Thursday, November 30, 2017
In 1930, the Congress enacted the Perishable Agricultural Commodities Act (PACA) to address unfair and fraudulent practices in the marketing of perishable agricultural commodities in interstate and foreign commerce. 7 U.S.C. §§ 499a et seq. A provision in the PACA requires a covered “dealer” to “promptly pay” for the purchase of perishable agricultural commodities. One way that the PACA ensures prompt payment is via the creation of a PACA trust to hold the proceeds of the sale of perishable commodities for the for the benefit of the unpaid seller until full payment is made. 7 U.S.C. § 499e(c)(2).
This PACA trust provision was added in 1984 to address the problem of buyers filing bankruptcy after purchasing perishable commodities, but before full payment was made. Basically, once an unpaid seller learns that a buyer has become insolvent, a PACA trust is created and the PACA trust funds (amounts owed to the seller) are escrowed for pro rata distribution to the PACA trust beneficiary or beneficiaries. The point is that the assets in a PACA trust are excluded from the bankruptcy estate of a bankrupt buyer.
A recent case involved an interesting question - whether the PACA trust bars a bankruptcy debtor-in-possession (DIP), from using the cash collateral of the PACA trust in the continued operation of the DIP’s business. Is the status of the perishable commodity seller as a PACA trust beneficiary sufficient, by itself, to bar the DIP’s use of the cash collateral?
The rights of a DIP to use cash collateral of a PACA trust, that’s the topic of today’s post.
Chapter 11 and the DIP
A DIP is a party (individual or corporation) that has filed a Chapter 11 (reorganization) bankruptcy petition. While creditors of the DIP have liens in the DIP’s property, the DIP remains in control of the property and continues to operate the underlying business. The DIP essentially continues to operate the business in a fiduciary capacity for the creditors’ best interest. Thus, ordinary business operations are permissible, but the DIP has to get court approval for actions that are beyond the scope of normal business practices.
Recent Bankruptcy Case
In a recent Chapter 11 bankruptcy case, In re Cherry Growers, Inc., No. 17-04127-swd, 2017 Bankr. LEXIS 3838 (W.D. Mich. Nov. 1, 2017), the debtor, as a Chapter 11 DIP, filed a motion for an order authorizing its use of cash collateral. A bank, the DIP’s principal secured creditor, supported the motion. However, a claimant asserting PACA rights opposed the motion because, in its view, such an order would violate the claimant’s PACA trust rights as well as the rights of others as beneficiaries of the PACA trust.
As mentioned above, the PACA creates a statutory trust to protect growers of perishable agricultural products against the risk of non-payment by buyers and others. A PACA claimant, as a seller of eligible produce, has a trust claim against the qualifying inventory and proceeds that is superior to the claims and liens of the buyer’s creditors with no regard to whether the creditors are secured or unsecured and without regard to the priority level of the claim. Under the facts of the case, the claimant held an equitable interest in the bankruptcy estate with respect to its $337,159.18 PACA claim, and the question before the court was whether that equitable interest was sufficient to deny the debtor’s requested (and otherwise consensual) use of its secured lender’s cash collateral, especially where a sufficient equity cushion existed to adequately protect the PACA claimant’s claim.
The court held an interim hearing on the motion at which it took testimony, granted interim relief and scheduled a final hearing. At the final hearing PACA claimant argued that its PACA claim reached all of the DIP’s property, at least if the DIP could not prove otherwise. The claimant asserted that its status as PACA trust beneficiary was sufficient to bar a debtor from utilizing the cash collateral. The claimant also argued that in the absence of proof the contrary from the DIP, all income derived during the case from any of the property in the DIP’s possession, would constitute proceeds of the PACA trust, and that the DIP could not use any of the property because it belonged to the PACA claimant and not the bankruptcy estate.
The court did note the power of the PACA trust. Specifically, the court pointed out that, under PACA, growers and suppliers of perishable agricultural products who have properly preserved their rights under the statute are entitled to the benefit of a broad and powerful “floating trust” in their buyer’s qualifying inventory and proceeds thereof. These trust claims are to be paid first from trust assets, even prior to any claims or interests of secured creditors in such property. Furthermore, the court noted that the commingling of trust assets is specifically contemplated under the federal regulations implementing PACA. As the court recognized, PACA is “designed to promote priority payment to the PACA claimant.”
However, the court held that to conclude that the subject matter of the PACA trust is excluded from the bankruptcy estate overstated the case holdings that the PACA claimant cited. Instead, the court determined that the PACA expressly contemplates the commingling of trust and non-trust property, the creation of a “floating trust,” and the continued operation of the PACA trustee. Thus, within the context of a Chapter 11 bankruptcy, the DIP presumptively continues operating its business in accord with applicable non-bankruptcy law. In turn, the court reasoned, this meant that it made sense to think in terms of permitting the DIP to use its buildings and equipment to conduct its business as it had done for years, along with the cash and cash equivalents derived from that use, even though they may be impressed to some extent with a statutory trust, as long as the DIP provides adequate protection of the PACA claimant’s interest in the estate property. In addition, because the value of the property of the estate that the PACA claimant believed to be impressed with the PACA trust far exceeded the claimant’s claim, the court concluded that the DIP had met its burden of showing that the claimant would be adequately protected. Therefore, the court granted the DIP’s motion authorizing the use of the cash collateral in the property in which the PACA claimant had an equitable interest, in accordance with 11 U.S.C. §363 “as long as the DIP provides adequate protection of [the PACA claimant’s] interests in the estate property.” Because the DIP’s property that the PACA claimant alleged was subject to the PACA trust was much greater than the PACA claimant’s $337,159.18 claim, the court found that the PACA claimant’s interests were adequately protected.
The court also disagreed with the PACA claimant’s assertion that the DIP bore the burden of proof that the property that the DIP wanted to utilize in its business operations were not property of the PACA trust. Instead, the court determined that the PACA claimant had to first prove that the claimant had an interest in the DIP’s property. After that, the DIP had to establish that adequate protection was provided to the PACA claimant. In so holding, the court distinguished a contested matter under 11 U.S.C. §363 from that involving a battle of competing property interests.
What’s the “take-home” from the court’s decision? Certainly, PACA claimants have substantial rights. But, there are limits on those rights. In addition, according to the court, a PACA claimant’s equitable interests in the PACA trust are not bankruptcy estate property, but the assets themselves are under 11 U.S.C. §541. The case could also indicate that DIPs may have more leverage with creditors in getting authority to use cash collateral to conduct continuing business operations.
Tuesday, November 28, 2017
Sometimes farmers and ranchers operate in the partnership form without any formal documentation of their business association. Other times, there is a formalized agreement that really isn’t paid much attention to. But, the details of partnership law and the associated tax rules can produce some surprises if those details are not properly understood.
Today’s post takes a look at some key tax features, and surprises, surrounding the partnership form of doing business.
A major tax consideration for farmers and ranchers (and others) when deciding the appropriate form of business structure is self-employment tax. This year, the tax rate is 15.3 percent on the first $127,200 of an individual’s self-employment income. The rate then goes to 2.9 percent up to self-employment income of $250,000 (for a married person that files jointly). Then, thanks to the health care law, the rate jumps another 31 percent to 3.8 percent on any additional amount of self-employment income. For the 3.8 percent amount, the combined earned income of spouses is measured against the $250,000 threshold.
But, self-employment tax is treated differently in a partnership – at least for limited partners. A limited partner, under the tax law, is treated like an owner of an S corporation. A limited partner’s compensation income is subject to self-employment tax, but the limited partner’s share of partnership income is not net earnings from self-employment. Accordingly, it is not subject to self-employment tax. For a limited liability company (LLC) that is treated as a partnership for tax purposes, the self-employment tax burden depends on the structure of the LLC and whether it is member-managed or manager-managed. In other posts, I have written on that structure and the associated self-employment tax issues. Basically, however, if a member does not have management authority under the agreement, the member is viewed under the tax law as a limited partner.
Recent cases. A couple of recent cases illustrate the self-employment tax treatment of members of partnerships. In Hardy v. Comr., T.C. Memo. 2017-17, the petitioner was a plastic surgeon who purchased a 12 percent manager interest in an LLC that operated a facility in which the plaintiff could conduct surgeries when necessary. The petitioner also conducted surgeries in his own office separate from the LLC facility, and owned a separate company run by his wife for his surgical practice. The court did not allow the IRS to group the two activities together based on the weight of the evidence that supported treating the two activities as separate economic units. The petitioner did not have any management responsibilities in the LLC, did not share building space, employees, billing functions or accounting services with the LLC. In addition, the petitioner’s income from the LLC was not linked to his medical practice. Thus, by looking to the petitioner’s actual conduct, the Tax Court determined that the petitioner was a limited partner in the LLC for self-employment tax purposes even though the petitioner held a manager interest in the LLC. Hardy v. Comr., T.C. Memo. 2017-17. For reasons further explained below, one should not rely on the Hardy case to avoid self-employment tax if the person may exercise management authority.
By comparison, consider Methvin v Comr., 653 Fed. Appx. 616 (10th Cir. Jun. 24, 2016), aff’g., T.C. Memo. 2015-81. In this case, the petitioner was a CEO of a computer company, and didn’t have any specialized knowledge or expertise in oil and gas ventures. In the 1970s, he acquired working interests in several oil and gas ventures of about 2-3 percent each. The ventures were not part of any business organization, but were established by a purchase and operating agreement with the actual operator of the interests. The operator managed the interests and allocated to the petitioner the income and expense from the petitioner's interests. The petitioner had no right to be involved in the daily management or operation of the ventures. Under the agreement, the owners of the interests elected to be excluded from Subchapter K via I.R.C. §761(a).
For the year at issue, the petitioner's interests generated almost $11,000 of revenue and approximately $4,000 of expenses. The operator classified the revenues as non-employee compensation and issued the petitioner a Form 1099-Misc. (as non-employee compensation). No Schedule K-1 was issued and no Form 1065 was filed. The petitioner reported the net income as "other income" on line 21 of Form 1040 where it was not subject to self-employment tax. The petitioner believed that his working interests were investments and that he was not involved in the investment activity to an extent that the income from the activity constituted a trade or business income. He also believed that he was not a partner because of the election under I.R.C. §761(a), so his distributive share was not subject to self-employment tax.
The IRS agreed with the petitioner’s position in prior years, but chose not to for 2011, the year in issue. The IRS claimed that the income was partnership income that was subject to self-employment tax. The Tax Court agreed with the IRS because a joint venture had been created with the working interest owners (of which the petitioner was one) and the operator. Thus, the petitioner's income was partnership income under the broad definition of a partnership in I.R.C. I.R.C. §7701(a)(2). Importantly, the trade or business was conducted, the court determined, by agents of the petitioner, and simply electing out of Subchapter K did not change the nature of the entity from a partnership. Also, the fact that IRS had conceded the issue in prior years did not bar the IRS from changing its mind and prevailing on the issue for the year at issue.
On appeal, the Tenth Circuit affirmed, noting that the petitioner did not hold a limited partner interest which would not be subject to self-employment tax pursuant to I.R.C. §1402(a)(13). The Tenth Circuit also noted that the fact that the IRS had conceded the self-employment tax issue in prior years did not preclude the IRS from pursuing the issue in a subsequent tax year.
The outcome of the case is not surprising. In the oil and gas realm, operating agreements often create a joint venture between the owners of the working interests (who are otherwise passive) and the operator. That will make the income for the working interest owners self-employment taxable, and an election out of Subchapter K won’t change that result. That’s particularly the case if the court finds an agency relationship to be present, as it did in the present case. And, IRS gets a pass for inconsistency. At least the investor’s income would not be subject to the 3.8 percent Net Investment Income Tax imposed by the health care law (I.R.C. §1411).
As for the IRS, its position on the matter was most recently announced in a Chief Counsel Advice in 2014. C.C.A. 201436049 (May 20, 2014). Citing I.R.C. §1402(a)(13), the IRS noted that a limited partner is not subject to self-employment tax on the limited partner’s share of partnership income, but an active owner is.
The cases point out several things of importance. First, even though a taxpayer may not be personally active in the management of a partnership that is carrying on a trade or business that generates self-employment income, the taxpayer can still be subject to self-employment tax on the taxpayer’s share of partnership income if the partnership business is carried out on the partner’s behalf by an agent (or employee). In addition to Methvin, the Tax Court decided similarly in a 1988 case. Cokes v. Comr., 91 T.C. 222 (1998). It doesn’t matter how large or small the taxpayer’s interest in the partnership is.
The second point is that an election out of Subchapter K (the partnership tax section of the Code) has no impact on the nature of the entity for self-employment tax purposes. That’s fundamental partnership tax law dating at least back to the Tax Court’s 1998 decision. The real question is whether the entity satisfies the definitional test set forth in I.R.C. §7701(a)(2). Likewise, a partnership’s existence turns on the parties’ intent. That’s a factual determination and numerous considerations are important to answering that question. See Luna v. Comr., 42 T.C. 1067 (1964). So, even if a taxpayer doesn’t participate in the partnership’s business activities, it may not matter from a self-employment tax standpoint. That’s why the Congress included a special “carve-out” for limited partners in I.R.C. §1402(a)(13). A taxpayer classified as a general partner (or one with a manager interest) can’t use the special provision. Viewed in this light, the Tax Court’s Hardy decision would appear incorrect. But, there were other unique issues in Hardy that may have influenced the court’s conclusion on the self-employment tax issue.
The third point is that the IRS can change its administrative position on an issue. It need not be “fair” as it applies the tax rules to a taxpayer’s situation. The simple fact is that an IRS concession of an issue for a taxpayer in one tax year does not mean it must concede the issue in other years. See, e.g., Burlington Northern Railroad Co. v. Comr., 82 T.C. 143 (1984). The same can be said for taxpayers. The American Institute of Certified Public Accountants has Statements on Standards for Tax Services. One of those Standards, No. 5, allows a CPA to argue a position that is contrary to one that the client has conceded in prior tax years.
Clarity on the type of partnership and the type of interest is important. A well-drafter partnership agreement can go a long way to ensuring that the desired tax result is achieved. Operating under an informal arrangement and/or not fully understanding the meaning of the type of ownership interest held from a tax standpoint can result in an unexpected tax result.
Wednesday, November 22, 2017
For certain types of agricultural employment, federal labor laws are relevant. Exemptions exist that cover the vast majority of smaller operations, but there can come a point at which either the number of employees hired or the type of agricultural production involved will trigger the federal rules.
A recent case from Indiana illustrates the application of federal law, and why the classification of the type of employment matters. What is often involved is the line between “agricultural” employment, “secondary agriculture” or a job in an ag setting that is more properly designated as “commercial” employment.
The Indiana Case
Facts. In Kidd v. Wallace Pork Sys., No. 3:16-CV-210-MGG, 2017 U.S. Dist. LEXIS 163174 (N.D. Ind. Oct. 2, 2017).The defendant operated a hog farm and a feed mill. The plaintiffs were employed at the feed mill between 2013 and 2016, during which time they often worked more than forty hours per week and were never paid overtime. From the time of the feed mill’s inception until summer 2016 the defendant used its own employees to produce animal feed at the feed mill while simultaneously contracting with Bi-County Pork, Inc. to purchase feed produced by Bi-County’s own staff at its independent neighboring facilities using inputs provided solely by the defendant. Bi-County only produced feed for the defendant and the defendant purchased all the feed Bi-County produced. All of the defendant’s feed is either fed to animals that the defendant owns or raises or is sold to third-parties.
Before the plaintiffs began working for the defendant at the feed mill, at least one other feed mill employee (other than the plaintiffs) complained about not receiving overtime pay. The complaint prompted an investigation by the United States Department of Labor (DOL) into the applicability of the Fair Labor Standard Act’s (FLSA) overtime exemption for secondary agricultural labor at the feed mill. The DOL concluded that the feed mill’s operations warranted a secondary agricultural designation exempting feed mill employees from overtime pay because the primary use of the feed produced there was feeding the defendant’s hogs. The DOL also concluded that the defendant used 55 percent of the feed it produced itself and sold the remaining 45 percent. The DOL also pointed out that although the feed mill qualified as secondary agriculture at that time and date, the success with outside suppliers and clients might change that designation in the future.
The court’s analysis. The plaintiffs both sued alleging that the defendant’s failure to pay them overtime constituted violations of state (IN) minimum wage and wage payment statutes as well as the FLSA. The cases were subsequently removed to federal court based upon original jurisdiction arising from their claims under the federal FLSA. Through discovery actions, the defendant reported that about 75 percent of their total feed output was sold to third parties with 75-80 percent of that total feed output being produced by Bi-County. Under 29 U.S.C. § 213(b)(12), the overtime provisions of the FLSA do not apply “to any employee employed in agriculture.” The FLSA distinctly identifies two branches of agriculture: primary agriculture and secondary agriculture. The parties agreed that the work that the plaintiffs performed at the feed mill only qualified for the agricultural exemption from overtime pay if it constituted secondary agriculture. The federal court concluded that in order to defer to the DOL’s report it must first assess whether the totality of the circumstances especially with respect to the portion of the defendant’s income streams, during the time of the plaintiffs’ employment, changes significantly enough from the time covered by the DOL’s investigation to warrant reclassifying work at the feed mill from secondary agriculture to manufacturing. The court held that because the defendant failed to produce data specifying the total feed production and sales from the feed mill and Bi-County separately during the relevant period of the plaintiffs’ employment, a genuine issue of fact existed as to what proportion of the feed mill’s feed output was sold to third parties. As a result, the court concluded that neither party was entitled to summary judgement as a matter of law.
Employment matters in agriculture sometimes trigger the application of federal law (as well as certain state law requirements). The Indiana case is an example of how contemporary agricultural production activities might trigger their application.
To the readers of this blog, enjoy Thanksgiving with your families. As Abraham Lincoln stated in his Proclamation of Thanksgiving on October 3, 1863, take time to reflect and give thanks for the provision of the “blessings of fruitful fields and healthful skies.” The next post will be on November 28.
Monday, November 20, 2017
Last week, the House passed its version of legislation to overhaul the tax Code. H.R. 1 passed on a 227-205 (two abstentions). Also, last week, the Senate Finance Committee approved its version of tax legislation by a 14-12 vote. The bills are similar on some points, but dramatically different on others. While I tend not to focus to heavily on tax bills before the legislation takes the form of a bill that is headed to the President’s desk, there have been some items in these two bills that have required a detailed examination and commentary to staffers of Committee members with further explanation of their likely impact on the agricultural sector. My blog post of November 6 on the self-employment tax impact of the House bill was an example of that. Fortunately, those provisions were stripped out in a Chairman’s amendment.
Today, I compare some of the provisions contained in the bills and also point out a few areas of likely impact on ag producers and agribusiness activities. My friend, Tony Nitti (a CPA in Colorado) who is a contributor to Forbes, has done a great job in breaking down some of the provisions in both the House and Senate bills in one of his recent columns. Today’s post begins with Tony’s framework and expands into additional areas that have direct application to agricultural producers and businesses. I am also not covering every provision contained in either the House or Senate bills. The bills are each several hundred pages long.
For those interested in hearing my commentary on these provisions, I will be covering it on RFD-TV and my other radio interviews in the coming days. Those interviews and commentary will be captured and made available on www.washburnlaw.edu/waltr. I will also be discussing the two bills at upcoming practitioner seminars, including one this week in Kansas City. I will also cover the bills in Topeka, Salina and Wichita, Kansas the following week, and in Des Moines, Iowa on December 6 as well as in Pittsburg, KS on Dec. 14 (also simulcast over the web). My full CPE schedule can also be found on www.washburnlaw.edu/waltr.
The following is what I “think” the language in the House and Senate bills on the provisions discussed means at the present time. Some of the bill language is confusing and convoluted and practically impossible to discern. Thus, the reader is duly cautioned.
Ordinary Income Tax Brackets and Rates
The House bill contains four brackets (from 12% to 39.6% (with a tack-on for those with over $1 million of AGI).
The Senate bill has seven brackets (from 10% to 38.5%). While the rates are indexed for inflation, they sunset after 2025. In addition, based on the where the brackets begin and end, many people with modest-to-high incomes, particularly under the Senate Bill, will see a significant rate increase, at least as compared to the House Bill.
Capital Gain/Dividend Rates
The House bill preserves the present rates of 0 percent, 15 percent and 20 percent. The Senate bill is the same as the House bill on capital gain/dividend rates. Also, neither the House nor the Senate bill repeals (or otherwise modifies) I.R.C. §1411 – the 3.8 percent additional tax on passive sources of income that was added by the health care law. Thus, the maximum capital gain (or ordinary dividend) rate (based on the ordinary income tax rate applicable to the taxpayer) would be 23.8 percent. For estates and trusts, the capital gain rates are also 0 percent, 15 percent and 20 percent, with the 20 percent rate beginning amounts above $12,700. The 3.8 percent additional tax would also apply to passive gains.
Both the House bill and the Senate Bill essentially double the existing level of the standard deduction, setting it at $24,000 for a married couple filing jointly, for example.
The “price” for the doubling of the standard deduction, at least in part, is the elimination of the personal exemption for a taxpayer. The House bill, while it eliminates the personal exemption and the use of a flexible spending account for child care, enhances the existing child tax credit ($1,600 per qualified child; and increases the phase-out range), and adds a $300 credit for non-child dependents (through 2022), and a “Family Flexibility” credit of $300 for each spouse. The refundable portion of the child tax credit is set at $1,000, with the phase-out beginning (MFJ) at $230,000.
The Senate bill also eliminates the personal exemption, and increases the child tax credit to $2,000 (through 2025 for children under age 18, when it is then eliminated) with the phaseout range set much higher than the House phase-out range – it begins at $1,000,000 (MFJ).
The House bill eliminates all major deductions except for up to $10,000 of property taxes; mortgage interest (up to $500,000 on new loan and none for second home or on home equity loans); losses associated with federally declared disaster areas; and charitable deductions. As for charitable contributions, the contribution limit is increased to 60 percent. Also, the charitable mileage statutory cap of $.14 is eliminated and adjusted for inflation. In addition, the House bill requires that all charitable contributions (of any dollar amount) be substantiated.
The Senate bill also eliminates all major deductions except for medical expenses (they remain deductible to the extent they exceed 10 percent of AGI); mortgage interest (limited to $1,100,000 with no deduction on home equity loans); charitable contributions (same provisions as the House bill with additional specification that an electing small business trust must follow the charitable contribution deduction rules for individuals); alimony deduction; the deduction for student loan interest; and the educator deduction. Unlike the House bill, the Senate bill entirely eliminates all deductibility for property taxes. That last point on property tax deductibility will be a sticking point in getting a final bill to the President’s desk.
The House bill enhances the American Opportunity Tax Credit, but repeals the Lifetime Learning Credit and the Hope Scholarship Credit. Also, new Coverdell ESA contributions would be barred, but tax-free rollovers to an I.R.C. §529 plan would be allowed. Similarly, elementary and high school expenses of up to $10,000 annually would qualify for I.R.C. §529 plans. The House bill repeals the deductibility of interest expense on education loans; the exclusion for interest on U.S. savings bonds that are used to pay higher education expenses; the deduction for qualified tuition and related expenses; the exclusion for qualified tuition reduction programs, and the exclusion for employer-provided educational assistance. The House bill also includes a 1.4 percent excise tax on the endowment income of colleges, and treats tuition reductions for graduate students (and others) as taxable income.
The Senate bill, while not including many of the higher education provisions of the House bill, does impose a tax on the investment income of private colleges with endowments of at least $250,000 per student. It also increases the schoolteacher deduction to $500.
Pass-Through Business Income
The House bill establishes a top rate of 25 percent on S corporation income. That rate applies to all of a passive owner’s income, and it applies to 30 percent of a materially participating owner’s income that is attributable to the capital of the business. The balance of the owner’s income is taxed at the taxpayer’s applicable individual rate. The House bill establishes a presumption that none of the income of an owner of a service business is subject to the 25 percent rate. As noted above, the self-employment tax changes that were in the original House version have been removed.
Under the Senate bill, sole proprietors, S corporation owners and partnership members get a deduction of 17.4 percent of “qualified business income” (limited to 50 percent of FICA wages paid by the business owner). The deduction is not available to “specified service businesses.” The calculation of the deduction is brought over from the domestic production activity deduction (DPAD) provision of I.R.C. §199, which is removed by both the House and Senate versions. Unfortunately, it is impossible to tell whether the computation for the deduction is at the individual level or the entity level.
The House bill taxes “carried interest” (the portion of an investment fund’s profits (typically 20 percent) that is paid to investment managers), but limits the application of the capital gain rate to the gain on the sales of assets held three years or more (as opposed to one-year under current law).
The Senate bill mirrors the House bill.
Alternative Minimum Tax (AMT)
Both the House bill and the Senate bill eliminate the AMT.
The House bill contains no significant change in the manner of how a worker is classified either as an independent contractor or an employee.
The Senate bill establishes a safe harbor under which a worker is treated as an independent contractor and not an employee upon the satisfaction of three objective tests – the relationship between the parties; the location of the services or means by which they are provided; and the existence of a written contract stating the independent contractor relationship and acknowledging responsibility for taxes and a reporting/withholding obligation. The bill establishes a $1,000 threshold for Form 1099-K reporting, and raises the 1099-MISC threshold from $600 to $1,000. The Senate bill also limits the ability of the IRS to reclassify service providers as employees (and service recipients/payors as employers) in cases where the parties try in good faith to comply with the safe harbor, but fail. In other words, the IRS can only recharacterize the relationship as an employment relationship on a prospective basis. The Senate bill also amends Tax Court jurisdiction to allow a worker to bring a case challenging worker classification.
The House bill sets the applicable exclusion from estate, gift and generation-skipping transfer tax (GSTT) at $11.2 million for 2018. The House bill eliminates the estate tax and the GSTT after 2023. The House bill retains stepped-up basis for property included in a decedent’s estate, and also retains the gift tax.
The Senate bill does not repeal the estate or GSTT, but doubles the applicable exclusion (11.2 million for 2018).
The House does not repeal the penalty tax applied to an individual that is mandated to purchase health insurance (the so-called “Roberts” tax).
The Senate bill eliminates the individual mandate penalty tax.
The House bill establishes a 20 percent top corporate rate beginning in 2018. For personal service corporations, the rate is 25 percent. The bill also modifies current accounting rules in numerous aspects. For example, a C corporation must use accrual accounting if gross receipts exceed $25 million, and businesses with inventory must use accrual accounting if gross receipts exceed $25 million. The bill also requires a business to change from the completed contract method to the percentage of completion method for accounting for long-term contracts if gross receipts exceed $25 million. In addition, the House bill specifies that the uniform capitalization rules apply to inventory if the taxpayer’s gross receipts exceed $25 million. The bill also eliminates the carryback for net operating losses (NOLs) (except for small businesses and farms – they get a one-year carryback), but they can be carried forward indefinitely but are limited to 90 percent of pre-NOL taxable income. In addition, deductible net interest expense is limited to 30 percent of business “adjusted taxable income” (with a 5-year carryover). However, interest deductibility is retained for a business with average gross receipts up to $25 million, with an “opt-out” election for farmers. If the opt-out provision is elected, alternative depreciation will apply to all of the taxpayer’s farm property and a 10-year recovery period will apply. That could be an especially important election for larger cattle feedlots and other livestock facilities that are highly leveraged. Entertainment expenses are not deductible, and the I.R.C. §199 DPAD is eliminated.
The Senate bill is similar. The top corporate rate is set at 20 percent, but the bill delays the implementation of that rate until the start of 2019. Like the House bill, the Senate bill contains similar accounting rule changes from current law. Under the Senate bill, a C corporation must use accrual accounting if gross receipts exceed $15 million. Likewise, businesses with inventory must use accrual accounting if gross receipts exceed $15 million. Businesses will also be forced to change from the completed contract method to the percentage of completion method when accounting for long-term contracts if gross receipts exceed $15 million. Also, the uniform capitalization rules will apply to inventory if the taxpayer’s gross receipts exceed $15 million. Also, under the Senate bill, there is no carryback for net operating losses. However, a net operating loss can be carried forward indefinitely, subject to a limit of 90 percent of taxable income; deductible net interest expense is limited to 30 percent of adjusted taxable income capped at $15 million of revenue with an indefinite carryover. Also, entertainment expenses are not deductible, and the DPAD is eliminated.
The House bill specifies that the I.R.C. §179 limit is enhanced to $5 million (phaseout beginning at $20 million), and immediate expensing of assets is allowed for assets with a life of less than 20 years that are acquired and placed in service after September 27, 2017 through 2022. A tax-deferred exchange (I.R.C. §1031) would be allowed only for real property.
The Senate bill pegs the I.R.C. §179 limit at $1 million, and there is immediate expensing of new assets with a life of less than 20 years through 2022. Under the Senate bill, farm equipment would be depreciated over five years, and the 150 percent declining balance depreciation method for farm property would be eliminated (except for 15-year and 20-year property).
The Senate bill creates a new IRS Form – Form 1040SR. The 1040SR is to be a simplified return for those taxpayers over age 65.
The House bill reduces the existing $.023-per-kilowatt-hour tax credit for wind energy production to $.015/kWh and changes the definition of “under construction.” That definition applies in the context of defining when the credit availability begins. The House bill also eliminates the $7,500 electric vehicle tax credit and makes the investment tax credit for solar projects a targeted credit. The House bill also extends the credit for residential energy efficient property through 2021, with a reduced rate of 26 percent for 2020 and 22 percent for 2021.
The Senate bill largely leaves existing energy credits in place, including the existing credit for marginal wells.
The House bill provides for a 100 percent dividends-received deduction to U.S. corporations when amounts are repatriated from foreign subsidiaries. There is also a one-time “deemed repatriation” tax imposed that applies a 14 percent tax on cash parked overseas and seven percent on any illiquid assets
The Senate bill is the same as the House bill, except that the deemed repatriation tax is 10 percent on cash and 5 percent on illiquid assets.
The House bill also modifies the FICA tip credit. In addition, the Employer-Provided Child Care Credit is eliminated, as is the Rehabilitation Credit, the Work Opportunity Tax Credit, the New Markets Tax Credit, the deduction for certain unused business credits, and deductions for expenses incurred to provide access to disabled persons. In addition, the House bill repeals I.R.C. §118 (capital contributions to a corporation); the deduction for transportation fringe benefits; the deduction for on-premises gyms; and limits the deduction for qualifying businesses meals to 50 percent. The House bill makes deferred compensation taxable when there is no longer a substantial risk of forfeiture. The bill also imposes an excise tax on excess tax-exempt organization executive compensation – its 20 percent on compensation that exceeds $1 million (in certain situations).
The Senate bill specifies that the alternative depreciation system for residential rental property is shortened to 30 years. It also eliminates the deduction for meals provided for the convenience of the employer. The Senate bill allows for rollovers between I.R.C. §529 plans and ABLE plans, bars an increase in user fees for installment agreements, delays the deduction by lawyers for litigation costs associated with expenses paid on contingent fee cases until the contingency is resolved, and eliminates the deduction for attorney fees and settlement payments in sex harassment or abuse cases if there is a nondisclosure agreement. The Senate bill also proposes to significantly impact the tax strategy of grain gifting by a farmer to a child by changing the child’s tax rates on unearned income to be equal to the tax rates for estates and trusts. Thus, once the child reaches $12,700 (2018) of unearned income, the child will face a maximum tax rate of 38.5 percent on all income above the $12,700 threshold.
It remains to be seen whether any of the provisions described above will ever become law. Certainly, the “sausage-making” process will be interesting to watch. The cynic in me says nothing of significance will ultimately get accomplished this year. There are just too many in the Senate that don't want the President to be perceived to have achieved a legislative victory on anything. Perhaps I am wrong. Time will tell.
Thursday, November 16, 2017
When stock values decline, an investor loses money. But the tax law does not allow that loss to be claimed until the investor sells the stock. The investor can’t sell stock at a loss and simply turn around shortly after the sale and buy back substantially identical stock or securities and get to recognize the loss. However, if an investor sells stock at a gain and buys back identical stocks (or securities), the gain is not disallowed. The government wins in either situation. The rule barring the loss deduction in such a situation is known as the “wash sale” rule.
The wash sale rule can apply in situations involving transactions other than simply stock or securities. It can also apply when “related parties” are involved.
The wash-sale rule. That’s the focus of today’s post.
The Wash-Sale Rule
An investor often prefers to time deductions on investments by claiming then when they can get the greatest benefit. That might include a situation where a loss is desired to be deducted and the stock be retained because the investor thinks that the stock value will increase again. So, the idea might to sell the stock and then turn around and immediately buy it back. But, that’s where I.R.C. §1091 applies. That Code sections disallows a loss deduction incurred on the sale or other disposition of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired (by purchase or by an exchange on which the entire amount of gain or loss was recognized by law), or has entered into a contract or option so to acquire, substantially identical stock or securities. The only exception is if the taxpayer is a dealer in stock or securities and the loss is sustained in a transaction made in the ordinary course of that business. Thus, the rule applies only to losses and bars a taxpayer from wiping out a gain from a sale by buying the same stock back within 30 days.
As is noted in the statute, for the wash-sale rule to be triggered, the stocks or securities must truly be “substantially identical.” Stocks or securities issued by one corporation are not considered substantially identical to stocks or securities of another. Are mutual funds caught by the rule? The IRS basically leaves that an open question subject to the facts and circumstances of the situation. But, selling one fund and buying a similar fund within 30 probably should be avoided. In addition, a “related party” rule can also come into play if a spouse or other “related party” such as the taxpayer’s controlled corporation is used to try to avoid the application of the rule.
Consequences. As can be discerned from the above commentary, the wash-sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale and the 30 days after the sale. The wash sale rule has three consequences: (1) denial of the deductibility of the loss; (2) the amount of the disallowed loss is added to the basis of the replacement stock (which means that when the replacement stock is sold, the disallowed loss will either reduce gain or increase loss on the transaction); and (3) the taxpayer’s holding period for the replacement stock includes the holding period of the stock that was sold. This last rule prevents a taxpayer from converting a long-term loss into a short-term loss, which can produce a rather harsh result. In general, a taxpayer receives more tax savings from a short-term loss than a long-term loss.
Basis adjustment rule. The basis adjustment rule has the effect of preserving the benefit of the disallowed loss – the taxpayer will receive the benefit on a future sale of the replacement stock.
Example: In the mid-1990s, Sam bought 100 shares of ABC, Inc. at $40 per share. The stock declined to $15 per share, and Sam sold the stock in 2000 to take the loss deduction. But, Sam then read a significant amount of good news about the stock and the economy in general and bought the stock back for $20, less than 31 days after the sale. Sam will not be able to deduct the loss of $25 per share. But he can add $25 per share to the basis of his replacement shares. Those shares have a basis of $65 per share: the $40 Sam paid, plus the $25 wash sale adjustment. In other words, Sam is treated as if he bought the shares for $65. If Sam ends up selling the shares for $70, he’ll only report $5 per share of gain. If he sells them for $40 (the same price he paid to buy them), he’ll report a loss of $25 per share.
Because of the basis adjustment rule, a wash-sale is usually not a major disaster taxwise. In many instances, the result is a simple postponement of the tax benefit of having sold stock at a loss. Indeed, if the taxpayer receives the tax benefit later in the same tax year, there may not actually be any impact on taxes. But, there are times when the wash sale rule can have a significantly negative tax impact. For example, If the taxpayer doesn’t sell the replacement stock in the same year, the loss will be postponed, possibly to a year when the deduction is of far less value. Also, if the taxpayer dies before selling the replacement stock, neither the taxpayer nor the taxpayer’s heirs will benefit from the basis adjustment rule. Similarly, the benefit of the deduction can be permanently lost if the taxpayer sells the stock and arranges to have a related person buy replacement stock. Furthermore, a wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.
Sales to Related Parties
As noted, a related party rule can come into play even though the wash-sale rule does not explicitly contain a related-party rule. The rule bars loss deductibility when a “taxpayer” sells stock at a loss, and then the “taxpayer” buys substantially identical securities within 30 days before or after the sale as replacement shares. But, the way the IRS interprets “taxpayer” is in terms of control. For example, the IRS has ruled that a taxpayer triggers the wash sale rule when stock is sold at a loss and the taxpayer’s IRA buy’s substantially identical stock within 30 days before or after the sale. Rev. Rul. 2008-5, 2008-3 I.R.B. 272. The rationale was that the taxpayer had retained control over the stock. The IRS later extended its position to stock a taxpayer sells which is then bought by the taxpayer’s spouse or controlled corporation. See, e.g., IRS Pub. 550. In essence the IRS position will capture any transaction that involves any type of entity that a taxpayer uses to maintain indirect ownership of other assets, including stock.
The end result of the IRS position is that even if repurchases by a related taxpayer don't fall within the wash sale rule, a loss can be disallowed under the related taxpayer rules of I.R.C. §267. In addition, the U.S. Supreme Court has held that a transaction between related taxpayers consisting of two separate parts might be treated as a single sale to a related taxpayer, resulting in a disallowed loss. McWilliams v. Comr., 331 U.S. 694 (1947). However, transactions between related parties through an exchange that is purely coincidental and is not prearranged are not caught by the related party rule.
Planning for Wash-Sales
What, if anything, can be done to plan around the wash-sale rule? Clearly, a taxpayer can sell the stock and wait 31 days before buying it again. But, the risk with this strategy is that the stock may rise in price before it is repurchased. If the taxpayer is convinced that the stock is at rock bottom, the strategy might be to buy the replacement stock 31 days before the sale. If the stock happens to go up during that period the gain is doubled, and if it stock value stays even, the taxpayer can sell the older stock and claim the loss deduction. But, the strategy could backfire – if the projection about the stock turns out to be wrong, a further decline in value could be painful. If the stock has a strong tendency to move in tandem with some other stock, it might be possible to reduce the risk of missing a big gain by buying stock in a different company as "replacement" stock. This is not a wash-sale because the stocks are not substantially identical. Thirty-one days later the taxpayer could switch back to the original stock if desired. But, there's no guarantee that any two stocks will move in the same direction, or with the same magnitude.
So, the bottom line is that there is no risk-free way to get around the wash-sale rule. But it’s just as true that continuing to hold a stock that has lost value isn't risk-free, either. It’s really up to each particular investor to evaluate all the risks, and balance them against the benefit that can be obtained by claiming a loss deduction.
The wash-sale rules are important to understand in terms of what losses they disallow. They are designed to prevent a taxpayer from manipulating the tax code for the taxpayer’s advantage with respect to stocks or securities. Sometimes, the rules come into play with respect to IRAs and entities, with little opportunity in taxpayers to avoid their impact.
Tuesday, November 14, 2017
In the context of Chapter 12 (farm) bankruptcy, unless a secured creditor agrees otherwise, the creditor is entitled to receive the value, as of the effective date of the plan, equal to the allowed amount of the claim. Thus, after a secured debt is written down to the fair market value of the collateral, with the amount of the debt in excess of the collateral value treated as unsecured debt which is generally discharged if not paid during the term of the plan, the creditor is entitled to the present value of the amount of the secured claim if the payments are stretched over a period of years.
What does “present value” mean? It means that a dollar in hand today is worth more than a dollar to be received at some time in the future. It also means that an interest rate will be attached to that deferred income. But, what interest rate will make a creditor whole? A recent decision by the Second Circuit Court of Appeals for the Second Circuit sheds some light on the issue.
Determining Present Value
Basically, present value represents the discounted value of a stream of expected future incomes. That stream of income received in the future is discounted back to present value by a discount rate. The determination of present value is highly sensitive to the discount rate, which is commonly express in terms of an interest rate. Several different approaches have been used in Chapter 12 bankruptcy cases (and nearly identical situations in Chapters 11 and 13 cases) to determine the discount rate. Those approaches include the contract rate – the interest rate used in the debt obligation giving rise to the allowed claim; the legal rate in the particular jurisdiction; the rate on unpaid federal tax; the federal civil judgment rate; the rate based on expert testimony; a rate tied to the lender’s cost of funds; and the market rate for similar loans.
In 2004, however, the U.S. Supreme Court, in, addressed the issue in the context of a Chapter 13 case that has since been held applicable in Chapter 12 cases. Till v. SCS Credit Corporation, 541 U.S. 465 (2004). In Till, the debtor owed $4,000 on a truck at the time of filing Chapter 13. The debtor proposed to pay the creditor over time with the payments subject to a 9.5 percent annual interest rate. That rate was slightly higher than the average loan rate to account for the additional risk that the debtor might default. The creditor, however, argued that it was entitled to a 21 percent rate of interest to ensure that the payments equaled the “total present value” or were “not less than the [claim’s] allowed amount.” The bankruptcy court disagreed, but the district court reversed and imposed the 21 percent rate. The United States Court of Appeals for the Seventh Circuit held that the 21 percent rate was “probably” correct, but that the parties could introduce additional concerning the appropriate interest rate.
On further review by the U.S. Supreme Court, the Court held that the proper interest rate was 9.5 percent. That rate, the Court noted, was derived from a modification of the average national loan rate to account for the risk that the debtor would default. The Court’s opinion has been held to be applicable in Chapter 12 cases. See, e.g., In re Torelli, 338 B.R. 390 (Bankr. E.D. Ark. 2006); In re Wilson, No. 05-65161-12, 2007 Bankr. LEXIS 359 (Bankr. D. Mont. Feb. 7, 2007); In re Woods, 465 B.R. 196 (B.A.P. 10th Cir. 2012). The Court rejected the coerced loan, presumptive contract rate and cost of funds approaches to determining the appropriate interest rate, noting that each of the approaches was “complicated, impose[d] significant evidentiary costs, and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments ha[d] the required present value.” A plurality of the Court explained that these difficulties were not present with the formula approach. The Court opined that the formula approach requires that the bankruptcy court determine the appropriate interest rate by starting with the national prime rate and then make an adjustment to reflect the risk of nonpayment by the debtor. While the Court noted that courts using the formula approach have typically added 1 percent to 3 percent to the prime rate as a reflection of the risk of nonpayment, the Court did not adopt a specific percentage range for risk adjustment.
Since the Supreme Court’s Till decision, the Circuit Courts have split on whether the appropriate interest rate for determining present value should be the market rate or a rate based on a formula. In the most recent Circuit Court case on the issue, the Second Circuit held that a market rate of interest should be utilized if an efficient market existed in which the rate could be determined. In re MPM Silicones, L.L.C., No. 15-1682(l), 2017 U.S. App. LEXIS 20596 (2nd Cir. Oct. 20, 2017). In the case, the debtor filed Chapter 11 and proposed a reorganization plan that gave first-lien holders an option to receive immediate payment without any additional “make-whole” premium, or the present value of their claims by utilizing an interest rate based on a formula that resulted in a rate below the market rate. The bankruptcy court confirmed the plan, utilizing the formula approach of Till. The federal district court affirmed. On further review, the appellate court reversed noting that Till had not conclusively specified the use of the formula approach in a Chapter 11 case. The appellate court remanded the case to the bankruptcy court for a determination of whether an efficient market rate could be determined based on the facts of the case.
The interest rate issue is an important one in reorganization bankruptcy. The new guidance of the appropriate interest rate in a Chapter 11 is instructive. That’s particularly true because of the debt limit of $4,153,150 that applies in a Chapter 12. That limit is forcing some farmers to file Chapter 11 instead. There is no debt limit in a Chapter 11 case. Whether the Second Circuit’s recent decision will be followed by other appellate courts remains to be seen. But, the market rate, as applied to an ag bankruptcy, does seem to recognize that farm and ranch businesses are subject to substantial risks and uncertainties from changes in price and from weather, disease and other factors. Those risks are different depending on the type of agricultural business the debtor operates. A market rate of interest would be reflective of those factors.
Friday, November 10, 2017
Amidst all of the news recently about tax proposals in the Congress and the attention that has garnered, there is another important date that is creeping up on many livestock producers. Unless an extension is granted, on November 15, a reporting rule administered by the federal Environmental Protection Agency (EPA) will be triggered that will apply to certain livestock operations. The reporting applies to certain “releases” of “hazardous” substances and the requirement that the government be notified.
The federal government has been involved in regulating air emissions for over 50 years. The first serious effort at the national level concerning air quality was passage of the 1963 Clean Air Act (CAA) amendments. This legislation authorized the then Department of Health, Education and Welfare (now Department of Health and Human Services) to intervene directly when air pollution threatened the public “health or welfare” and the state was unable to control the problem.
The 1970 CAA amendments represented a major step forward at the federal level in terms of regulating the activities contributing to air pollution. This legislation created air quality control regions and made the individual states responsible for sustaining air quality in those regions. The states could regulate existing sources of pollution with less restrictive requirements. See, e.g., State, ex rel. Cooper v. Tennessee Valley Authority, et al., 615 F.3d 291 (4th Cir. 2010).
Additional federal Specifically, under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the Environmental Protection Agency (EPA) has discretion to take remedial actions or order further monitoring or investigation of the situation.
On January 21, 2005, the EPA announced the Air Quality Compliance Consent Agreement to facilitate the development of scientifically credible methodologies for estimating emissions from animal feeding operations (AFOs). A key part of the agreement is a two-year benchmark study of the air emissions from livestock and poultry operations. The study was designed to gather data relative to the thresholds of the CAA, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), and set national air policies so that excessive levels could be regulated. Under both CERCLA and EPCRA, the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the EPA has discretion to take remedial actions or order further monitoring or investigation of the situation.
In mid-2007, the U.S. Court of Appeals for the D.C. Circuit upheld the EPA’s ability to enter into the consent agreements with participating AFOs. Association of Irritated Residents v. EPA, 494 F.3d 1027 (D.C. Cir. 2007). Community and environmental groups had challenged the consent agreements as rules disguised as enforcement actions, that the EPA had not followed proper procedures for rulemaking and that EPA had exceeded its statutory authority by entering into the agreements. The court disagreed, holding that the consent agreements did not constitute rules, but were enforcement actions within EPA’s statutory authority that the court could not review.
In early 2009, EPA, pursuant to the EPCRA, issued a final regulation regarding the reporting of emissions from confined AFO’s – termed a “CAFO.” The rule applies to facilities that confine more than 1,000 beef cattle, 700 mature dairy cows, 1,000 veal calves, 2,500 swine (each weighing 55 pounds or more), 10,000 swine (each weighing less than 55 pounds), 500 horses and 10,000 sheep. The rule requires these facilities to report ammonia and hydrogen sulfide emissions to state and local emergency response officials if the facility emits 100 pounds or more of either substance during a 24-hour period.
2008 Regulations and Court Case
In late 2008, the EPA issued a final regulation exempting farms from the reporting/notification requirement of CERCLA (Sec. 103) for air releases from animal waste on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for CAFOs under the EPCRA’s public disclosure rule. Various environmental activist groups challenged the exemption in the final regulation on the basis that the EPA acted outside of its delegated authority to create the exemption. Agricultural groups claimed that the carve-out for CAFOs was also impermissible, but for a different reason.
The environmental groups claimed that emissions of ammonia and hydrogen sulfide (both hazardous substances under CERCLA) should be reported as part of furthering the overall regulatory objective. The court noted that there was no clear way to best measure the release of ammonia and hydrogen sulfide, but noted that continuous releases are subject to annual notice requirements. The court held that the EPA’s final regulation should be vacated as an unreasonable interpretation of the de minimis exception in the statute. As such, the challenge brought by the agriculture groups to the CAFO carve out was mooted and dismissed. Waterkeeper Alliance, et al. v. Environmental Protection Agency, No. 09-1017, 2017 U.S. App. LEXIS 6174 (D.C. Cir. Apr. 11, 2017).
The court set a deadline for the beginning of the reporting of releases, but the EPA sought an extension. In response, the court extended the date by which farms must begin reporting releases of ammonia and hydrogen to November 15, 2017. The reporting requirement will have direct application to larger livestock operations with air emissions that house beef cattle, dairy cattle, horses, hogs and poultry. It is estimated that approximately 60,000 to 100,000 livestock and poultry operations will be subject to the reporting requirement.
EPA Interim Guidance
On October 26, 2017, the EPA issued interim guidance designed to educate livestock operations about the upcoming reporting requirements for emissions from animal waste.
Under the guidance, the EPA notes that the reportable quantity for each of ammonia and hydrogen sulfide is triggered at a release into the air of 100 pounds or more within a 24-hour period. That level would be reached by a facility with approximately 330-head (for a confinement facility) according to a calculator used by the University of Nebraska-Lincoln which is based on emissions produced by the commingling of solid manure and urine. If that level of emission occurs for either substance, the owner (or operator) of the “facility” must inform the U.S. Coast Guard National Response Center (NRC) of any individual release by calling (800) 424-8802. Unless changed at the last minute, this reporting must be done by November 15, 2017. In addition, a written report must also be filed with the regional EPA office within 30 days of the NRC reporting.
If releases will be “continuous and stable,” “continuous release reporting” is available by filing an “initial continuous release notification” to the NRC and the regional office of the EPA. Once that is done, reporting is only required annually unless the facility’s air emissions change significantly. However, unless an extension is granted, the initial “continuous release” notification is to be filed on or before November 15, 2017.
While air emissions occurring from the crop application of manure or federally registered pesticides are not subject to reporting, spills and accidents that involve manure (other fertilizers) and pesticides must be reported if they are over applicable thresholds.
The EPA Guidance also indicates that reporting does not apply under the EPCRA to air emissions from substances that are used in “routine agricultural operations.” Those substances, according to the EPA don’t meet the definition of “hazardous.” “Routine agricultural operations,” EPA states, includes “regular and routine” operations at farms AFOs, nurseries and other horticultural and aquacultural operations. That would include, EPA notes, on-farm manure storage used as fertilizer, paint for maintaining farm equipment, fuel used to operate farm machinery or heat farm buildings, and chemicals for growing and breeding fish. It would also appear to include livestock ranches where cattle are grazed on grass. A similar conclusion could be reached as to the term “facility” – a “facility” under CERCLA should not include a cow/calf grass operation where the livestock graze on grass. However, at the present time, the EPA has not provided any official guidance concerning the issue.
There doesn’t appear to be any harm in reporting when it is not clearly required. In other words, while the land application of livestock manure would appear to fall under the “fertilizer” exemption and not be included in the definition of “facility” a producer could still report such emissions. While grass operations could also report to be on the side of caution, the reportable emission level (if it were to apply to a grass operation) will be triggered at a higher head count of livestock because commingled solid waste and urine will not be present.
Recently, the EPA filed a motion with the court to push the November 15 deadline back. Also, on November 9, 2017, the National Pork Producers Council and the U.S. Poultry and Egg Association filed an amicus brief in support of the EPA’s motion. They are asking the court to give the EPA more time to “provide farmers more specific and final guidance before they must estimate and report emissions.” In addition, the EPA notes that getting additional time will allow to finalize a reporting system.
Whenever the reporting requirement becomes effective, either November 15 or sometime later if the court grants an extension, it will be important for livestock producers to comply. For now, livestock producers should study the EPA interim guidance. That guidance is available here: https://www.epa.gov/epcra/cercla-and-epcra-reporting-requirements-air-releases-hazardous-substances-animal-waste-farms#Resources. If reportable quantities of emissions will occur, the compliance deadline and proper reporting in a timely manner is very important so that applicable fines are avoided. It is also suggested the livestock producers look for guidance from their state and national livestock associations.
Wednesday, November 8, 2017
Next June, Washburn University School of Law will be sponsoring a two-day seminar in Pennsylvania on farm income tax and farm estate and business planning. I will be one of speakers at the event as will Paul Neiffer, the author of the Farm CPA Today blog. Paul and I have done numerous events together over the past few years and I thoroughly enjoy working with Paul. The K-State Department of Agricultural Economics will be co-sponsoring the event, and we are looking forward to working with the Pennsylvania Society of CPAs and Farm Credit East. The seminar dates will be June 7-8 and the location, while not set at the present time, will be within a couple of hours of Harrisburg, PA.
Our two-day event will precede the 2018 conference in Harrisburg of the National Association of Farm Business Analysis Specialists (NAFBAS) and the National Farm and Ranch Business Management Education Association, Inc. (NFRBMEA) which begins on June 10. We are looking forward to partnering with the two groups to provide technical and practical tax information in an applied manner that the attendees to the NAFBAS/NFRBMEA conference will find to be a beneficial supplement to their conference. Accordingly, we are planning the agenda to supplement the information that will be provided at the NAFBAS/NFRBMEA conference.
We will follow our traditional two-day seminar approach with farm income tax information on Day 1 and farm estate and business planning topics on Day 2. On Day 1, we will provide an update on recent cases and rulings. Of course, if there is new tax legislation, we will cover its application to various client situations. We will also provide farm income averaging planning strategies, farm financial distress tax planning issues, self-employment tax and how to structure leases and entities. Also on Day 1, we will explain how to handle indirect production costs and the application of the repair/capitalization regulations. In addition, we will explain the proper handling of farm losses and planning opportunities with farming C corporations.
On Friday, Day 2, we will cover the most recent developments in farm estate and business planning. Of course, if there is legislation enacted that impacts the transfer tax system, we will cover it in detail. We will also have a session on applicable tax planning strategies for the retiring farmer, and ownership transition strategies. Also discussed on Day 2 will be the procedures and tax planning associated with incorporating the farm business tax-free. We will also get into long-term health care planning, how best to structure the farming business to take maximum advantage of farm program payments, special use valuation as well as installment payment of federal estate tax. Those handling fiduciary returns will also find our session on trust and estate taxation and associated planning opportunities to be of great benefit.
Mark your calendars now for the June7-8 seminar in PA. If flying, depending on the location we settle on, flights into either Pittsburgh, Philadelphia or Baltimore will be relatively close. Be watching www.washburnlaw.edu/waltr for further details as the weeks go by. Until then, upcoming tax seminars will find me next week in North Dakota, and then Kansas in the following two weeks. In early December, I will be leading-off the Iowa Bar’s Bloethe Tax School in Des Moines with a federal tax update. I have also heard from numerous Iowans that will be attending tax school in Overland Park in late November, and I am looking forward to seeing you there along with the other attendees. Next week’s seminar from Fargo will be simulcast over the web in case you can’t attend in-person. Also, the seminar from Pittsburg, KS will be simulcast over the web. In addition, there will be a 2-hour ethics seminar/webinar on Dec. 15. Be watching my CPE calendar on www.washburnlaw.edu/waltr for more details.
I have a new book out, published by West Academic – “Agricultural Law in a Nutshell.” Here’s the link to more information about the book and how to order. http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/agriculturallawnutshell/index.html If you are involved in agriculture or just like to read up on legal issues involving those involved in agricultural production or agribusiness, the book would make a great stocking-stuffer. If you are teaching or taking an agricultural law class in the spring semester of 2018, this is a “must have” book.
There are always plenty of legal issues to write about and current developments to keep up on. Readers of this blog are well aware of that fact.
Monday, November 6, 2017
H.R. 1, the House tax bill, was publicly released last week. Of course, it’s getting a lot of attention for the rate changes for individuals and corporations and flow-through entities. However, there is an aspect that is getting relatively little focus – how the self-employment tax rules would change and impact leasing and entity structuring.
Most farmers don’t like to pay self-employment tax, and utilize planning strategies to achieve that end. Such a strategy might include entity structuring, tailoring lease arrangements to avoid involvement in the activity under the lease, and equipment rentals, just to name a few. However, an examination of the text of the recently released tax bill, H.R. 1, reveals that self-employment tax planning strategy for farmers will change substantially if the bill becomes law. If enacted, many farmers would see an increase in their overall tax bill while others would get a tax break. In addition, existing business structures put in place to minimize the overall tax burden would likely need to be modified to achieve that same result.
Today’s post examines the common strategies employed to minimize self-employment tax, and the impact of H.R. 1 on existing business structures and rental arrangements.
The Basics – Current Law
The statute. In addition to income tax, a tax of 15.3 percent is imposed on the self-employment income of every individual. Self-employment income is defined as “net earnings from self-employment.” The term “net earnings from self-employment” is defined as gross income derived by an individual from a trade or business that the individual conducts. I.R.C. §1402. For individuals, the 15.3 percent is a tax on net earnings up to a wage base (for 2017) of $127,200. It’s technically not on 100 percent of net earnings up to that wage base for an individual, but 92.35 percent. That’s because the self-employment tax is also a deductible expense. In addition, there is a small part of the self-employment tax that continues to apply beyond the $127,200 level.
In general, income derived from real estate rents (and personal property leased with real estate) is not subject to self-employment tax (see I.R.C. §1402(a)(1)) unless the arrangement involves an agreement between a landowner or tenant and another party providing for the production of an agricultural commodity and the landowner or tenant materially participates. I.R.C. §1402(a)(1)(A). For rental situations not involving the production of agricultural commodities where the taxpayer materially participates, rental income is subject to self-employment tax only if the activity constitutes a trade or business “carried on by such individual.” See, e.g., Rudman v. Comr., 118 T.C. 354 (2002). Similarly, an individual rendering services is subject to self-employment tax if the activity rises to the level of a trade or business.
This all means that real estate rentals are not subject to self-employment tax, nor is rental income from a lease of personal property (such as equipment) that is tied together with a lease of real estate. But, when personal property is leased by itself, if it constitutes a business activity the rental income would be subject to self-employment tax. See, e.g., Stevenson v. Comr., T.C. Memo. 1989-357.
Trade or business. Clearly, the key to the property reporting of personal property rental income is whether the taxpayer is engaged in the trade or business of renting personal property. The answer to that question, according to the U.S. Supreme Court, turns on the facts of each situation, with the key being whether the taxpayer is engaged in the activity regularly and continuously with the intent to profit from the activity. Comr. v. Groetzinger, 480 U.S. 23 (1987). But, a one-time job of installing windows over a month’s time wasn’t regular or continuous enough to be a trade or business, according to the Tax Court. Batok v. Comr., T.C. Memo. 1992-727.
As noted above, for a personal property rental activity that doesn’t amount to a trade or business, the income should be reported on the “Other Income” line of page 1 of the Form 1040 (presently line 21). Associated rental deductions are reported on the line for total deductions which is near the bottom of page 1 of the Form 1040. A notation of “PPR” is to be entered on the dotted line next to the amount, indicating that the amount is for personal property rentals.
Planning strategy. The income from the leasing of personal property such as machinery and equipment will trigger self-employment tax liability if the leasing activity rises to the level of a trade or business. But, by tying the rental of personal property to land, I.R.C. §1402(a)(1) causes the rental income to not be subject to self-employment tax. Alternatively, a personal property rental activity could be conducted via an S corporation or limited partnership. If that is done, the income from the rental activity would flow through to the owner without self-employment tax. However, with an S corporation, reasonable compensation would need to be paid. For a limited partnership that conducts such an activity, any personal services that a general partner provides would generate self-employment income.
Passive loss rules. In general, rental income is passive income for purposes of the passive loss rules of I.R.C. §469. But, there are a couple of major exceptions to this general rule. Under one of the exceptions, net income from a rental activity is deemed to not be from a passive activity if less than 30 percent of the unadjusted basis of the property is depreciable. Treas. Reg. §1.469-2T(f)(3). The effect of this exception is to convert rental income (and any gain on disposition of the activity) from passive to portfolio income. But, that is only the result if there is net income from the activity. If the activity loses money, the loss is still passive.
Under another exception, the net rental income from an item of property is treated as not from a passive activity if it is derived from rent for use in a business activity in which the taxpayer materially participates. Treas. Reg. §1.469-2(f)(6).
LLC members. Whether LLC members can avoid self-employment tax on their income from the entity depends on their member characterization. Are they general partners or limited partners? Under I.R.C. §1402(a)(13), a limited partner does not have self-employment income except for any guaranteed payments paid for services rendered to the LLC. So what is a limited partner? Under existing proposed regulations, an LLC member has self-employment tax liability if: (1) the member has personal liability for the debts or claims against the LLC by reason of being a member; (2) the member has authority under the state’s LLC statute to enter into contracts on behalf of the LLC; or (3) the member participated in the LLC’s trade or business for more than 500 hours during the LLC’s tax year. Prop. Treas. Reg. §1.1402(a)-2(h)(2). If none of those tests are satisfied, then the member is treated as a limited partner.
Structuring to minimize self-employment tax. There is an entity structure that can minimize self-employment tax. An LLC can be structured as a manager-managed LLC with two membership classes. With that approach, the income of a member holding a manager’s interest is subject to self-employment tax, but if non-managers that participate less than 500 hours in the LLC’s business hold at least 20 percent of the LLC interests, then any non-manager interests held by members that participate more than 500 hours in the LLC’s business are not subject to self-employment tax on the pass-through income attributable to their LLC interest. Prop. Treas. Reg. §1.1402(a)-2(h)(4). They do, however, have self-employment tax on any guaranteed payments. However, this structure does not achieve self-employment tax savings for personal service businesses. Prop. Treas. Reg. §1.1402(a)-2(h)(5) provides an exception for service partners in a service partnership. Such partners cannot be a limited partner under Prop Treas. Reg. §1.1402(a)-2(h)(4) (or (2) or (3), for that matter). Thus, for a professional services partnership structuring as a manager-managed LLC would have no beneficial impact on self-employment tax liability.
However, for LLCs that are not a “service partnership,” such as a farming operation, it is possible to structure the business as a manager-managed LLC with a member holding both manager and non-manager interests that can be bifurcated. The result is that a member holding both manager and non-manager interests is not subject to self-employment tax on the non-manager interest, but is subject to self-employment tax on the pass-through income and a guaranteed payment attributable to the manager interest.
Here's what it might look like for a farming operation:
A married couple operates a farming business as an LLC. The wife works full-time off the farm and does not participate in the farming operation. But, she holds a 49 percent non-manager ownership interest in the LLC. The husband conducts the farming operation full-time and also holds a 49 percent non-manager interest. The husband, as the farmer, also holds a 2 percent manager interest. The husband receives a guaranteed payment with respect to his manager interest that equates to reasonable compensation for his services (labor and management) provided to the LLC. The result is that the LLC’s income will be shared pro-rata according to the ownership percentages with the income attributable to the non-manager interests (98 percent) not subject to self-employment tax. The two percent manager interest is subject to self-employment tax along with the guaranteed payment that the husband receives. This produces a much better self-employment tax result than if the farming operation were structured as a member-managed LLC.
Additional benefit. There is another potential benefit of utilizing the manager-managed LLC structure. Until the health care law is repealed or changed in a manner that eliminates I.R.C. §1411, the Net Investment Income Tax applies to a taxpayer’s passive sources of income when adjusted gross income exceeds $250,000 on a joint return ($200,000 for a single return). While a non-manager’s interest in a manager-managed LLC is typically considered passive with the income from the interest potentially subject to the 3.8 percent surtax, a spouse can take into account the material participation of a spouse who is the manager. I.R.C. §469(h)(5). Thus, the material participation of the manager-spouse converts the income attributable to the non-manager interest of both spouses from passive to active income that will not be subject to the 3.8 percent surtax. Based on the example above, the result would be that self-employment tax is significantly reduced (it’s limited to 15.3 percent of the husband’s reasonable compensation (in the form of a guaranteed payment) and his two percent manager interest) and the net investment income surtax is avoided on the wife’s income.
What about an S corporation? The manager-managed LLC provides a better result than that produced by the member-managed LLC for LLCs that are not service partnerships. For those that are service providers, the S corporation is the business form to use to achieve a better tax result. For an S corporation, “reasonable” compensation will need to be paid subject to FICA and Medicare taxes, but the balance drawn from the entity can be received free of self-employment tax. The disadvantage of operating a business or holding property in the S corporation is inflexibility. Appreciated property cannot be removed from the S corporation without triggering gain. Upon the death of an S corporation shareholder, the tax bases of the underlying assets are not adjusted to fair market value. The partnership is the more tax-friendly and flexible structure.
Impact of H.R. 1 on Business Structures
In general. The new proposals (contained in H.R. 1) add complexity in many situations involving partnerships and leasing arrangements. Section 1004 of H.R. 1 eliminates the rental real estate exception from self-employment tax of existing I.R.C. §1402(a)(1) and proposes a new maximum tax of 25 percent to income received from a flow-through entity (such as a partnership, LLC or S corporation). The 25 percent rate applies to all net passive income, plus all “qualified business income.” Under Sec. 1004 of H.R. 1, “qualified business income” is the greater of 30 percent of active business income or a deemed return from the sum of the investment in depreciable property plus real property used in the business. Depreciable property is determined without regard to bonus depreciation and Section 179. Also in Sec. 1004, the deemed return is set at seven percent plus the short-term Applicable Federal Rate (AFR) as of the end of the year. The short-term AFR is slightly over 1 percent at the present time.
How does the formula for the application of the 25 percent tax flow-through rate work? Consider the following:
Robert has capital invested in his farming S corporation of $4 million (based on depreciated values not including Section 179 and bonus depreciation). His allowed deemed return is 7 percent plus the short-term AFR rate as of the end of the year (assume, for purposes of the example, one percent). Thus, if Robert’s farming activity generates $320,000 or less, the farm income will be subject to the 25 percent rate, but not self-employment tax. If Robert’s S corporation generates more than $320,000, the excess amount will also be subject to self-employment tax.
In essence, H.R. 1 replaces the self-employment tax on business income with a computation that deems 70 percent of the business income to be attributable to labor and subject to self-employment tax, in accordance with the formula above. This applies to businesses of all types – sole proprietorships, partnerships and S corporations. That has some very important implications.
S corporations. S corporations have never been subject to self-employment tax. They will be under H.R. 1 in what appears to be an attempt to conform the business tax rate with the self-employment tax. For instance, if 70 percent of the income of the S corporation is subject to the labor rate, then 70 percent of the overall income of the S corporation (considering the amount of shareholders wages) should also be subject to self-employment tax.
Partnerships. The distributive share of a general partner in a general partnership has always been subject to self-employment tax. The distributive share of a limited partner has not. That changes under H.R. 1 via the repeal of I.R.C. §1402(a)(13) contained in Sec. 1004. Thus, a portion of a limited partner’s distributive share of partnership income will become subject to self-employment tax.
Sole proprietorships. The self-employment tax changes of H.R. 1 will also impact sole proprietorships. But, in this instance, the impact of the self-employment tax changes of H.R. 1 could work in the opposite direction. While sole proprietorship farming operations will also be subject to the 70 percent provision, it would actually result in a decrease in self-employment. tax. Under present law, 100 percent of the income of an active farmer that is reported on Schedule F is subject to self-employment. tax. Under H.R. 1, only 70 percent of Schedule F income would be subject to self-employment tax, but 70 percent of passive rental income would also be subject to S.E. tax. The bottom line – the ultimate tax outcome depends upon the mix that any particular farmer has of Schedule F (farm) income relative to Schedule E (passive rental income).
Multiple entities. Farmers who have arranged their farming business such that the land is in a separate entity (such as a limited liability company or other flow-through entity) and is leased to their operating farming business, would see an increase in self-employment tax. In addition, if the taxable income of these farmers has been taxed at a 25 percent rate or less, they won’t have the income tax benefits from the maximum 25 percent rate applied to flow-through entities. They will see a tax increase, because more of the income will be subject to S.E. tax.
This impact of this change in self-employment tax in the context of multiple entity farming arrangements is important to understand. The recent taxpayer victory in Martin v. Comr., 149 T.C. No. 12 (2017) which expanded the exception of McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000) for fair market leases to leases beyond the jurisdiction of the U.S. Court of Appeals for the Eighth Circuit, could be short-lived. Under the language of H.R. 1, the IRS will most assuredly argue that such rental income is part of an active trade or business such that 70 percent of it would be subject to self-employment tax.
What About Conservation Reserve Program (CRP) Income?
The IRS has long argued that CRP income is not rental income that could be excluded from self-employment tax under I.R.C. §1402(a). With that Code section removed, CRP income becomes business income under H.R. 1. As business income, the land owner is certainly passive in the CRP activity, which makes it business income subject to the maximum tax rate of 25 percent and not subject to self-employment tax. Even If CRP income were materially participating business income, however, only 70 percent of it would be subject to the self-employment tax at the labor rate of 25 percent. In any event, this change to the self-employment tax rules would likely stop IRS audits of CRP income.
Conclusion. So, what’s the bottom-line? The typical farmer that owns land and farms it either as a sole proprietor or as a general partner in a general partnership will see an overall tax decrease. That will be particularly true for these farmers in the high tax brackets. That’s because only 70 percent of the farm income will be subject to self-employment tax. However, a farmer that owns the land and rents it to a separate farming entity will incur more S.E. tax than under present law. If that farmer would be in a tax bracket higher than 25 percent, the benefit of the maximum business rate may fully offset the additional S.E. tax. That’s probably an oversimplification of the impact of H.R. 1. Obviously, each situation is unique and will require its own analysis. And, remember, H.R. 1 is only a proposal. It may never actually become law.
Thursday, November 2, 2017
The Uniform Commercial Code (UCC) holds merchants to a higher standard of business conduct than other participants to sales transactions. In every sale by a merchant who deals in goods of the kind sold, there is an implied warranty that the goods are merchantable. The warranty of merchantability exists even if the seller made no statements or promises and did not know of any defect in the goods.
What are the rules for merchantable goods?
What are Merchantable Goods?
In order for goods to be merchantable, they must be goods that:
- pass without objection in the trade under the contract description;
- in the case of fungible goods, are of fair average quality within the description;
- are fit for the ordinary purposes for which such goods are used;
- run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved;
- are adequately contained, packaged, and labeled as the agreement may require; and
- conform to the promises or affirmations of fact made on the container or label if any.
Requirements (a) through (c) above are most often encountered in agricultural sales, with much of the focus on whether the goods are fit for the ordinary purposes for which they are used. For instance, as to the fair average quality requirement, one court held that beetle infestation exceeding an acceptable level of contamination for fungible flour made the flour unmerchantable. T.J. Stevenson & Co., Inc. v. 81,193 Bags of Flour, 629 F.2d 338 (5th Cir. 1980). As for the requirement that the goods be properly packaged, the warranty is breached when defective packaging results in damage to the product or personal injury, when the package does not adequately warn about dangers with the product, and when misleading packaging inhibits subsequent resales. See, e.g., Agricultural Services Association, Inc. v. Ferry-Morse Seed Co., Inc., 551 F.2d 1057 (6th Cir. 1977).
The ordinary purpose standard is breached when goods are not reasonably safe or when they cannot be used to meet their normal functions. For example, in Latimer v. William Mueller & Son, 149 Mich. App. 620, 386 N.W.2d 618 (1986), the Michigan Court of Appeals ruled that bean seed was unfit for its ordinary purpose when the purchaser discovered, after planting, that the seed was infected with a seed-borne bacterial disease. This defect, the court held, invalidated the label provisions that attempted to disclaim warranties for merchantability and fitness. Likewise, in Eggl v. Letvin Equipment Co., 632 N.W.2d 435 (N.D. 2001), the court found that a tractor sold with defective O-rings was not fit for the ordinary purpose for which it was intended and, thus, breached the warranty of merchantability.
Requirement (d) involves bulk purchases and specifies that goods sold in bulk must be of an even kind, quality and quantity. Requirements (e) and (f) pertain to goods that are sold in containers or packaging, and reflect an overlap between express warranties and the implied warranty of merchantability. They are especially important in sales of labeled goods, such as feed, seed or pesticides. Some courts have suggested that statements on labels or containers create both an express and an implied warranty.
Merchantability also involves the standard of merchantability in the particular trade. Usage of trade is defined as “any practice or method of dealing having such regularity of observance in a place, vocation or trade as to justify an expectation that it will be observed with respect to the transaction in question.” UCC § 1-205(2). If a product fails to satisfy industry standards, an implied warranty of merchantability may arise. For example, in one case, the Pennsylvania Supreme Court held that feed for breeding cattle normally does not contain the female hormone stilbestrol because it is known to cause abortions in pregnant cows and sterility in bulls. Kassab v. Central Soya, 432 Pa. 217, 246 A.2d 848 (1968).
Even if a particular farmer does not qualify as a “merchant,” known product defects must be disclosed to a potential buyer. Every seller with knowledge of defects must fully disclose defects that are not apparent to the buyer on reasonable inspection. This duty arises out of the underlying rationale behind the implied warranty of merchantability, which is to assure that the buyer is getting what is being paid for, and the UCC’s requirement that market participants operate in “good faith.”
The UCC warranty provisions also apply to sales transactions involving livestock. In a series of cases in the 1970s, courts applied the UCC implied warranty provisions to the sale of livestock as goods. See, e.g., Vorthman v. Keith E. Myers Enterprises, 296 N.W.2d 772 (Iowa 1980); Holm v. Hansen, 248 N.W.2d 503 (Iowa 1976); Ruskamp v. Hog Builders, Inc., 192 Neb. 168, 219 N.W.2d 750 (1974); Hinderer v. Ryan, 7 Wash. App. 434, 499 P.2d 252 (1972). The livestock industry strongly reacted and successfully lobbied for an exclusionary provision limiting the application of implied warranties in livestock sales. Some version of the statutory exclusion now exists in about half of the states, especially those states where the livestock industry is of major economic importance. The statutes are of three general types: those that exempt sellers from implied warranties in all situations, those providing that no implied warranty exists unless the seller knew the animals were sick at time of sale, and those providing an exemption if certain conditions are met.
The statutory exclusion of warranties in livestock sale transactions applies only to implied warranties; express warranties are not affected. Express warranties can still be made in livestock transactions and may be particularly important in transactions involving breeding livestock. Many sellers tend to make statements that might rise to the level of an express warranty in order to induce buyers to conclude the sale. Such statements can become a part of the basis of the bargain and create an express warranty enforceable against the seller.
The typical statutory exclusion also is inapplicable in situations where the seller “knowingly” sells animals that are diseased or sick. However, it is likely to be difficult for a livestock buyer to prove that the seller knew animals were diseased or sick at the time they were sold. Under the UCC, a seller “‘knows’ or ‘has knowledge’ of a fact when the seller has ‘actual knowledge’ of it.” UCC § 1-201(25). Thus, in order to overcome the statutory exclusion, the buyer must prove (most likely by circumstantial evidence) the seller’s actual knowledge regarding the animal’s disease or sickness.
Under most state exclusionary statutes, the meaning of “diseased or sick” is unclear. For instance, in breeding animals, the failure to provide offspring may result from recognizable diseases or from defects, often genetic, that historically have not been considered diseases. It is uncertain whether the statutory exclusion of implied warranties applies in circumstances involving genetic defects. Presently, no court in a jurisdiction having the exclusion has addressed the issue. Similarly, uncertainty exists with respect to the application of the exclusion to the sale of semen or embryo transfers, which are increasingly common in the livestock industry. Arguably, the livestock exclusion does not apply to semen sales since semen is not “livestock.”
The implied warranty of merchantability arises in many sales transactions involving agricultural goods. The rule for merchantability have produced some very interesting cases over the years.