly dependent on how the wording of the legal complaint, settlement and release are drafted. Wording matters. This point was evident in a recent Tax Court case. In Stepp v. Comr., T.C. Memo. 2017-191, the petitioners, a married couple, could not exclude payments received in settlement of the wife’s Equal Employment Opportunity Commission complaint in which she alleged disability and gender-based discrimination, and retaliatory harassment for a job reassignment. The Tax Court noted that each of the complaint, settlement and release provided for emotional and financial harms. There wasn’t mention of any physical injury or sickness. Perhaps those documents were drafted without much thought given to the tax consequences of any eventual award or settlement.
1996 Legislation and the Aftermath
1996 legislation specified that recoveries representing punitive damages are taxable as ordinary income regardless of whether they are received on account of personal injury or sickness. Small Business Job Protection Act of 1996, P.L. 104-188, Sec. 1605(a). See, e.g., O'Gilvie v. United States, 519 U.S. 79 (1996); Whitley v. Comr., T.C. Memo. 1999-124. But punitive damages that are awarded in a wrongful death action are not taxable if applicable state law in effect on September 13, 1995, provides (by judicial decision or state statute) that only punitive damages may be awarded. In that case, the award is excludible to the extent it was received on account of personal injury or sickness. Small Business Job Protection Act, P.L. 104-188, § 1605(d)). The enactment also made it clear that damages not attributable to physical injury or physical sickness are includible in gross income.
In 2006, the U.S. Circuit Court of Appeals for the District of Columbia ruled that the distinction drawn in the 1996 amendment was unconstitutional. Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006). In the case, the plaintiff sued her former employer and was awarded $70,000 ($45,000 for mental pain and anguish and $25,000 for “injury to professional reputation”). The plaintiff originally reported the entire $70,000 as taxable and then filed amended returns excluding the income. The IRS maintained that the entire $70,000 was taxable, and the trial court agreed. On appeal, the court held that the $70,000 was not excludible from income under the statute, but that I.R.C. §104(a)(2) was unconstitutional under the Sixteenth Amendment since the entire award was unrelated to lost wages or earnings, but were, instead, payments for the restoration of the taxpayer’s human capital. Thus, the entire $70,000 was excludible from income. However, in late 2006, the court vacated its opinion and set the case for rehearing. Upon rehearing, the court reversed itself and held that even if the taxpayer’s award was not “income” within the meaning of the Sixteenth Amendment, it is within the reach of the power of the Congress to tax under Article I, Section 8 of the Constitution. In addition, the court reasoned that the taxpayer’s award was similar to an involuntary conversion of assets – the taxpayer was forced to surrender some part of her mental health and reputation in return for monetary damages.” Murphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), reh’g. den., 2007 U.S. App. LEXIS 22173 (D.C. Cir. Sept. 14, 2007), cert. den., 553 U.S. 1004 (2008).
What About Lost Profit?
In many lawsuits, there is almost always some lost profit involved, and recovery for lost profit is ordinary income. See, e.g., Simko v. Comm’r, T.C. Memo. 1997-9. For recoveries in connection with a business, if the taxpayer can prove that the damages received were for injury to capital, no income results except to the extent the damages exceed the income tax basis of the capital asset involved. The recovery is, in general, a taxable event except to the extent the amount recovered represents a return of basis. Recoveries representing a reimbursement for lost profit are taxable as ordinary income.
What if Contingent Fees are Part of an Award?
If the amount of an award or court settlement includes contingent attorney fees, the portion of the award representing contingent attorney fees is includible in the taxpayer’s gross income. Comr. v. Banks, 543 U.S. 426 (2005), rev’g and rem’g sub. nom., Banks v. Comr., 345 F.3d 373 (6th Cir. 2003). For fees and costs paid after October 22, 2004, with respect to a judgment or settlement occurring after that date, legislation enacted in 2004 provides for a deduction of attorney’s fees and other costs associated with discrimination in employment or enforcement of civil rights. I.R.C. § 62(a)(19).
Interest on Judgments
Statutory interest imposed on tort judgments, however, must be included in gross income under I.R.C. § 61(a)(4), even if the underlying damages are excludible. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir. 1996).
Under I.R.C. § 104(a), amounts received under workmen’s compensation as compensation for personal injuries or sickness are excludible. However, the exclusion is unavailable to the extent the payment is determined by reference to the employee’s age or length of service.
The Causation Issue
It’s important to determine whether payments received are for physical injury resulting from emotional distress or whether the payments received are for emotional distress resulting from physical injury. This key point on causation was at issue in a recent case decided by the Tax Court. In Collins v. Comr., T.C. Sum. Op. 2017-74, the petitioner sued his employer for workplace discrimination and retaliation, alleging that he “suffered severe emotional distress and anxiety, with physical manifestations, including high blood pressure.” The parties settled the case with the employer paying the petitioner a settlement amount of $275,000 that included an $85,000 allocation to “emotional distress.” The petitioner excluded the amount from his taxable income on his return, but the IRS denied the exclusion.
The Tax Court agreed with the IRS. The court noted that I.R.C. §104(a)(2) excludes from gross income damages paid on account of physical injury or sickness. However, the court noted that this Code section also says that emotional distress, by itself, does not count as physical injury or sickness. Thus, damages paid on account of emotional distress are not excludible. The court noted the legislative history behind I.R.C. §104(a) states that the Congress “intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.” However, the court also noted that Treas. Reg. §1.104-1(c)(2) states that emotional distress damages “attributable to a physical injury or physical sickness” are excluded from gross income. Thus, the court noted that if emotional distress results from a physical injury any resulting damages are excluded from gross income. However, if the physical injury results from emotional distress, damage payments are not excludible. In this case, the petitioner’s damage payment was paid on account of emotional distress that then caused physical injury and were not excludible.
Farmers and ranchers end up in litigation just like non-farmers and ranchers. In many instances those cases settle out-of-court. Sometimes those settlement amounts are significant. That makes the proper understanding of the tax treatment of the settlement award important. When cases don't settle and a judgment is obtained, it's still important to understand the tax consequences.
Monday, October 9, 2017
The farm economy continues to struggle. Of course, certain parts of the country are experiencing more financial trauma than are other parts of the country, but recent years have been particularly difficult in the Corn Belt and Great Plains. Aggregate U.S. net farm income has dropped by approximately 50 percent from its peak in 2011. It is estimated to increase slightly in 2017, but it has a long way to go to get back to the 2011 level. In addition, the value of farmland relative to the value of the crops produced on it has fallen to its lowest point ever. A dollar of farm real estate has never produced less value in farm production, and real net farm income relative to farm real estate values have not been as low as presently since 1980 to 1983.
A deeper dive on farm financial data indicates that after multiple years of declining debt-to-asset ratios, there was an uptick in 2015 and 2016. Relatedly, default risk remains low, but it also increased in 2015 and 2016. Also, there has been a decline in the ratio of working capital to assets, and a drop in the repayment capacity of ag loans. As a financial fitness indicator, repayment capacity is a key. At the beginning of the farm debt crisis in the early 1980s, it dropped precipitously due to a substantial increase in interest payments and a decline in farm production. That meant that land values could no longer be supported, and they dropped substantially. Consequently, many farmers found themselves with collateral value that was lower than the amount borrowed. Repayment capacity is currently a serious issue that could lead to additional borrowing.
While financial conditions may improve a bit in 2017 and on into 2018, working capital may continue to erode in 2017 which could lead to increased debt levels. That’s because average net farm income will remain at low levels. This could lead to some agricultural producers and lenders having to make difficult decisions before next spring. It also places a premium on understanding clause language in lending document and the associated rights and obligations of the parties.
Two clauses deserve close attention. One clause contains “cross collateralization” language. “Cross-collateralization” is a term that describes a situation when the collateral for one loan is also used as collateral for another loan. For example, if a farmer takes out multiple loans with the same lender, the security for one loan can be used as cross-collateral for all the loans. A second clause contains a “co-lessee” provision. That’s a transaction involving joint and several obligations of multiple parties.
Today’s post takes a deeper look at the implications of cross-collateral and co-lessee language in lending documents. My co-author for today’s post is Joe Peiffer of Peiffer Law Office in Hiawatha, Iowa. Joe brought the issues with cross-collateralization and co-lessee clause language to my attention. Joe has many years of experience working with farmers in situations involving lending and bankruptcy, and has valuable insights.
As noted above, clause language in lending and leasing documents should be carefully reviewed and understood for their implications. This is particularly true with respect to cross-collateralization language. For example, the following is an example of such a clause that appears to be common in John Deere security agreements. Here is how the language of one particular clause reads:
“Security Interest; Missing Information. You grant us and our affiliates a security interest in the Equipment (and all proceeds thereof) to secure all of your obligations under this Contract and any other obligations which you may have to us or any of our affiliates or assignees at any time and you agree that any security interest you have granted or hereafter grant to us or any of our affiliates shall also secure your obligations under this Contract. You agree that we may act as agent for our affiliates and our affiliates may as agent for us, in order to perfect and realize on any security interest described above. Upon receipt of all amounts due and to become due under this Contract, we will release our security interest in the Equipment (but not the security interest for amounts due an affiliate), provided no event of default has occurred and is continuing. You agree to keep the Equipment free and clear of all liens and encumbrances, except those in favor of us and our affiliates as described above, and to promptly notify us if a lien or encumbrance is placed or threated against the Equipment. You irrevocably authorize us, at any time, to (a) insert or correct information on this Contract, including your correct legal name, serial numbers and Equipment descriptions; (b) submit notices and proofs of loss for any required insurance; (c) endorse your name on remittances for insurance and Equipment sale or lease proceeds; and (d) file a financing statement(s) which describes either the Equipment or all equipment currently or in the future financed by us. Notwithstanding any other election you may make, you agree that (1) we can access any information regarding the location, maintenance, operation and condition of the Equipment; (2) you irrevocably authorize anyone in possession of that information to provide all of that information to us upon our request; (3) you will not disable or otherwise interfere with any information gathering or transmission device within or attached to the Equipment; and (4) we may reactivate such device.”
So, what does that clause language mean? Several points can be made:
- The clause grants Deere Financial and its affiliates a security interest in the equipment pledged as collateral to secure the obligations owed to it as well as its affiliates.
- When all obligations (including debt on the equipment purchased under the contract and all other debts for the purchase of equipment that Deere Financial finances) to Deere under the contract are paid, Deere Financial will release its security interest in the equipment. That appears to be straightforward and unsurprising. However, the release does not release the security interest of the Deere’s affiliates. This is the cross-collateral provision.
- The clause also makes Deere Financial the agent of its affiliates, and it makes the affiliates the agent of Deere Financial for purposes of perfection. What the clause appears to mean is that if a financing statement was not filed timely, perfection by possession could be pursued.
- The clause also irrevocably authorizes John Deere to insert or correct information on the contract.
- The clause allows John Deere to access any information regarding the location, maintenance, operation and condition of the collateral.
- The clause also irrevocably authorizes anyone in possession of that information to provide it to John Deere upon request.
- Also, under the clause, the purchaser agrees not to disable or interfere with any information gathering or transmission device in or attached to the Equipment and authorizes John Deere to reactivate any device.
Example. Consider the following example of the effect of cross-collateralization by machinery sellers and financiers:
Equity by Item
JD 4710 Sprayer 90' Boom
JD 333E Compact Track Loader
JD 8410T Crawler Tractor
JD 612C 12 Row Corn Head
Equity with Cross Collateralization
Equity without Cross Collateralization
The equity in the equipment without cross-collateralization is the sum of the equity in the Compact Track Loader, the Crawler Tractor and the Row Corn Head.
Sellers that finance the purchase price of the item(s) sold (termed a “purchase money” lender) seem to be using cross-collateralization provisions with some degree of frequency. As noted, the cross-collateralization provisions of the John Deere security agreement will allow John Deere to offset its under-secured status on some machinery by using the equity in other financed machines to make up the unsecured portion of its claims. Other machinery financiers (such as CNH and AgDirect) are utilizing similar cross-collateral provisions in their security agreements.
Can A “Dragnet” Lien Defeat a Cross-Collateralization Provision?
Would a bank’s properly filed financing statement and perfected blanket security agreement be sufficient to defeat a cross-collateralization provision? It would seem inequitable to allow an equipment financier’s subsequently filed financing statement to defeat the security interest of a bank. So far, it appears that when a purchase money security interest holder has sought to enforce a cross-collateralization clause, the purchase money security interest holder has always backed down. For example, in one recent scenario, John Deere Financial sought to enforce its cross-collateralization agreement against a Bank in a situation similar to the one set forth above. The Bank properly countered that its blanket security interest in farm equipment perfected before any of the Deere Financial purchase money security interests were perfected defeated the Deere Financial cross-collateralization. Deere Financial backed down thereby allowing the Bank to have all the equity in the equipment, $80,000, be paid to the Bank by the auctioneer after the liquidation auction.
A “Co-Lessee” Clause
When a guarantee on a loan cannot be obtained, a proposal may be made for “joint and several obligations.” In that situation, the lessor tries to compel one lessee to cover another lessee’s obligations or joint obligations. It’s a lease-sublease structure, with the original lessee becoming the sublessor. While the original lessee/sublessor has no rights to use the equipment (those rights are passed to the sublessee), the original lessee/sublessor remains legally obligated for performance. The sublease can then be assigned as collateral to the original lessor.
While a co-borrower situation is not uncommon, a transaction involving co-lessees is different inasmuch as a lease involves the right to use and possess property along with the obligation to pay for the property. A loan document simply involves the repayment of debt. So, what if a co-lessee arrangement goes south and the lessor tries to compel one lessee to cover another lessee’s joint obligation? What is the outcome? That’s hard to say simply because there aren’t any litigated cases on the issue with published opinions. But, numerous legal (and (tax) issues would be involved. For instance, with a true lease (see an earlier post on the distinction between a true lease and a capital lease), what if the lessees argue over the use and possession of the equipment or the removal of liens or maintenance of the property or the rental or return of the property? What about the payment of taxes? Similar issues would arise in a lease/purchase situation that encounters problems. What is known is that in such a dispute numerous Uniform Commercial Code issues are likely to arise under both Article 2 and Article 9.
The following is an example of John Deere’s co-lessee clause when it has an additional party sign on a lease:
“By signing below, each of the co-lessees identified below (each, a “Co-Lessee”) acknowledges and agrees that (1) the Lessee indicated on the above referenced Master Lease Agreement (the “Master Agreement”) and EACH CO-LESSEE SHALL BE JOINTLY AND SEVERALLY LIABLE FOR ANY AND ALL OF THE OBLIGATIONS set forth in the Master Agreement and each Lease Schedule entered into from time to time thereunder including, but not limited to, the punctual payment of any periodic payments or any other amounts which may become due and payable under the terms of the Master Agreement, whether or not said Co-Lessee signs each Lease Schedule or receives a copy thereof, and (2) it has received a complete copy of the Master Agreement and understands the terms thereof.
In the event (a) any Co-Lessee fails to remit to the Lessor indicated above any Lease Payment or other payment when due, (b) any Co-Lessee breaches any other provision of the Master Agreement or any Lease Schedule and such default continues for 10 days; (c) any Co-Lessee removes any Equipment (as such term is more fully described in the applicable Lease Schedule) from the United States; (d) a petition is filed by or against any Co-Lessee or any guarantor under any bankruptcy or insolvency law; (e) a default occurs under any other agreement between any Co-Lessee (or any of Co-Lessee's affiliates) and Lessor (or any of Lessor's affiliates); (f) or any Co-Lessee or any guarantor merges with or consolidates into another entity, sells substantially all its assets, dissolves or terminates its existence, or (if an individual) dies; or (g) any Co-Lessee fails to maintain the Insurance required by Section 6 of the Master Agreement, Lessor may pursue any and all of the rights and remedies available to Lessor under the terms of the Master Agreement directly against any one or more of the Co-Lessees. Nothing contained in the Addendum shall require Lessor to first seek or exhaust any remedy against any one Co-Lessee prior to pursuing any remedy against any other Co-Lessee(s).
Capitalized terms not defined in this Addendum shall have the meaning provided to them in the Master Agreement.”
Clearly, a party signing on as a co-lessee on a John Deere lease is assuming a great deal of risk.
Times are tough for many involved in production agriculture. The same is true for many agribusiness and agricultural lenders. If a producer is presented with a lending transaction that involves either a cross-collateralization or a co-lessee clause, legal counsel with experience in such transactions should be consulted. Fully understanding the risks involved can pay big dividends. Failing to understand the terms of these clauses can lead to the financial failure of the farmer that signs the document.
Thursday, October 5, 2017
Not all contractual transactions for agricultural goods function smoothly and without issues. From the buyer’s perspective, what rights does the buyer have if the seller breaches the contract? That’s an important issue for contracts involving agricultural goods. Ag goods, such as crops and livestock, are not standard, “cookie-cutter” goods. They vary in quality, size, shape, and moisture content, for example. All of those aspects can lead to questions as to contract breach.
So, what rights does a buyer have if there is a breach? A basic review of those rights is the topic of today’s post.
Right of Rejection
A buyer has a right to reject goods that do not conform to the contract. Under the Uniform Commercial Code (UCC), a buyer may reject nonconforming goods if such nonconformity substantially impairs the contract. A buyer usually is not allowed to cancel a contract for only trivial defects in goods. For example, in a 1995 New York case, a manufacturer of potato chips rejected shipments of potatoes for failure to conform to the contract based on the color of the potatoes. The court held that the failure to conform substantially impaired the contract and justified the manufacturer’s refusal to accept the potatoes. The defect was not merely trivial. Hubbard v. UTZ Quality Foods, Inc., 903 F. Supp. 444 (W.D. N.Y. 1995).
Triviality is highly fact dependent. It will be tied to industry custom, past practices between the parties and the nature of the goods involved in the contract.
Right To “Cover”
The traditional measure of damages for a seller’s total breach of contract is the difference between the market price and the contract price of the goods. For example, in Tongish v. Thomas, 251 Kan. 728, 840 P.2d 471 (1992), the seller breached a contract to sell sunflower seeds to a buyer. The buyer recovered damages for the difference in the market price and the contract price. The UCC retains this rule, (UCC § 2-713(1)) but also allows an aggrieved buyer to “cover” by making a good faith purchase or contract to purchase substitute goods without unreasonable delay. UCC § 2-712(1). The buyer that covers is entitled to recover from the seller the difference between the cost of cover and the contract price. UCC § 2-712(1).
Most of the agricultural cases concerning “covering” focus on the difference between the goods purchased as cover and the goods called for in the contract (cover goods must be like-kind substitutes), and the timeframe within which cover was carried out (there must be no unreasonable delay). On the timeframe issue, a Nebraska case serves as a good illustration of how the courts analyze the issue. In, Trinidad Bean and Elevator Co. v. Frosh, 1 Neb. App 281 494 N.W.2d 347 (1992), a navy bean producer was able to terminate a contract without penalty, even though prices had doubled by harvest (the delivery date specified in the contract). The farmer notified the elevator in May, when market prices were identical to the forward price, that the farmer would not fulfill the contract later that fall. The court noted that under the UCC when a seller repudiates a forward contract before delivery is required, the buyer is entitled to the difference between the contract price and the price of the goods on the date of repudiation if it is commercially reasonable for the buyer to cover at that time. The court ruled that the elevator was not entitled to damages because it could have filled the contract at the forward contract price at the time it was notified of the seller’s contract repudiation.
Right Of Specific Performance
If the goods are unique, the buyer may obtain possession of the goods by court order. This is known as specific performance of the contract. Contracts for the sale of real estate or art work, for example, are contracts for the sale of unique goods and the buyer’s remedy is to have the contract specifically performed. Monetary damages can be awarded to a contracting party along with specific performance if it can be shown that damages resulted from the other party’s failure to render timely performance. See, e.g., Perry v. Green, 313 S.C. 250, 437 S.E.2d 150 (1993).
A buyer has a right before acceptance to inspect delivered goods at any reasonable place and time and in any reasonable manner. The reasonableness of the inspection is a question of trade usage and past practices between the parties. If the goods do not conform to the contract, the buyer may reject them all within a reasonable time and notify the seller, accept them all despite their nonconformance, or accept part (limited to commercial units) and reject the rest. Any rejection must occur within a reasonable time, and the seller must be notified of the buyer's unconditional rejection. For instance, in In re Rafter Seven Ranches LP v. C.H. Brown Co., 362 B.R. 25 (B.A.P. 10th Cir. 2007), leased crop irrigation sprinkler systems failed to conform to the contract. However, the buyer indicated an attempt to use the systems and did not unconditionally reject the systems until four months after delivery. As a result, the buyer was held liable for the lease payments involved because the buyer failed to make a timely, unconditional rejection.
The buyer’s right of revocation is not conditioned upon whether it is the seller or the manufacturer that is responsible for the nonconformity. UCC § 2-608. The key is whether the nonconformity substantially impairs the value of the goods to the buyer.
A buyer rejecting nonconforming goods is entitled to reimbursement from the seller for expenses incurred in caring for the goods. The buyer may also recover damages from the seller for non-delivery of suitable goods, including incidental and consequential damages. If the buyer accepts nonconforming goods, the buyer may deduct damages due from amounts owed the seller under the contract if the seller is notified of the buyer’s intention to do so. See, e.g., Gragg Farms and Nursery v. Kelly Green Landscaping, 81 Ohio Misc. 2d 34; 674 N.E.2d 785 (1996)
Timeframe for Exercising Remedies
The UCC allows buyers a reasonable time to determine whether purchased goods are fit for the purpose for which the goods were purchased, and to rescind the sale if the goods are unfit. Whether a right to rescind is exercised within a reasonable time is to be determined from all of the circumstances. UCC §1-204. The buyer’s right to inspect goods includes an opportunity to put the purchased goods to their intended use. Generally, the more severe the defect, the greater the time the buyer has to determine whether the goods are suitable to the buyer.
Statute Of Limitations
Actions founded on written contracts must be brought within a specified time, generally five to ten years. For unwritten contracts, actions generally must be brought within three to five years. In some states, however, the statute of limitations is the same for both written and oral contracts. A common limitation period is four years. Also, by agreement in some states, the parties may reduce the period of limitation for sale of goods but cannot extend it.
Most contractual transactions for agricultural goods function smoothly. However, when the seller breaches, it is helpful for the buyer to know the associated rights and liabilities of the parties.
Tuesday, October 3, 2017
Estate tax portability allows a surviving spouse to carry over any unused portion of the deceased spouse’s estate tax exclusion (DSUE) to be used to offset estate tax in the surviving spouse’s estate, if necessary. It gets added to the surviving spouse’s own exemption. The DSUE has become a key aspect of post-2012 estate planning, and makes it quite simple for married couple to utilize the full estate tax exclusion over both of their estates. The full estate and gift tax coupled exclusion is $5.49 million per individual for deaths in 2017 and gifts made in 2017.
One of the concerns about portability is the ability of the IRS to audit the estate of the deceased spouse where portability was elected. Does the IRS have an open-ended statute of limitations to go back and examine that estate to determine if the “ported” amount of the unused exclusion was computed properly? A recent Tax Court decision confirms that the IRS does.
The election. To “port” the unused exclusion at the death of the first spouse to the surviving spouse, an election must be made. As noted, the amount available to be “ported” to the estate of the surviving spouse is the deceased spouse’s unused exclusion (DSUE). IRC §2010(c)(4); Treas. Reg. §20.2010-2. The portability election must be made on a timely filed Form 706 for the first spouse to die. I.R.C. §2010(c)(5)(A); Treas. Reg. §20.2010-2(a)(1). This also applies for nontaxable estates, and the return is due by the same deadline (including extensions) as taxable estates. The deadline for filing is nine months after the decedent’s date of death (with a six-month extension possible). The election is revocable until the deadline for filing the return expires.
While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that "a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the Form 706. No further action is required to elect portability…". This election, therefore, is made by default if there is a DSUE amount and an estate tax return is filed (as long as the box in section A of part 6 is not checked, which affirmatively elects out of portability).
Late election relief. In Rev. Proc. 2014-18, 2014-7 IRB 513, the IRS provided a simplified method for certain estates to obtain an extended time to make the portability election. That relief has now expired and has been extended by Rev. Proc. 2017-34, 2017-26 IRB 1282. The portability election must be submitted with a complete and properly filed Form 706 by the later of January 2, 2018, or the second anniversary of the decedent's death. After January 2, 2018, the extension is, effectively, for two years. The extension is only available to estates that are not otherwise required to file an estate tax return. Other estates can only obtain an extension under Treas. Reg. §301.9100-3. Form 706 must state at the top that the return is "FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A)."
An estate that files late, but within the extended deadlines of Rev. Proc. 2017-34, cannot rely on the revenue procedure if it later learns that it should have filed a Form 706. If a valid late election is made and results in a refund of estate or gift taxes for the surviving spouse, the time period for filing for a refund is not extended from the normal statutory periods. In addition, a claim for a tax refund or credit is treated as a protective claim for a tax credit or refund if it is filed within the time period of §6511(a) by the surviving spouse or the surviving spouse's estate in anticipation of Form 706 being filed to elect portability under Rev. Proc. 2017-34.
Election requirements. Treas. Reg. §20.2010-2 requires that the DSUE election be made by filing a complete and properly prepared Form 706. Treas. Reg. §20.2010-2(a)(7)(ii)(A) permits the “appointed” executor who is not otherwise required to file an estate tax return to use the executor's "best estimate" of the value of certain property and then report on Form 706 the gross amount in aggregate, rounded up to the nearest $250,000.
Treas. Reg. §20.2010-2(a)(7)(ii) sets forth simplified reporting for particular assets on Form 706, which allows for good faith estimates. The simplified reporting rules apply to estates that do not otherwise have a filing requirement under IRC §6018(a). This means that if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017), simplified reporting is not applicable.
Simplified reporting is only available for marital and charitable deduction property (under IRC §§2056, 2056A, and 2055) but not to such property if certain conditions apply. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without any value entered in the column for "Value at date of death." The sum of the asset values included in the return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10 and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2(a)(7)(ii)).
In addition to listing the assets on the appropriate schedules, the regulations require that certain additional information must be provided for each asset. Treas. Reg. §20.2010-2(a)(7)(ii)(A).
Availability. The inherited DSUE amount is available to the surviving spouse as of the date of the deceased spouse's death. It is applied to gifts and the estate of the surviving spouse before their own exemption is used. Accordingly, the surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the surviving spouse's estate at death. Treas. Reg. §20.2010-3(b)(ii).
The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed (and before the amount of the DSUE is established). Treas. Reg. §20.2010-3(ii). However, the DSUE amount is subject to audit until the statute of limitations expires on the surviving spouse’s estate tax return. Temp. Treas. Regs. §§20.2010-3T(c)(1) and 25.2505-2T(d)(1). However, the regulations do not address whether a presumption of survivorship can be established. Thus, there is no guidance on what happens if both spouses die at the same time and the order of death cannot be determined and it is not known whether the IRS would respect estate planning documents that include a provision for simultaneous deaths.
Statute of Limitations – IRS Audits
The statute of limitations for assessing additional tax on the estate tax return is the later of three years from the date of filing or two years from the date the tax was paid. However, the IRS can examine the DSUE amount at any time during the period of the limitations for the second spouse as it applies to the estate of the first spouse. Treas. Reg. §20.2010-2(d) allows the IRS to examine the estate and gift tax returns of each of the decedent's predeceased spouses. Any materials relevant to the calculation of the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Thus, a surviving spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all intervening estate and gift tax returns to substantiate the DSUE amount.
New Case On The Audit Issue
Facts. In Estate of Sower v. Comr., 149 T.C. No. 11 (2017), the decedent died in August of 2013 as the surviving spouse. Her predeceased spouse died in early 2012. His estate reported no federal estate tax liability on its timely filed Form 706. His estate also reported no taxable gifts although he had made $997,920 in taxable gifts during his life. However, his estate did include $845,420 in taxable gifts on the worksheet provided to calculate taxable gifts to be reported on the return. His estate reported a deceased spouse unused exclusion (DSUE) amount of $1,256,033 and a portability election of the DSUE was made on his estate’s Form 706 to port the DSUE to the surviving spouse.
The decedent’s estate filed a timely Form 706 claiming the ported DSUE of $1,256,033 and paid an estate tax liability of $369,036, and then an additional $386,424 of tax and interest to correct a math error on the original return. The decedent’s estate also did not include lifetime taxable gifts (of which there were $997,921) on the return, simply leaving the entry for them blank. About two months later, the IRS issued an estate tax closing letter to the husband’s estate showing no estate tax liability and noting that that the return had been accepted as filed.
IRS audit. In early 2015, the IRS began its examination of the decedent’s return. In connection with that exam, the IRS opened an exam of the husband’s estate to determine the proper DSUE to be ported to the decedent’s estate. As a result of this exam, the IRS made an adjustment for the amount of the pre-deceased spouse’s lifetime taxable gifts and issued a second closing letter and also reducing the DSUE available to port to the decedent’s estate of $282,690. The IRS also adjusted the decedent’s taxable estate by the amount of her lifetime taxable gifts and reduced it for funeral costs. The end result was an increase in federal estate tax liability for the decedent’s estate of $788,165, and the IRS sent the decedent’s estate a notice of deficiency for that amount and the estate disputed the full amount by filing a petition in Tax Court.
Estate’s arguments. The estate claimed that the IRS was estopped from reopening the estate of the predeceased spouse after the closing letter had been initially issued to that estate. The estate also claimed that the IRS was precluded from adjusting the DSUE for gifts made before 2010. The estate additionally claimed that I.R.C. §2010(c)(5)(B) (allowing IRS to examine an estate tax return to determine the correct DSUE notwithstanding the normal applicable statute of limitations) was unconstitutional for lacking due process because it overrode the statute of limitations on assessment contained in I.R.C. §6501.
Tax Court opinion. The Tax Court disagreed with the estate on all points. The court noted that I.R.C. §2010(c)(5)(B) gave the IRS the power to examine the estate tax return of the predeceased spouse to determine the correct DSUE amount. That power, the court noted, applied regardless of whether the period of limitations on assessment had expired for the predeceased spouse’s estate. This, the Tax Court noted, was bolstered by temporary regulations in place at the time of the predeceased spouse’s (and the decedent’s) death. I.R.C. §7602, the Tax Court noted, also gave the IRS broad discretion to examine a range of materials to determine whether a return was correct, including estate tax returns.
The Tax Court also determined that the closing letter did not amount to a closing document under I.R.C. §7121, which required a Form 866 and Form 906, and there had been no negotiation between the IRS and the estate. The Tax Court also held that the decedent’s estate had not satisfied the elements necessary to establish equitable estoppel against the IRS. The IRS had not made a false statement or had been misleadingly silent that lead to an adverse impact on the estate.
Also, the Tax Court noted that there had not been any second examination. No additional information had been requested from the pre-deceased spouse’s estate and no additional tax was asserted. The effective date of the proposed regulation was for estates of decedent’s dying after 2010 and covered gifts made by such estates irrespective of when those gifts were made.
There was also no due process violation because adjusting the DSUE did not amount to an assessment of tax against the estate of the pre-deceased spouse. Consequently, the Tax Court held that the IRS properly adjusted the DSUE and the decedent’s estate had to include the lifetime taxable gifts in the estate for estate tax liability computation purposes.
Because the election to utilize portability allows the IRS an extended timeframe to question valuations, the use of a bypass/credit shelter trust that accomplishes the same result for many clients may be a preferred approach. However, in those situations, it should be a routine practice for practitioners to obtain a signed acknowledgement and waiver from the executor of the first spouse’s estate that the potential benefit of portability in the surviving spouse’s death has been explained fully and has been waived.
As the Tax Court points out, the IRS has the power to audit the first spouse’s estate tax return and can add any increased tax to the surviving spouse’s estate tax return – no matter how many years have passed since the first spouse’s death. That means it should also be routine practice for practitioners to make sure that Form 706 for the first spouse’s estate is prepared with absolute perfection.