Wednesday, January 31, 2018
Some taxpayers strive to convert a hobby or minor occupation into a more typical business operation. Doing so doesn’t present any problems with the IRS if the business makes money and, of course, all taxes are properly paid. But, what if the business activity loses money? If the losses stack-up over a length of time (deductions from the activity exceed income), the IRS may take the position that the activity is a hobby that is not engaged in with a profit intent as would be a legitimate business.
What is the consequence of being classified by the IRS as a hobby? Deductions that are attributable to an activity that is not engaged in for profit are significantly limited. I.R.C. §183(a). Certain deductions will remain available because they aren’t tied to whether the activity is a hobby or not. Those include state and local property taxes, home mortgage interest and casualty losses, for example. See Treas. Reg. §1.183-1(d)(2). But, deductions associated with conducting the activity will be limited to the excess of gross income from the activity over those expenses that are deductible regardless of whether the activity is entered into for profit. In addition, for hobby activities, allowed expenses are deducted on Schedule A (Form 1040) as a miscellaneous itemized deduction subject to the 2 percent-of-AGI (adjusted gross income) floor. This is the rule through 2017. For tax years beginning after 2017, there are no deductions against the hobby income due to the elimination of the 2 percent-of-AGI floor. If the activity isn’t a hobby, deductible expenses are business expenses that are deductible (even if they exceed income) on Schedule C. If the activity is a hobby, however, the income is reported as "other income" and is not subject to self-employment tax. But, the critical point is that if an activity is not engaged in for profit, then losses from the activity can’t be used to offset other income.
Note: Where property is used in several activities, and one or more of the activities is determined not to be engaged in for profit, deductions relating to the property must be allocated between the various activities on a reasonable and consistently applied basis. Treas. Reg. §1.183-1(d)(2).
In recent months, indications are that the IRS is pushing the hobby loss rules harder, particularly with respect to farming operations. In early 2017, I wrote about a pilot program that IRS was initiating involving Schedule F expenses for small business/self-employed taxpayer examinations. The program started on April 1, 2017 and will go through March of 2018. The focus will be on “hobby” farmers, and it could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F.
The hobby loss rules and farming/ranching operations, that’s the topic of today’s post.
The Hobby Loss Rules
The key question is where the line is drawn between a hobby and a business. In general, as noted above, a “hobby” is any activity that is not engaged in primarily for profit. If a taxpayer’s gross income from an activity exceeds deductions for three or more of the last five years, a presumption arises that the activity is not a hobby. In other words, an activity is presumed to be a business if there are profits for three or more of the last five years. For activities consisting of breeding, training, showing or racing horses, however, the presumption arises if there is a profit in any two out of the last seven years. The IRS can rebut the presumption by carrying the burden of proof and establishing a lack of profit motive. Thus, for farms or ranches operated for pleasure or recreation and not as commercial enterprises, the deduction of expenses is permitted if a profit occurs over a long enough period.
If the presumption does not resolve the issue of whether a farm is being operated for pleasure or recreation and not as a commercial enterprise, a determination must be made as to whether the taxpayer was conducting the activity with the primary purpose and intention of realizing a profit. The expectation of profit need not be reasonable, but there must be an actual and honest profit objective. Whether the requisite intention to make a profit is present is determined by the facts and circumstances of each case with the burden of proof on the taxpayer attempting to deduct the losses. See, e.g., Ryberg v. Comr., T.C. Sum. Op. 2012-24.
Nine-Factor Test of the Regulations
The hobby loss rules won't apply if the facts and circumstances demonstrate that the taxpayer has a profit-making objective. The IRS has developed nine factors) that are to be examined in determining whether the requisite profit motive exists. See, e.g., Treas. Reg. §1.183-2(b).
Business-like manner. The first IRS factor is concerned with the manner in which the activity is conducted. Is the activity being conducted in a manner that demonstrates that the taxpayer had a business purpose in mind, or is the taxpayer really conducting the activity as would be expected of someone engaged in a hobby? For instance, does the taxpayer keep adequate records and use them in a manner that is designed to aid the profitability of the business? See, e.g., Knudsen v. Comm’r, T.C. Memo. 2007–340. If the activity is conducted in a “business-like” manner, with accurate and complete records and books of account, the hiring of experienced supervisors or managers, or the seeking of expert advice, this factor will weigh in the taxpayer’s favor.
Expertise. The second factor focuses on the taxpayer’s expertise. If the taxpayer or an advisor has expertise in the particular agricultural area involved, a profit intent is shown. If, for example, the taxpayer has a small beef herd, does the taxpayer know anything about beef breeding or nutrition? What about health problems, etc.?
Time commitment. The third factor involves an examination of how much time the taxpayer devotes to the activity. Sufficient manual labor by the taxpayer may overcome an IRS argument that the taxpayer was engaged in a hobby operation. The question often boils down to whether the taxpayer put in enough time into the activity to reduce or eliminate successive years’ worth of losses.
Expectation of asset appreciation. The fourth factor recognizes that a realistic expectation of asset appreciation can show an intent to profit overall from the activity. See, e.g., Stromatt v. Comm’r, T.C. Sum. Op. 2011-42
Experience. The sixth factor looks at whether the taxpayer has been involved in a loss venture in the past that was turned around into a profitable venture. With respect to this factor, it is appropriate to examine the history of income on all sides of the activity.
History of income or loss. The sixth factor involves an examination of the history of income or loss from the activity. While start-up losses are to be expected in many ventures, continuing losses beyond the period usually required to achieve profitability may indicate a lack of a profit motive. There must be a prospect, not only for earning future profits, but for profits sufficient to offset losses sustained during the early years of operation. A taxpayer's subjective intent must be demonstrated with objective facts, such as comparing the taxpayer's income and loss numbers to comparable neighboring operations.
Amount of profit. The seventh factor examines the amount of profits earned from the activity. Activities generating large losses that occasionally produce a profit are not necessarily indicative of a profit intent. Also important are whether the only gross receipts are federal farm program payments.
Financial status. If the taxpayer has sufficient non-farm income to maintain a comfortable standard of living even with the losses from the “farming” activity, the factor will weigh in the favor of the IRS.
Elements of recreation and/or pleasure. If a taxpayer derives pleasure or recreational benefits from the activity, this factor will cut in favor of the IRS.
Two recent cases illustrate the application of the hobby loss rules to agricultural activities.
Large losses don’t necessarily negate profit intent. In Welch, et al. v. Comr., T.C. Memo. 2017-229, the taxpayer was a professor that taught at several universities over a 40-year span. In the 1970s he founded a consulting business. In the early 1980s he formed another business that provided software to researchers, and developed a statistical program in 2007 to assist businesses in their hiring practices. In 1987, he purchased an initial 130-acre tract with the original intent to grow hay as a cash crop and to raise some cattle.
Over time, the ranch grew to become a multi-operational, 8,700-acre ranch with 25 full-time employees. The ranch also had a vet clinic that provided services for large and small animals. In addition, the ranch had a trucking operation and owned numerous 18-wheel trucks that were used to move cattle and hay around the ranch and to transport cattle to and from market and perform backhauls. The ranch also conducted timber operations and employed a timber manager.
The taxpayer subscribed to numerous professional publications, and changed the type of cattle that the ranch raised to increase profitability. Steadily increasing herd size. The hay operation was also modified to maximize profitability due to weather issues. In addition, the ranch built its own feed mill that was used to chopping and dry storage of the hay. In 2003, the taxpayer also started construction of a horse center as part of the ranch headquarters, including a breeding facility that operated in tandem with the veterinary clinic. Ultimately, the taxpayer’s horses were entered in cutting competitions, with winnings increasing annually from 2007 to 2010.
The IRS issued notices of deficiency for 2007-2010. For those years, the taxpayer had total losses of approximately $15 million and gross income of approximately $7 million. Also, for those years, the taxpayer’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income.
The Tax Court determined that all of the taxpayer’s activities were economically intertwined into a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations favored the IRS. Accordingly, the taxpayer’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated.
Reasonable jury could find profit intent. In Wicks v. United States, No. 16-CV-0638-CVE-FHM, 2018 U.S. Dist. LEXIS 9352 (N.D. Okla. Jan. 22, 2018), the plaintiff owned and operated a company that provided mechanical inspection services for major oil refineries and gas plants. That business was quite profitable. In addition to his business, the plaintiff, in the late 1990’s, started in the cattle business when he bought 80 acres of land containing a dilapidated barn and unusable fence. He repaired the fence and barn and purchased two longhorn heifers, built a new barn, bought and adjacent 180-acre tract so he could increase the herd to make the venture ultimately profitable, and improved the entire property by replacing fence, enlarging an existing pond, installing rural water and constructing a cattle working facility and loafing shed. The plaintiff also consulted with a successful local rancher regarding profitable methods of cattle ranching. He also purchased 20 cows to crossbreed so as to produce quality milk and beef, knowing that obtaining a crossbreed would take at least four years. The plaintiff also purchased new hay baling equipment and feed bins.
The plaintiff performed all of the labor and spent three to four days weekly working on the ranching activity. However, the cattle ranching activity never showed a year of profitability, with total gross receipts from 1997 through 2015 totaling $32,602 and net losses totaling $807,380. The plaintiff did not establish a written business plan or have any written financial projections, and did not use any accounting software or form a business entity for the cattle operation, although he did use a spreadsheet to track his expenses. He also did not market or promote the cattle operation, insure the herd against catastrophic loss or consult a financial advisor. Before 1997, the plaintiff’s only experience with cattle was feeding and working them as a child. He sold cattle in 2013, after the cattle market had rebounded from prior lows, and also attended seminars on cattle breeding and pasture management and read as much as he could about raising cattle. He also joined two different state cattlemen’s associations.
For 2010 and 2011, the IRS denied the loss deductions from the plaintiff’s cattle ranching activity, and assessed penalties with the total amount of tax and penalties (including interest) due being $89,838.09. The plaintiff paid the deficiency (plus interest) and sued for a refund, claiming that he engaged in the cattle ranching activity with profit intent). The IRS moved for summary judgment, arguing that the activity was not engaged in for profit and the resulting losses were non-deductible under the hobby loss rules of I.R.C. §183. On an evidentiary question, the court allowed tax return information from post-2011 years into evidence because it was relevant in showing whether the plaintiff had a profit intent for the tax years in issue. The court also allowed into evidence testimony of an ag economist for the plaintiff to the extent the testimony bore on economic conditions and their impact on the plaintiff’s cattle ranching activity.
The court examined each of the nine factors in the regulations and ultimately determined that, based on the totality of the circumstances, and viewing the evidence in the light most favorable to the plaintiff, a reasonable jury could conclude that the plaintiff engaged in the cattle ranching activity with a profit intent. The court denied the IRS motion for summary judgment.
The IRS is looking closely at agricultural activities that it believes might be a hobby. Operating the activity in conformity with the regulations is a must for maintaining full deductibility of expenses associated with the activity.
Monday, January 29, 2018
The Economic Recovery Tax Act of 1981 introduced the “Credit for Increasing Research Activities.” The credit is better known as the research and development credit, or simply the “R&D” credit. It’s a general business credit that, for a business with under $50 million in average annual gross receipts, offsets both regular tax and alternative minimum tax. For certain defined smaller businesses, it can offset the employer portion of Social Security taxes up to $250,000 (with some limitations). The purpose of the credit as enacted is still the same today – to incentivize research and experimentation by providing a tax credit for activities that develop a new component of a taxpayer’s business or improve an existing component’s performance, functionality, reliability or quality. I.R.C. §41(d)(3)(A).
While the credit is available to a wide array of businesses, including farming businesses, what is the scope of its application? Does it apply to a farmer that utilizes cover crops or installs a bioreactor? What about a farmer that uses nitrification inhibitors? If the farmer receives a cost-share amount from the government, does that impact the ability to claim the R&D credit?
Today’s post takes a look at the R&D credit and its potential application to farming and ranching operations.
Mechanics of The Credit
As noted above, the R&D credit applies to activities (including research and software development) that develop a new business component or improve an existing component’s performance, functionality, reliability or quality. Treas. Reg. §1.41-4(a). What is a business component? It’s “any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license,” or which is used by the taxpayer in the taxpayer’s trade or business. An activity qualifies for the credit by means of a four-part test: (1) the activity must develop or improve the functionality, quality, etc., of a business component; (2) the activity must rely on technological principles; (3) substantially all of the activity must employ a process of experimentation that is designed to evaluate one or more alternatives; and (4) the process of experimentation must be designed to eliminate uncertainty (regarding the company’s capability, methodology, or appropriateness of design of a business component). I.R.C. §41(d).
Expenses that are incurred with respect to a qualified activity are used to compute the R&D credit and are termed “qualified research expenditures” (QREs). QREs can result for in-house activity as well as expenses incurred via contract. For in-house activity, QRE includes W-2 wages paid to employees that are either directly involved in an activity (including research) that develops a new business component, or supervise it or support it, as well as the cost of supplies and payments for qualified services (e.g., consultants and engineers). I.R.C. §41(b); see also Suder v. Comr., T.C. Memo. 2014-201.
Note: Under certain federal farm programs, especially those programs designed to provide environmental benefits, the USDA shares in part of the expense associated with complying with the program. While the expense associated with establishing a conservation/environmental structure/program on the farm might otherwise qualify as a QRE, the portion that the government subsidizes (via I.R.C. §126) would not be a QRE because the taxpayer did not incur the cost. In addition, as noted below, qualified expenses would be limited to a test plot rather than applying to expenditures incurred for the entire farm.
Once the qualified activities and QREs are determined, the credit is six percent of eligible expenses for each of the first three years that qualified research activities are conducted. I.R.C. §41(c)(5)(B)(ii). After that, the alternative simplified method that sets the R&D credit at 14 percent of the excess of QREs for the tax year over 50 percent of the average QREs for the three preceding tax years multiplied by 65 percent (factoring in a reduction via I.R.C. §280C). I.R.C. §§41(c)(5); I.R.C. §41(h).
Bill is trying to determine his R&D credit for 2018. Assume that Bill incurs QREs of $50,000 in 2015; $62,500 in 2016 and $75,000 in 2017. The average over those three years is $62,500. 50 percent of that three-year average is $31,250. For 2017, he incurred $75,000 of QREs. From that amount, Bill subtracts 50 percent of the average QREs for the prior three years, or $31,250. That amount is then multiplied by 14 percent (.14 x $31,250 = $4,375). The $4,375 amount is then multiplied by 65 percent (the I.R.C. §280C credit reduction), which yields an R&D credit of $2,843.75.
The R&D credit is claimed on Form 6765 and the associated instructions are instrumental in properly computing the credit and completing Form 6765 properly.
If a farmer doesn’t incur at least the level of QREs that Bill did in the example, it may not be worth the extra recordkeeping and tax preparation cost of claiming the credit.
As an additional point, for privately held businesses that have $50 million or less in average gross receipts for the three preceding tax years can use the R&D credit to offset the alternative minimum tax. Also, start-up companies, or those with less than $5 million in gross receipts for the current tax year and no gross receipts for the five preceding years may use R&D credits against their payroll tax liability up to $250,000.
Application to Agriculture
As noted above, the R&D credit applies costs incurred associated with research to develop new products or improve existing ones. It’s important that the research involves technological information or some sort of application that is intended to develop new or improved business products or processes. It’s also important that the research activities have a process of experimentation that relates to a new or improved function, performance, reliability, efficiently or quality.
So what kind of research activities on a farm will generate qualified expenses for the R&D credit? It is those research activities that are new to the farm and involves testing of something before it can be used on a larger scale. For farmers, the credit could potentially have a wide application – farmers often are “tinkering” or investigating ways to improve productivity or efficiency of crop and/or livestock production. Common examples might include testing new fungicides and seed treatment in an attempt to control insect disease; testing precision planting equipment in an effort to find ways to increase efficiency and/or yield; experimenting with organic fertilizer or with a with a cover crop to determine the impact on soil fertility and/or soil erosion; trying new cultivation techniques such as strip tillage; experimenting with irrigation and drainage and determining the impact on soil productivity and/or erosion; coming up with new weed/pest management techniques; experimenting with crop genetics; testing various planting dates, plant population, and row spacing to determine the impact on plant growth and development; testing combines and other harvesting equipment to minimize crop waste and/or decrease harvest time; working on customized animal feed formulations; developing customized software; researching and designing new grain bins. The list could go on, but you get the point.
The R&D credit can have a broad application to many activities that occur on a farm or ranch. But, don’t expect the IRS to allow the R&D credit to be applied to the whole farm. The credit is for research and development – in other words something that would occur in a laboratory. The entire farm is not a laboratory, but a test plot is. It is likely that the IRS will argue that the qualified research activities (which give rise to QREs) would have to occur in a test plot, with expenses (including qualified wages, and the cost of chemicals, fertilizer, seed, etc.) allocated to the specific area of the test plot. That will result in a small number for most farmers, especially in the Midwest. Higher value crops, such as potatoes, onions and fruits, might have bigger numbers, but the point remains that the QREs (and, hence the R&D credit) must be associated with a test plot and not the entire farm.
Thursday, January 25, 2018
A taxpayer can elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenses paid or incurred in connection with a trade or business. This is I.R.C. §174. The R&D credit, computed based upon qualified research expenditures, is a general business tax credit which reduces tax liability (rather than reducing taxable income), if allowed. I.R.C. §41.
Can farmers use the credit? Does it apply for the “testing” of chemicals and fertilizers on crops? If so, the credit could be a very valuable tax planning tool. That’s particularly the case because the credit offsets alternative minimum tax (AMT) and can also offset payroll tax in lieu of income tax (if certain tests are met). Does the recently enacted Tax Cuts and Jobs Act (TCJA) assist farming operations in utilizing the credit?
The benefit from R&E expenditures in farming operations – that’s the topic of today’s post.
Deductions for R&E Expenses
Under prior law, taxpayers could elect to deduct currently the amount of certain reasonable research or experimentation (R&E) expenditures paid or incurred in connection with a trade or business. Instead of making the election, a taxpayer could forgo a current deduction, capitalize their research expenses, and recover them ratably over the useful life of the research, up to five years. Alternatively, an election could be made to recover them over a period of 10 years. By doing so, the taxpayer would avoid AMT preferences and adjustments.
Generally, no current deduction under I.R.C. §174 is allowable for expenditures for the acquisition or improvement of land or of depreciable or depletable property used in connection with any research or experimentation. In addition, no current deduction is allowed for research expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.
What is qualified research? It’s basically related to developing a product that can be used in the taxpayer’s trade or business. It’s an activity or project that a taxpayer undertakes to create a new or improved component of the taxpayer’s business utilizing a systemic experimentation process that relies on principles of physical or biological sciences, engineering or computer science that is designed to evaluate one or more alternatives to achieve a result that was uncertain when the research activity began.
R&E Expenses under the TCJA?
The TCJA specifies that for amounts paid or incurred in tax years beginning after Dec. 31, 2021, “specified R&E expenses” incurred in the United States must be capitalized and amortized ratably over a 5-year period beginning with the midpoint of the tax year in which the specified R&E expenses were paid or incurred. TCJA, Sec. 13206, amending I.R.C. §174. In addition, it’s treated as a change in the taxpayer's accounting method (I.R.C. §481) initiated by the taxpayer, and made with IRS's consent. If the expenses are incurred in tax years beginning after Dec. 31, 2025, the provision is applied on a cutoff basis. That means that there would be no adjustment under I.R.C. §481(a) for expenses paid or incurred in tax years that begin before 2026.
So, in essence there isn’t any change in the mix for the R&E expenditures until 2022.
Application to Farming and Ranching Operations
Ag businesses deduct R&E expenditures every year, as farmers experiment with different chemicals and fertilizers, the benefit of which depend upon weather, soil types and hardiness of the plants. Expenses associated with product development activities can count, and they may also generate an R&D credit. Over the years, numerous products have been created by innovations developed by a farmer or rancher. Expenses associated with innovative activities that develop a new business product are deductible R&E expenditures, even though the innovations provide future benefits. That can also apply to activities that develop a new chemical that can be applied to seed or crops that enhances productivity. In short, due to the R&E expenditures, the farmer doesn’t need to determine if the expense provides only a current benefit, or a benefit that may last into the future. That’s what I.R.C. §174 is all about: allowing current deductions for researching better ways of doing things.
For farmers, researching and experimenting with different products and procedures generates current tax deductions. The R&D credit is another provision and the topic of my next post.
Tuesday, January 23, 2018
Farmers, ranchers and rural landowners frequently deal with many types of legal issues. Two of those sometimes involve the rules surrounding partition of farmland and adverse possession. These are two issues that heavily depend on state law and, as a result, the same set of facts can produce a different depending on the particular state.
In today’s post I take a look at a couple of recent cases that have again highlighted the importance of these issues.
Unfortunately, an all too common problem in estate planning for farm families is that farmland is left to multiple children equally as co-owners at the death of the surviving parent. That can create problems, particularly if there is at least one child that wants to continue farming the land and siblings that don’t. The sibling (or siblings) that don’t want to farm will often want to “cash out” their inheritance. Can the farmland be split-out between the siblings? That’s often difficult to accomplish, as a recent case illustrates.
In Wihlm v. Campbell, No. 15-0011 (Iowa Sup. Ct. Jan. 12, 2018), vac’g., 886 N.W.2d 617 (Iowa Ct. App. 2016), three siblings inherited approximately 300 acres of farmland as tenants in common when their father died. The land was divided into several parcels and two of the siblings brought partition actions seeking to have the properties sold and the proceeds divided. The other sibling (the defendant) wanted an in-kind division with respect to her share of about 79 acres and the homestead. The trial court ordered the entire property sold with the proceeds divided equally. The defendant appealed. An appraiser had testified at trial that if the property were sold at auction he would recommend selling it in separate parcels to bring a higher total selling price. The appraiser also testified that the tract that the defendant sought would be worth approximately one-third of the total value of the 300-acre tract. He also testified that an in-kind division would be fair and equitable. Another appraiser testified that it would be better to sell the entire tract together, but still another appraiser testified that more money could be realized on sale if separate tracts were sold.
The appellate court noted that the trial court had concluded that the defendant had failed to prove that the division of the properties in kind was equitable and practicable based on the testimony of two of the appraisers. But, the appellate court disagreed, noting that an appraisal is much more certain than speculation and that, in this case, the appraiser’s opinion was well supported. Accordingly, the court held that the defendant had proved that the division of the property was equitable and practicable. The court remanded the case for an in-kind partition of the property that the defendant requested, and for partition by sale of the balance with the proceeds split by the other siblings.
On further review, the Iowa Supreme Court vacated the court of appeals’ opinion on the basis that the defendant failed to meet her burden to prove that the partition in-kind was equitable and practicable. The Supreme Court gave no analysis for its opinion other than noting a 1968 Iowa Supreme Court opinion that stated the rule pertaining to partition of real estate “is unequivocal in favoring partition by sale and in placing upon the objecting party the burden to show why this should not be done in the particular case.” The Court followed that view in Newhall v. Roll, 888 N.W.2d 636 (Iowa 2016). Apparently, the conflicting testimony of the appraisers was insufficient to allow the defendant to prove that the division of the properties in-kind would be equitable and practicable.
Another topic that often arises in rural settings involves adverse possession. Adverse possession can involve boundary issues as well as access to property. But, again, the rules surrounding this issue are highly dependent on state law concerning the elements that must be establish to prove adverse possession. A recent case illustrates how the adverse possession rules work in Texas. Adverse possession gets particularly “messy” when mineral rights are also involved.
The facts of Hardaway v. Lou Eda Korth Stubbs Nixon, No. 04-16-00252-CV, 2017 Tex. App. LEXIS 10957 (Tex. Ct. App. Nov. 22, 2017) date back over 100 years. In the late 1800s, the Eckford’s owned, among other property, a 147.5-acre tract in Karnes County, Texas as community property. Mrs. Eckford was appointed as guardian of the community estate in 1893. Mr. Eckford died intestate on November 10, 1896. Under the laws of intestacy, one-half of the real property, which was community property, passed to Mrs. Eckford, and the other half of the real property passed to the couple’s nine surviving children. Mrs. Eckford conveyed portions of the property throughout her life, including a conveyance to the defendant’s predecessor in interest. When Mrs. Eckford died in 1928, her court appointed administrator advised the trial court that “all of the real estate” belonging to the estate should be sold to pay claims and expenses. Ultimately, in 1939, the administrator purported to sell all of the property once owed by the Eckfords as community property, including the 147.5 acres to the defendant’s predecessors.
The defendant’s parents entered into a mineral lease with Texas Oil & Gas Corp. in 1978 leasing the mineral rights in the entire 147.5 acres. At some point before 2012, Burlington Resources Oil & Gas Company and East 17th Resources, LLC (BRO&G) discovered information that led them to believe that the heirs of the Eckford’s owned an unleased one-half interest in the 147.5-acre tract that the defendant possessed. BRO&G believed that the defendant and the Eckford’s heirs were cotenants with regard to the 147.5 acres. As a result, BRO&G sought out and entered into mineral leases with numerous Eckford heirs. In 2012, because some of the numerous Eckford heirs could not be located, BRO&G instigated a receivership proceeding. The defendant intervened in the receivership action alleging sole ownership of the entire 147.5-acre tract. Ultimately, the defendant filed a motion for partial summary judgment in which he alleged full ownership of the property as a matter of law.
The trial court granted summary judgment in the defendant’s favor with regard to ownership of the property based only on constructive ouster and subsequent adverse possession. The Eckford heirs appealed. The appellate court held that a party claiming adverse possession as to a cotenant must not only prove his possession was adverse, but must also prove some sort of ouster. In addition, Texas law requires a summary judgment movant to do more than assert and prove “long-continued” possession under a claim of ownership and nonassertion of a claim by the titleholder to prove constructive ousters as a matter of law.
The appellate court determined that the only ground for summary judgment as to constructive ouster set forth in the defendant’s motion is long-continued possession coupled with absence of a claim by the Eckford heirs. The court determined that this neither asserted or established that they took “unequivocal, unmistakable, and hostile acts.” Therefore, the defendant failed to prove constructive ouster as a matter of law on the sole ground asserted in their motion. Accordingly, the appellate court reversed the trial court’s grant of summary judgment and remanded the matter to the trial court.
There are many cases involving these two issues, and the cases mentioned above are just a very small sample that illustrate an aspect of the real estate-related issues that rural landowners face. The cases also point out that a good lawyer well versed in these type of issues is good to have in tow.
Friday, January 19, 2018
Normally, the computation of a tax deduction for a gift to charity is simple – it’s the fair market value of the donated property limited by basis. That’s why, for example raised grain gifted to charity by a farmer doesn’t generate an income tax deduction. The farmer that gifts the grain doesn’t have a basis in the grain. But, special rules apply to a trust from which property is gifted to charity.
Today’s post looks at the issue of the tax deduction for property gifted to charity from a trust. Those special rules came up in a recent case involving a multi-million-dollar gift.
Rule Applicable to Trusts
I.R.C. §642(c)(1) says that a trust can claim a deduction in computing its taxable income for any amount of gross income, without limitation, that under the terms of the governing instrument is, during the tax year, paid for a charitable purpose. Note the requirement of “gross income.” A trust only gets a charitable deduction if the source of the contribution is gross income. That means that tracing the contribution is required to determine its source. See, e.g., Van Buren v. Comr., 89 T.C. 1101 (1987); Rev. Rul. 2003-123, 2003-150 I.R.B. 1200. Does the tracing have to be to the trust’s gross income earned in years before the year of the contribution? Or, does the trust just have to show that the charitable contribution was made out of gross income received by the trust in the year the contribution was made? According to the U.S. Supreme Court, the trustee does not have to prove that the charitable gift was made from the current year’s income, just that the gift was made out of trust income. Old Colony Trust Company v. Comr., 301 U.S. 379 (1937).
But, does trust income include unrealized gains on appreciated property donated to charity? That’s an interesting question that was answered by a recent federal appellate court.
A recent case involving a charitable donation by a trust raised the issue of the amount of the claimed deduction. Is it the fair market value of the property or is it the basis of the donated property if that amount is less than the fair market value? Under the facts of Green v. United States, 144 F. Supp. 3d 1254 (W.D. Okla. 2015), the settlors created a dynasty trust in 1993 with terms authorizing the trustee to make charitable distributions out of the trust's gross income at the trustee's discretion. The trust wholly owned a single-member LLC and in 2004, the LLC donated properties that it had purchased to three charities. Each property had a fair market value that exceeded basis. The LLC received the funds to buy the properties from a limited partnership's distribution to the trust in which the trust was a 99 percent limited partner. The limited partnership owned and operated most of the Hobby-Lobby stores in the United States.
The IRS initially claimed that the trust could not take a charitable deduction, but then decided that a deduction could be claimed if it were limited to the trust's basis in each property. The trust claimed a charitable deduction in excess of $20 million on Form 1041 for 2004, and later filed an amended Form 1041 increasing the claimed charitable deduction to just shy of $30 million, and seeking a tax refund of over $3 million. The IRS denied the refund, claiming that the charitable deduction was limited to cost basis. The trust paid the deficiency and sued for a refund.
On the trust's motion for summary judgment, the parties agreed that the donated properties were acquired by the trust with funds coming from gross income from a pre-2004 tax year. Thus, according to the trust, I.R.C. Sec. 642(c)(1) allowed the charitable deduction to be computed based on the donated property's fair market value. The court agreed, noting that I.R.C. § 642(c)(1) allowed a deduction without limitation contrary to the basis limitation contained in I.R.C. §170, and that charitable deduction provisions are to be construed liberally in the taxpayer's favor.
The trial court noted that the donated properties were all acquired with distributions from the limited partnership to the trust, and each distribution was part of the LLC's gross income for the year of distribution. Thus, the donated properties were clearly bought with funds traceable to the trust's gross income and were donated under the terms of the trust. The court noted that the IRS admitted that there was no caselaw or other substantial authority that supported the government's position. The court granted summary judgment for the trust.
On appeal, the U.S. Court of Appeals for the Tenth Circuit reversed. Green v. United States, No. 16-6371, 2018 U.S. App. LEXIS 885 (10th Cir. Jan. 12, 2018). The appellate court noted that the parties agreed that the trust had acquired the donated properties with gross income and that the charitable donation was made out of gross income. However, the IRS claimed that only the basis of the properties was traceable to an amount paid out of gross income. It was that amount of gross income, according to the IRS, that was utilized to acquire each property. The appellate court agreed. There was no realization of gross income on the appreciation of the properties because the underlying properties had not been sold. So, because the trust had not sold or exchanged the properties, the gains tied to the increases in market value were not subject to tax. The appellate court reasoned that if the deduction of I.R.C. §642(c)(1) extended to unrealized gains, that would not be consistent with how the tax Code treats gross income. The appellate court tossed the “ball” back to the Congress to make it clear that the deduction under I.R.C. §642(c)(1) extends to unrealized gains associated with real property originally purchased with gross income
The charitable donation rules associated with trusts are complicated. The income tax deduction is tied to the trust’s gross income. Now we have greater certainty that the deduction is limited to realized gains, not unrealized gains. Maybe the Congress will clarify that unrealized gains should count in the computation. But, then again, maybe not.
Wednesday, January 17, 2018
Much of the focus on the new tax law (TCJA) has been on its impact on the rate changes for individuals along with the increase in the standard deduction, and the lower tax rate for C corporations. Also receiving a great deal of attention has been the qualified business income (QBI) deduction of new I.R.C. §199A.
But, what about the impact of the changes set forth in the TCJA on estate planning? That’s the focus of today’s post.
Estate Planning Implications
Existing planning concepts reinforced. The TCJA reinforces what the last major tax act (the American Taxpayer Relief Act (ATRA) of 2012) put in motion – an emphasis on income tax basis planning, and the elimination of any concern about the federal estate tax for the vast majority of estates. Indeed, the Joint Committee on Taxation (JCT) estimates that in 2018 the federal estate tax will impact only 1,800 estates. Given an approximate 2.6 million deaths in the U.S. every year, the federal estate tax will now impact about one in every 1,400 estates. Because of this minimal impact, estate planning will rarely involve estate tax planning, but it will involve income tax basis planning. In other words, the basic idea is to ensure that property is included in a decedent’s estate at death for tax purposes so that a “stepped-up” basis at death is achieved (via I.R.C. §1014).
Increase in the exemption. Why did the JCT estimate that so few estates will be impacted by the federal estate tax in 2018? It’s because the TCJA substantially increases the value of assets that can be included in a decedent’s estate without any federal estate tax applying – doubling the exempt amount from what it would have been in 2018 without the change in the law ($5.6 million) to $11.2 million per decedent. That amount can be transferred tax-free during life via gift or at death through an estate. In addition, for gifts, the present interest annual exclusion is set at $15,000 per donee. That means that a person can make cumulative gifts of up to $15,000 per donee in 2018 without any gift tax consequences (and no gift tax return filing requirement) and without using up any of the $11.2 million applicable exclusion that offsets taxable gifts – it will be fully retained to offset taxable estate value at death. In addition, the $15,000 amount can be doubled by spouses via a special election. But, if the $15,000 (or $30,000) amount is exceeded, Form 709 must be filed by April 15 of the year following the year of the gift.
Marital deduction and portability. For large estates that exceed the applicable exclusion amount of $11.2 million, the tax rate is 40 percent. The TCJA didn’t change the estate tax rate. Another aspect of estate tax/planning that didn’t change involves the marital deduction. For spouses that are U.S. citizens, the TCJA retains the unlimited deduction from federal estate and gift tax that delays the imposition of estate tax on assets one spouse inherits from a prior deceased spouse until the death of the surviving spouse. Thus, assets can be gifted to a spouse with no tax complications at the death of the first spouse, and the first spouse can simply leave everything to a surviving spouse without any tax effect until the surviving spouse dies. This, of course, may not be a very good overall estate plan depending on the value of the assets transferred to the surviving spouse.
The “portability” concept of prior law was retained. That means that a surviving spouse can carry over any unused exemption of the surviving spouse’s “last deceased spouse” (a phrase that has meaning if the surviving spouse remarries). Portability allows married couples to transfer up to $22.4 million without any federal transfer tax consequences, and without any need to have complicated estate planning documents drafted to achieve the no-tax result. But, portability is not “automatic.” The estate executor must “elect” portability by filing a federal estate tax return (Form 706) within nine months of death (unless a six-month extension is granted). That requirement applies even if the estate is beneath the applicable exclusion amount such that no tax is due.
Remember the “Alamo” – state transfer taxes. A minority of states (presently 17 of them) tax transfers at death, either via an estate tax or an inheritance tax. The number of states that do is dwindling - two more states repealed their estate tax as of the beginning of 2018. A key point to remember is that in the states where an estate tax is retained, the exemption is often much less than the federal exemption. Only three states that retain an estate tax tie the state exemption to the federal amount. This all means that for persons in these states, taxes at death are a real possibility. This point must be remembered by persons in these states – CT, HI, IL, IA, KY, ME, MD, MA, MN, NE, NJ, NY, OR, PA, RI, VT, WA and the District of Columbia.
Generation-skipping transfer tax. The TCJA does retain the generation-skipping transfer (GSTT) tax. Thus, for assets transferred to certain individuals more than a generation younger than the decedent (that’s an oversimplification of the rule), the “generation-skipping” transfer tax (GSTT) applies. The GSTT is an addition to the federal estate or gift tax, but it does come with an exemption of $11.2 million (for 2018) for GSTT transfers made either during life (via gift) or at death. Above that exemption, a 40 percent tax rate applies. Portability does not apply to the GSTT.
Income tax basis. As noted above, the TCJA retains the rule that for income tax purposes, the cost basis of inherited assets gets adjusted to the fair market value on the date of the owner’s death. This is commonly referred to as “stepped-up” basis, but that may not always be the case. Sometimes, basis can go down. When “stepped-up” basis applies, the rule works to significantly limit (or eliminate) capital gains tax upon subsequent sale of the asset by the heir(s). This can be a very important rule for ag estates where the heirs desire to sell the inherited assets. Ag estates are commonly comprised of low-basis assets. So, while the federal estate tax won’t impact very many ag estates, the basis issue is important to just about all of them. That’s why, as mentioned above, the basic estate plan for most estates is to cause inclusion of the property in the estate at death. Achieving that basis increase is essential.
Estate planning still remains important. While the federal estate tax is not a concern for most people, there are still other aspects of estate planning that must be addressed. This includes having a basic will prepared and a financial power of attorney as well as a health care power of attorney. In certain situations, it may also include a pre-marital/post-marital agreement. If a family business is involved, then succession planning must be incorporated into the overall estate plan. That could mean, in many situations, a well-drafted buy-sell agreement. In addition, a major concern for some people involves planning for long-term health care.
Also, it’s a good idea to always revisit your estate plan whenever there is a change in the law to make sure that the drafting language used in key documents (e.g., a will or a trust) doesn’t result in any unintended consequences.
Oh…remember that the changes in the federal estate tax contained in the TCJA mentioned above are only temporary. If nothing changes as we go forward, the law reverts to what the law was in 2017 starting in 2026. That means the exemption goes back down to the 2017 level, adjusted for inflation. That also means estate planning is still on the table. The federal estate tax hasn’t been killed, just temporarily buried a bit deeper.
Monday, January 15, 2018
If tax simplicity was the goal of the recently enacted “Tax Cuts and Jobs Act” (not the official title), it’s hard to claim that the goal was met, at least as to the entirety of the bill. Perhaps a number of the individual income tax provisions were streamlined by virtue of the elimination of some itemized deductions and the near doubling of the standard deduction. Likewise, the corporate tax rate structure was simplified by moving to a single 21 percent rate. But that single lower rate doesn’t necessarily mean that there will be a stampede to form C corporations or convert existing businesses to C corporate status. There are other issues that work against converting a business to the C corporate form.
For sole proprietorships and pass-through businesses, a new deduction makes tax planning and preparation more complex - much more complex. Today’s post takes a brief look at this new deduction – a 20 percent deduction for qualified business income (QBI) that is available to businesses other than C corporations. There are many issues associated with the QBI, and those issues will be left for future posts. But, a couple of implications are addressed in this post.
The QBI Deduction
The complexity of the QBI deduction Code section (I.R.C. §199A) is difficult to overstate. The new QBI provision is 23 pages in length, at least when counting pages of the text of the provision in the final bill version that the President signed. If my count is correct, there are over 20 definitions in §199A, more than two dozen cross references to other parts of the Code, and just as many cross-references to other parts of §199A. The QBI deduction computation contains several formulas with “lesser than” or “greater than” language, and some of the computations are embedded inside each other. In addition, those computations involve addition, subtraction and multiplication (remember the ordering rules from grade school math class?). The QBI deduction also includes exemption amounts, formulas that phase-out those exemptions, and an international tax provision that applies to domestic pass-through entities.
The basics. The genesis for the §199A deduction dates at least to 2009. Before he became House Majority Leader in 2011, Rep. Eric Cantor, proposed a 20 percent deduction for small businesses. That proposal came up again a couple of times in later years, but nothing was formally introduced until the tax legislative discussions started to take shape in the summer of 2016, and the legislative process unfolded in 2017. The 20 percent deduction found its life in newly created I.R.C. §199A as part of the recently enacted tax bill.
Like the original proposal years ago, the QBI deduction is a deduction against business income for non-C corporations that aren’t specified service businesses. Some of the other basic points about the QBI deduction include: 1) for income above a threshold a W-2 wage limitation applies; 2) the deduction is claimed at the partner or shareholder level; 3) trusts and estates are eligible, as are agricultural and horticultural cooperatives; 4) the deduction applies only for income tax purposes, and is determined without regard to alternative minimum tax (AMT) adjustments; and 5) the accuracy-related penalty for substantial understatement of tax for a tax return claiming the QBI deduction applies if the understatement if five percent, rather than the normal 10 percent.
The formulas. The QBI deduction equals the sum of the lesser of the “combined qualified business income” of the taxpayer, or 20 percent of the excess of taxable income over the sum of any net capital gains and qualified cooperative dividends, plus the lesser of 20 percent of qualified cooperative dividends or taxable income less net capital gain. What is “combined qualified business income”? It’s not really income. Instead, it’s a deduction. It’s 20 percent of the taxpayer’s “qualified business income” from each of the taxpayer’s qualified trade or business; limited to the greater of 50 percent of W-2 wages with respect to the business or 25 percent of the W-2 wages with respect to the business, plus 2.5 percent of the unadjusted basis (immediately after acquisition of all qualified property). Plus, 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income.
Definitions. As noted the definition of terms for purpose of the deduction are many. “Qualified property” is defined as tangible property that is subject to I.R.C. §167 depreciation. Likewise, “qualified business income” is the taxpayer’s ordinary income (less ordinary deductions) from the taxpayer’s non-C corporate business. Not included are any wages earned as an employee. Thus, for independent contractors, self-employment income is QBI that is potentially eligible for the 20 percent deduction. Conversely, for employees, wages earned are not eligible for the 20 percent deduction. Also, the definition of QBI does not include short or long-term capital gain or loss, dividend income or interest income. In addition, QBI does not include any wages or guaranteed payments received from a flow-through business, and any income that is not “effectively connected with the conduct of a U.S. trade or business.”
QBI might also include rental income. Clearly, the QBI must be earned in a “qualified trade or business.” But, what definition is going to be used to determine “trade or business”? My guess is it will be the I.R.C. §162 definition. If so, certain rental activities may not meet the definition, such as a triple-net lease where the owner has practically no regular involvement. Also, not satisfying the test would be cash rentals and non-material participation crop-share or livestock-share leases.
As noted above, the formula applies a W-2 wage limitation to pass-through businesses and sole proprietorships. However, the limitation does not apply to taxpayers below $315,000 (MFJ) – half of that for all other filers. Once taxable income exceeds the threshold, the W-2 limitations are phased-in over the next $100,000 of taxable income (MFJ) - $50,000 for all other taxpayers. But, what are W-2 wages? They must be wages subject to withholding. So, by definition, that excludes payments a business makes to an independent contractor, management fees that are paid, and ag wages paid in-kind.
However, wages paid to children under age 18 by parents count as qualified wages. How so? I.R.C. Sec. 199A(b)(4)(A) references I.R.C. Sec. 6501(a) for the definition of W-2 wages. In particular, I.R.C. Sec. 6051(a)(3) specifies that the total wages are defined in I.R.C. Sec. 3401(a) which is the definition of wages for withholding purposes. The I.R.C. §3401(a) definition comprises all wages, including wages paid in a medium other than cash, except wages paid for agricultural labor unless the wages are for payroll tax purposes under I.R.C. §3401(a)(2). Wages paid to children under age 18 by their parents are not included as an exception in IRC §3401(a). Such wages are subject to withholding but are often exempt because the amount is less than the standard deduction. However, under IRC §3401(a)(2), commodity wages are not included because they are not “wages” under IRC §3121(a). Therefore, wages paid to children under age 18 by their parents count as wages for QBI purposes, but agricultural wages paid in-kind do not.
In addition, the wages must be paid for amounts that are properly allocable to producing QBI.
Net Operating Losses. As for net operating losses (NOLs), if a taxpayer claims the QBI deduction in the same year as an NOL, the deduction does not add to the NOL.
Agricultural and horticultural cooperatives. One issue that Senators Thune (R-SD) and Hoeven (R-ND) (among others) are presently working on is a technical correction that would balance out how the QBI deduction works with respect to agricultural products sold to a cooperative by a patron and those sold to a non-cooperative. A cooperative is eligible for the QBI deduction in accordance with a formula (of course). That is not in controversy. A cooperative’s deduction is 20 percent of the cooperative’s excess gross income over qualified cooperative dividends, or the greater of 50 percent of the cooperative’s W-2 wages, or the sum of 25 percent of the cooperative’s W-2 wages relating to the cooperative’s business plus 2.5 percent of the unadjusted basis immediately after acquisition of the cooperative’s qualified property. The deduction is then limited to the cooperative’s taxable income for the tax year.
What is controversial is that the QBI deduction is essentially 20 percent of taxable income (less capital gains) in the hands of a taxpayer that is a patron of a cooperative that sells to the cooperative. For a taxpayer in the 35 percent bracket, the deduction would reduce the effective rate by seven percentage points. However, for a taxpayer that doesn’t sell the ag products to a cooperative (say, for example) to a private elevator, the deduction is 20 percent of net farm income. That will often result in a lower deduction, but whether a sale should be made to a cooperative or a non-cooperative will depend on various economic factors as well as the tax factors.
The discrepancy could cause some farm landlords to switch from a cash lease to a crop-share lease if doing so will allow the landlord to claim the QBI deduction. Sales to a non-cooperative require that the taxpayer be engaged in a “trade or business” to qualify for the deduction. That means that a cash rent landlord will not qualify for the deduction. On the other hand, sales to a cooperative do not require the existence of a trade or business. Thus, the tenant under a cash lease gets the entire deduction. The landlord under a crop-share lease would be entitled to the landlord’s share.
Form 4797 and the QBI Deduction
Even though the new tax bill bars personal property trades, farmers will undoubtedly continue “trading” equipment. The “trade-in” value will be listed as the “selling price” of the “traded” equipment. A key question is whether the gain reported on Form 4797 will be QBI. As noted, the QBI deduction does not apply to capital gain income. I.R.C. §199A refers to “capital gain.” It does not refer to “gain on capital assets.” Thus, income taxed as “capital gain,” even though it is from an I.R.C. §1231 asset, is included in the definition of “capital gain” that is not eligible for the QBI deduction.
Form 4797 separates out the I.R.C. §1231 gain, the ordinary income and the gain attributable to recapture from sales or exchanges of business property. Specifically, Form 4797 Part I property is includible as LTCG property (taxed at a favorable rate), and is not QBI. Form 4797 Part II property is not considered STCG property, which is specifically excluded from the calculation. Gain or loss reported on Part II is QBI. The same is true for income reported on Part III of Form 4797.
The Form 4797 issue is not restricted just to personal property trades. It will also arise, for example, with respect to dairy operations. Dairies that are not C corporations, can be eligible for the QBI deduction. However, without careful planning, the deduction could be of limited value. Dairies typically have two sources of income – Schedule F income from milk sales (which is likely minimal due to offsetting expenses); and Form 4797 where sales of culled dairy cows are reported. The gain attributable to the dairy cow sales is not eligible for the QBI deduction.
I will get into more of the QBI-related issues at the law school’s January 24 seminar/webinar. Our first one on January 10 sold-out, and available spots for the January 24 event are filling up fast. Information on registration is available here: http://washburnlaw.edu/employers/cle/taxlandscape2.html.
By the time we get to January 24, there may be additional developments concerning the QBI deduction, especially with respect to its application to cooperatives and patrons. In addition, Paul Neiffer and I will delve deeply into these issues at our summer seminar in Shippensburg, PA on June 7-8. Plan now to attend. Be watching http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/index.html for information concerning the seminar in the next few days. If you would like to be put on a list to be notified of the June seminar, please send an email to firstname.lastname@example.org.
Thursday, January 11, 2018
The Fourth Amendment protects against illegal searches and seizures. In general, government officials must secure a search warrant based on probable cause before searching an area unless the owner gives consent. However, the Fourth Amendment’s protection accorded to “persons, houses, papers and effects,” does not extend to all open areas contiguous to a person’s home, but rather only to the home itself and its surrounding curtilage. Curtilage is generally defined as the land immediately surrounding an individual’s home or dwelling, including any closely associated buildings and structures, but not any “open fields” or buildings or structures that contain separate activities conducted by others. For example, in United States v. Ritchie, 312 Fed. Appx. 885 (9th Cir. 2009), the court held that a trailer used occasionally as a place to sleep while performing farm chores did not constitute a “home” for purposes of establishing a Fourth Amendment protection in the curtilage of the home.
The scope and extent of curtilage is an important issue to farming and ranching operations – much of the business occurs in the “open.” Are those areas subject to warrantless searches? It’s an issue that comes up more than one might think, particularly with respect to possible environmental crimes.
Curtilage and Agriculture
Multi-factor test. The extent of the curtilage is defined with reference to the proximity to the home of the area claimed to be curtilage, whether the area is included within an enclosure surrounding the home, the nature of the uses to which the area is put, and the steps taken by the resident to protect the area from observation by passersby. These are known as the “Dunn factors” based on United States v. Dunn, 480 U.S. 294 (1987). One key case applying the factors was United States v. Gilman, No. 06-00198 SOM, 2007 U.S. Dist. LEXIS 32524 (D. Haw. May 2, 2007), aff’d, sub nom., United States v. Terragna, 390 Fed. Appx. 631 (9th Cir. 2010), cert. den., Terragna v. United States, 562 U.S. 1191 (2011). In this case, which turned the typical curtilage analysis on its head, the court held that all evidence that was seized from a shed was to be suppressed because the shed was not within the curtilage of the residence for which a search warrant had been issued. The court reasoned that the home and shed were not enclosed by a fence or natural boundary, and there was no evidence that the shed was used for illegal activities. In addition, the court noted that the defendant took no steps to prevent the observation of the shed from passersby.
Another instructive case applying the Dunn factors is Wilson v. Florida, 952 So. 2d 564 (Fla. Ct. App. 2007). In that case, a warrantless search was allowed of a greenhouse that was not within the curtilage of the defendant’s home. The greenhouse was used to manufacture controlled substances. It was not locked and was made of semitransparent materials. The court determined that there was no reasonable expectation of privacy with respect to the greenhouse to which the protection against an illegal search and seizure extended.
The “open fields doctrine.” Obviously, a great deal of farming and ranching activities occurs in the “open” and the courts have held that, under the “open fields doctrine,” that government officials can make warrantless searches of such areas. Here’s a sample of some of the more prominent cases involving the doctrine:
- In United States v. Kirkwood, No. CR11-5488RBL, 2012 U.S. Dist. LEXIS 65214 (W.D. Wash. May 9, 2012), an open clearing near a rural home that separated the home and outbuildings from a wooded area functioned as curtilage. The court determined that the area was suitable for activities associated with the home and the use of the area associated with the home.
- In Westfall v. State, 10 S.W.3d 85 (Tex. Ct. App. 1999), a sheriff entered a pasture without a warrant. The sheriff seized cattle and charged the owner with cruelty to animals. The warrantless search was challenged, but was upheld under the open fields doctrine.
- In Trimble v. State, 842 N.E.2d 798 (Ind. 2006), the court upheld a conviction for cruelty to a dog even though the police did not have a search warrant to search the defendant’s home. While the dog house was within the curtilage of the home, the court determined that the defendant had no expectation of privacy because the dog was visible from the route any visitors to the property would be expected to use.
- In Hill v. Commonwealth, 47 Va. App. 442, 624 S.E.2d 666 (2006), the court upheld convictions for violations of the Virginia Food Act even though an administrative inspection of the defendant’s goat cheese manufacturing facility was conducted without a search warrant. The court determined that the state had a significant interest in protecting public health and that even though the facility was located within the curtilage of the defendant’s home, it was subject to search because it was functioning as commercial property.
- In United States v. Boyster, 436 F.3d 986 (8th Cir. 2006), open fields were found not to be within the curtilage of the defendant’s home. The fields were within the plain view of an aerial flyover and were 100 yards from the defendant’s residence and not enclosed by a fence and no other precautions had been taken to keep the growing marijuana from being visible by others. Thus, the fields were not protected by the Fourth Amendment.
- In State v. Nance, 149 N.C. App. 734, 562 S.E.2d 557 (N.C. Ct. App. 2002), a warrantless search was upheld under the open fields doctrine, where the animals observed were in plain view from the nearby road. However, the court noted that the seizure of items in plain view may require a warrant absent exigent circumstances.
The scope of curtilage in an ag setting was recently before another court – this time the Ohio Court of Appeals. In State v. Powell, No. 27580, 2017 Ohio App. LEXIS 5096 (Ohio Ct. App. Nov. 22, 2017), the defendant was charged with seven counts of cruelty to animals. A humane agent for the local Humane Society testified that she was constantly getting complaints, both from the public, next door neighbors, news and also from the County Sherriff’s Office regarding the defendant’s horse not being fed and a pig being stuck. The agent testified that she responded to the area based upon only seeing two of the three horses she knew were normally on the property. The agent also testified that she heard the pigs squealing and followed the sound of animal distress, a sound which she recognized through her experiences as a humane agent. She stated that she first observed the pigs on January 3, 2017. At this time, they were standing in “liquid mud” and she smelled “fecal and urine ammonia” coming from the pen. Fecal and urine ammonia is toxic to pigs. She further stated that pigs were at risk of hypothermia due to the cold weather. The agent spoke with the defendants concerning the condition of the pig pen and the fact that it needed to be remedied along with the pigs’ food and water. The humane agent stated that she and the defendants agreed on a timetable for these items to be remedied. The defendants stated that they would work on it through the week remedy the situation in a timely manner, and that the pigs would be provided food and water. The humane agent testified that when she returned to the property the next day, the pigs were in the same condition and the weather was getting colder. Finally, on her third trip to the property, the humane agent stated the pigs lacked food and fresh water, and that they were “actively freezing to death.” The outside temperature had fallen to six degrees, according to the humane agent. The humane agent arranged for the removal of the pigs from the property on January 7, 2017 at around 12:30am.
The defendant filed a motion to suppress the evidence obtained by the humane agent as the result of an illegal warrantless search of the curtilage surrounding their home. The trial court sustained the defendant’s motion to suppress and the state appealed. On appeal, the appellate court reversed. The appellate court noted that while curtilage is considered to be part of a defendant’s home and, as such, is entitled to Fourth Amendment protection, the agent’s testimony revealed that the home on the property was uninhabitable due to a collapsed roof and no windows. In addition, the evidence showed that the pig pen was 100 yards from the vacant home, and the pig pen was not in an enclosure surrounding the vacant home. There also was no evidence that steps had been taken to protect the area from observation from the adjacent lane, such as the erection of a privacy fence, locked gates or “No Trespassing” signs. Thus, the court concluded that the pig pen was not within the defendant’s residence or its curtilage, and that the defendant’s observation of the pigs was not a “search” for purposes of the Fourth Amendment. Accordingly, the trial court’s judgment was reversed and the matter remanded for further proceedings.
Warrantless searches can be an important issue for farmers and ranchers, particularly with respect to the possibility of inadvertent violations of the criminal provisions of environmental laws. It’s helpful to know when a search warrant is required.
Tuesday, January 9, 2018
In response to attempts by activist groups opposed to animal agriculture, legislatures in several states have enacted laws designed to protect specified livestock facilities from certain types of interference. Some of the laws have been challenged on free speech and equal protection grounds with a few courts issuing opinions that have largely found the laws constitutional suspect. However, last week’s opinion by the U.S. Court of Appeals for the Ninth Circuit construing the Idaho provision provides a roadmap for lawmakers to follow when crafting similar statutes to protect livestock facilities that will survive constitutional scrutiny.
I asked my research assistant, Washburn law student Melissa Miller, to dig into the Ninth Circuit’s opinion for me so that I could wrap her insight from that case into a broader piece for today’s post. Today’s post includes some of her thoughts.
General Statutory Construct
The basic idea of state legislatures that have attempted to provide a level of protection to livestock facilities is to bar access to an animal production facility under false pretenses. At their core, the laws attempt to prohibit a person having the intent to harm a livestock production facility from gaining access to the facility (such as via employment) to then commit illegal acts on the premises. See, e.g., Iowa Code §717A.3A. (a legal challenge to the Iowa law was filed in late 2017). Laws that bar lying and trespass coupled with the intent to do physical harm to an animal production facility likely are not constitutionally deficient. Laws that go beyond those confines may be.
Recent Court Opinions
Recently, a challenge to the North Carolina statutory provision was dismissed for lack of standing. The plaintiffs in the case, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a North Carolina employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act unconstitutionally stifled their ability to investigate North Carolina employers for illegal or unethical conduct and restricted the flow of information those investigations provide. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
The Utah law, however, was deemed unconstitutional. At issue was Utah Code §76-6-112 (Act) which criminalizes the entering of a private agricultural livestock facility under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility. Anti-livestock activist groups sued on behalf of the citizen-activist claiming that the Act amounted to an unconstitutional restriction on speech in violation of the First Amendment. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist.” For those reasons, the court determined that the Act was unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017).
A Wyoming law experienced a similar fate. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" included numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection of resource data. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016).
The Idaho Statute and the Courts
In 2012, an animal rights activist went undercover to get a job at an Idaho dairy farm then secretly filmed ongoing animal abuse there. The video was then given to Mercy for Animals, an animal rights group, that publicly released portions of the video, drawing national attention. The dairy farm owner responded to the video by firing the employees who were caught on camera, instituting operational protocols, and conducting an animal welfare audit at the farm. Following the release of the video, the Idaho Legislature responded by enacting the Interference with Agricultural Production Law, Idaho Code § 18-7042. The legislation broadly criminalizes making misrepresentations to access an agricultural production facility as well as making audio and video recordings of the facility without the owner’s consent. Specifically, Idaho Code Sec. 18-7042(1)(d)) criminalizes "interference with agricultural production" when a person knowingly enters an ag production facility without permission or without a court order or without otherwise having the right to do so by statute (in other words, the person is on the premises illegally), and makes a video or audio recording of how the ag operation is conducted.
In March of 2014, The Animal League Defense Fund (ALDF) sued challenging the constitutionality of the law. The complaint alleged that the purpose and effect of the statute “are to stifle political debate about modern agriculture by criminalizing all employment-based undercover investigations and criminalizing investigative journalism, whistleblowing by employees, or other expository efforts that entail images or sounds” in violation of the First and Fourteenth Amendments. The district court determined that four subsections of the statute—§18-7042(1)(a)-(d)—were unconstitutional on First Amendment and Equal Protection Grounds.
On appeal, the Ninth Circuit partially reversed parts of the trial court’s ruling, thereby upholding parts of the law. Animal Legal Defense Fund v. Wasden, No. 15-35960, 2018 U.S. App. LEXIS 241 (9th Cir. Jan. 4, 2018). The appellate court analyzed the statute, subsection-by-subsection.
Subsection (a). Subsection (a) criminalizes entry into an agricultural production facility “by force, threat, misrepresentation or trespass.” The ALDF challenged only the misrepresentation prong of this subsection as unconstitutional and the appellate court agreed that it was unconstitutional, affirming the trial court. The appellate court determined that, unlike lying to obtain records or gain employment (which are associated with a material benefit to the speaker), lying to gain entry merely allowed the speaker to cross the threshold of another’s property, including property that is generally open to the public. Thus, the appellate court determined that the provision was overbroad and could potentially criminalize behavior that, by itself, was innocent, and was targeted at speech and investigative journalists. The court stated that it saw no reason why the state could not narrow the subsection by requiring specific intent or by limiting criminal liability to statements that cause particular harm. The court also held that an easy solution to the First Amendment issue would be to simply strike the word “misrepresentation.”
Subsection (b). Subsection (b) criminalizes obtaining records of an agricultural production facility by misrepresentation. Unlike the trial court, the appellate court upheld this subsection on the basis that it protects against a legally cognizable harm associated with a false statement. The court determined that unlike false statements made to enter property, false statements made to actually acquire agricultural production facility records inflict a property harm upon the owner, and may also bestow a material gain on the acquirer.
Subsection (c). The appellate court also reversed the trial court’s finding of unconstitutionality with respect to subsection (c). This subsection criminalizes knowingly obtaining employment with an agricultural production facility by misrepresentation with the intent to cause economic or other injury to the facility’s operations, property or personnel. The appellate court determined that subsection (c) properly followed U.S. Supreme Court guidance as to what constitutes a lie made for material gain. This was particularly the case, the appellate court noted, because subsection (c) limits criminal liability to only those who gain employment by misrepresentation and who have the intent to cause economic or other injury which further limits the scope of the subsection.
Subsection (d). This subsection bars a person from entering a private agricultural production facility and, without express consent from the facility owner, making audio or video recordings of the “conduct of an agricultural production facility’s operations.” The appellate court determined that because the recording process is itself expressive and is inextricably intertwined with the resulting recording, the creation of audiovisual recordings is speech entitled to First Amendment protection as purely expressive activity. In addition, the appellate court concluded that the subsection was both under-inclusive and over-inclusive. It was under-inclusive by prohibiting audio or video recordings but saying nothing about photographs. It was over-inclusive and suppressed more speech than necessary to further Idaho’s stated goals of protecting property and privacy. Accordingly, the appellate court agreed with the trial court that subsection (d) was unconstitutionally defective.
The Ninth Circuit’s opinion provides a roadmap for state lawmakers to follow to provide at least a minimal level of protection to animal production facilities from those that would intend to do them economic harm. Barring entry to a facility by force, threat or trespass is allowed. Likewise, the acquisition of economic data by misrepresentation can be prohibited. Similarly, criminalizing the obtaining of employment by false pretenses coupled with the intent to cause harm to the animal production facility is not constitutionally deficient. However, provisions that criminalize audiovisual recordings likely will not stand. That conclusion shouldn’t trouble animal production facilities – if they are operating properly there is nothing to hide.
Friday, January 5, 2018
This week we are looking at the biggest developments in agricultural law and taxation for 2017. On Monday, I discussed those developments that were important but just not quite significant enough based on their national significance to make the top ten. On Wednesday I addressed developments 10 through 6. Today I discuss the top five developments of 2017 – the really big ones. These are the developments that I deem to be of the highest importance on a national scale to agricultural producers, agribusiness and rural landowners in general.
Today’s blog post – the top five developments in agricultural law and taxation in 2017.
- 5 – Federal Implied Reserved Water Rights Doctrine Applies to Groundwater. Water issues are big in the West, and the Federal Government owns about 28 percent of the land area of the United States, with approximately 50 percent of that amount concentrated in 11 Western states (excluding Alaska). Across the West, most water rights are granted under and governed by state law. Federal law touching on water rights has generally deferred to state law for over 140 years, and the federal government waives its sovereign immunity from state court proceedings involving water rights. However, the U.S. Supreme Court has long recognized that Native American tribes can be entitled to water rights under federal law, rights that supersede many of these state rights. These federal implied rights are based upon the belief that the United States, when establishing Indian reservations, “intended to deal fairly with the Indians by reserving for them the waters without which their lands would have been useless.” But, the federal government’s water rights are not limited to its trustee capacity for Native American Tribes, but also apply to national monuments, national forests, and other public lands. In 2017, the U.S. Court of Appeals for the Ninth Circuit became the first federal appellate case to reach a decision on this issue, and its reasoning follows multiple state court decisions across the West. The court first held that the United States clearly intended to reserve water under federal law when it created the Tribe’s reservation. The court noted that the underlying purpose of the reservation was to establish a tribal homeland supporting an agrarian society. That purpose would be entirely defeated, the court reasoned, without sufficient water supplies held under federal law. Thus, the Tribe was entitled to a reserved water right for the Agua Caliente Reservation. Next, the Ninth Circuit held that the Tribe’s reserved water right extended to groundwater. It was necessary for the Tribe to access groundwater in the Coachella Valley Basin because surface supplies were clearly inadequate—a reservation without an adequate supply of surface water must be able to access groundwater as well. Thus, the court held that the reservation and establishment of the Agua Caliente Reservation carried with it an implied federal reserved right to use water from the aquifer. The court also determined that the Tribe’s implied reserved water rights pre-empted state water rights, and the Tribe’s lack of groundwater pumping did not defeat those rights, because they are immune from abandonment. The court also determined that the proper inquiry was whether water was envisioned as necessary for the reservation’s purpose at the time the reservation was created. Thus, the Ninth Circuit held, the issue of the Tribe’s state law-based water rights did not affect the existence of its federal implied reserved water right. That right, the court held, always applies as a matter of federal pre-emption, regardless of how a state allocates groundwater rights. The court’s opinion is significant because groundwater has become the dominant supply of water across the West. The decision also has important implications for California, the number one agricultural state in the nation (in terms of cash receipts), which enacted the Sustainable Groundwater Management Act (SGMA) in 2014. Because the Ninth Circuit’s decision establishes strong (and largely non-negotiable) rights for tribes within California’s groundwater basins, it complicates the formidable task of achieving sustainable groundwater management. Across the West, the other implications of the decision likely depend upon what remains of basin-wide adjudications of water rights.
Note: On November 27, 2017, the U.S. Supreme Court denied certiorari in the first phase of the case, allowing the Ninth Circuit’s holding to stand. Coachella Valley Water District v. Agua Caliente Band of Cahuilla Indians, No. 17-40, Vide No. 17-42, 2017 U.S. LEXIS 7044 (U.S. Sup. Ct. Nov. 27, 2017).
- 4 - EPA Rule Exempting Farms From Air Release Reporting Vacated.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. In 2008, the EPA issued a final regulation exempting large (commercial) farms (those that emit more than 100 pounds total of hydrogen sulfide or ammonia daily) from the CERCLA reporting/notification requirement for air releases from animal waste (by issuing an annual report of “continuous releases”) on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for Confined Animal Feeding Operations (CAFOs) under EPCRAs public disclosure rule. Indeed, 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. 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. 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. Later, the court, granted a motion filed by the EPA and ag groups to delay the removal of the exemption until November 14, 2017. The EPA’s interim guidance on the new reporting requirements was issued on October 26, 2017, but the EPA again motioned for an extension of time to fully implement the regulations. The court granted the motion on November 22, 2017, staying the implementation of the new reporting regulations until January 22, 2018. 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. The reporting 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. The underlying action is Waterkeeper Alliance, et al. v. Environmental Protection Agency, 853 F.3d 527 (D.C. Cir. 2017).
- 3 – Clean Water Act “WOTUS” Developments. In 2015, the Environmental Protection Agency (EPA) and the U.S. Army Corps of Engineers (COE) finalized a regulation (known as the “Clean Water Rule”) concerning “waters of the United States” (WOTUS) which expanded the parameters of waters (streams, rivers, ponds, ditches, puddles and other water bodies) that are subject to federal jurisdiction and regulation. The final regulation became effective in the late summer of 2015, but a federal court stayed its implementation later that year in October. In early 2016, the U.S. Court of Appeals for the Sixth Circuit held that federal law placed jurisdiction with the federal appellate courts rather than the federal district courts concerning any challenges to the WOTUS rule. In January of 2017, the U.S. Supreme Court agreed to review the Sixth Circuit’s decision. National Association of Manufacturers v. Department of Defense, et al., 137 S. Ct. 811 (2017). About a month later, President Trump issued an Executive Order directing the EPA and the COE to revisit the Clean Water Rule and change their interpretation of waters subject to federal jurisdiction such that it only applied to waters that were truly navigable – the approach taken by Justice Scalia in Rapanos v. United States, 547 U.S. 715 (2006). The EPA and Corps later indicated they would follow the President’s suggested approach, and would push the effective date of the revised Clean Water Rule to two years after its finalization and publication.
In addition, there were several important WOTUS cases decided/finalized in 2017:
- COE jurisdictional determination is final agency action; no WOTUS present. The plaintiff, a peat moss mining company, sought the approval of the Corps of Engineers (COE) to harvest a swamp (wetland) for peat moss to use in landscaping projects. The COE issued a jurisdictional determination that the swamp was a wetland subject to the permit requirements of the Clean Water Act (CWA). The plaintiff sought to challenge the COE determination, but the trial court ruled for the COE, holding that the plaintiff had three options: (1) abandon the project; (2) seek a federal permit costing over $270,000; or (3) proceed with the project and risk fines of up to $75,000 daily and/or criminal sanctions including imprisonment. On further review, the U.S. Supreme Court unanimously reversed, holding that COE Jurisdictional Determinations constitute final agency actions that are immediately appealable in court. The court noted that to hold elsewise would allow the COE to effectively kill the project without any determination of whether it's position as to jurisdiction over the wetland at issue was correct. Not only did the jurisdictional determination constitute final agency action under the Administrative Procedure Act, the court held that it also determined rights or obligations from which legal consequences would flow. That made the determination judicially reviewable. United States Army Corps of Engineers v. Hawkes Company, No. 15-290, 136 S. Ct. 1807 (2016). On remand, the trial court granted summary judgment for the plaintiff on the grounds that the plaintiff’s property did not constitute “waters of the United States” that the defendant had jurisdiction over. The court determined that the government did not establish a “significant nexus” under the Rapanos standard between the plaintiff’s property and the Red River 93 miles away that the defendant claimed were connected via ditches and seasonal tributaries. The court also determined that the Jurisdictional Determination was not based on the “significant nexus” standard of Rapanos and was arbitrary and capricious. The court entered an injunction that ordered the defendant to not assert jurisdiction over the plaintiff’s property. In doing so, the court determined that the defendant had an adequate chance to develop a record which negated a remand back to the defendant to address the evidentiary inadequacies. Hawkes Co., Inc., et al. v. United States Army Corps of Engineers, No. 13-107 ADM/TNL, 2017 U.S. Dist. LEXIS 10680 (D. Min. Jan. 24, 2017).
- Prior Converted Cropland Exception to CWA Jurisdiction Inapplicable.The plaintiff, a developer, obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995. The defendant claimed federal jurisdiction over water on a portion of the property on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S. After exhausting administrative appeals, the court upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. The court also determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned. The court noted that the defendant and the EPA had jointly adopted a rule in 1993 adopting the NRCS exemption for prior converted cropland. The court also that prior caselaw had held that the CWA’s exemption of “prior converted croplands” included the abandonment provision, and that it would apply the same rationale in this case. The court noted that the specific 13-acre parcel at issue in the case had not been farmed since 1996, and that conversion to a non-ag use did not remove the abandonment provision. The plaintiff also claimed that the wetlands at issue were “artificial” wetlands (created by adjacent development) under 7 C.F.R. §12.2(a) that were not subject to the defendant’s jurisdiction. However, the court noted that the defendant never adopted the “artificial wetland” exemption of the NRCS and, therefore, such a classification was inapplicable. The court granted the defendant’s cross motion for summary judgment. Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017).
- Conviction Upheld for Clean Water Act Violations.The defendant, a disabled Vietnam Navy veteran, was charged with multiple counts of criminal violations of the (CWA) by virtue of the unauthorized knowing discharge of “pollutants” into the “waters of the United States” (WOTUS) (in violation of 33 U.S.C. §1251-1388) and depredation of U.S. property (18 U.S.C. §1361). The defendant was indicted for building illegal ponds (nine in total) in an existing stream on two parcels - one federal and one private (which the defendant did not own). The defendant did the work due to multiple fires in the area that had recently occurred and to create stock water ponds for his animals. The government claimed that the ponds resulted in the discharge of dredged and fill material into a tributary stream and adjacent wetlands and damaged both properties, even though there was no tributary from the ponds. Dredged material from the ponds had been used to create the berms and had been placed in and around the streams and wetlands. The trial court determined that the stream at issue was a WOTUS on the basis that the stream headwater and wetland complex provided critical support to trout in downstream rivers and fisheries, including the Boulder and Jefferson Rivers (60 miles away) – navigable waters of the U.S. The trial court jury, after a second trial and the introduction by the government of evidence that it allegedly manufactured, found the defendant guilty of two counts of illegal discharge of pollutants into WOTUS without a federal permit and one count of injury or depredation of U.S. property. On appeal, the appellate court affirmed. The appellate court held that U.S. Supreme Court Justice Kennedy’s opinion in Rapanos v. United States, 547 U.S. 715 (2006) was controlling and that the trial court jury instructions based on Justice Kennedy’s “significant nexus test contained in his opinion in Rapanos were proper. The appellate court also held that the definition of WOTUS was not too vague to be enforced. Thus, there was no due process violation. The defendant had fair warning that his conduct was criminal. United States v. Robertson, 875 F.3d 1281 (9th Cir. 2017).
- 2 – Rental and Employment Agreements Appropriately Structured; No Self-Employment Tax on Rental Income.The petitioners, a married couple, operated a farm in Texas. In late 1999, they built the first of eight poultry houses to raise broilers under a production contract with a large poultry integrator. The petitioners formed an S corporation in 2004, and set up oral employment agreements with the S corporation based on an appraisal for the farm which guided them as to the cost of their labor and management services. They also pegged their salaries at levels consistent with other growers. The wife provided bookkeeping services and the husband provided labor and management. In 2005, they assigned the balance of their contract to the S corporation. Thus, the corporation became the "grower" under the contract. In 2005, the petitioners entered into a lease agreement with the S corporation. Under the agreement, the petitioners rented their farm to the S corporation, under which the S corporation would pay rent of $1.3 million to the petitioners over a five-year period. The court noted that the rent amount was consistent with other growers under contract with the integrator. The petitioners reported rental income of $259,000 and $271,000 for 2008 and 2009 respectively, and the IRS determined that the amounts were subject to self-employment tax because the petitioners were engaged in an "arrangement" that required their material participation in the production of agricultural commodities on their farm. The Tax Court, in an opinion by Judge Paris, noted that the IRS agreed that the facts of the case were on all fours with McNamara v. Comr., T.C. Memo. 1999-333 where the Tax Court determined that the rental arrangement and the wife's employment were to be combined, which meant that the rental income was subject to self-employment tax. However, the Tax Court's decision in that case was reversed by the Eighth Circuit on appeal. McNamara v. Comr., 236 F.3d 410 (8th Cir. 2000). Judge Paris, in the current case, determined that the Eighth Circuit's rationale in McNamara was persuasive and that the "derived under an arrangement" language in I.R.C. §1402(a)(1) meant that a nexus had to be present between the rents the petitioners received and the "arrangement" that required their material participation. In other words, there must be a tie between the real property lease agreement and the employment agreement. The court noted the petitioners received rent payments that were consistent with the integrator's other growers for the use of similar premises. That fact was sufficient to establish that the rental agreement stood on its own as an appropriate measure as a return on the petitioners' investment in their facilities. Similarly, the employment agreement was appropriately structured as a part of the petitioners' conduct of a legitimate business. Importantly, the court noted that the IRS failed to brief the nexus issue, relying solely on its non-acquiescence to McNamara (A.O.D. 2003-003, I.R.B. 2003-42 (Oct. 22, 2003)) and relying on the court to broadly interpret "arrangement" to include all contracts related to the S corporation. The Tax Court refused to do so and, accordingly, the court held that the petitioner's rental income was not subject to self-employment tax. Martin v. Comr., 149 T.C. No. 12 (2017).
- No 1 – The Tax Bill ("To provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018"). The most significant development of 2017 with the widest impact on agricultural producers, agribusinesses and rural landowners is unquestionably the tax bill enacted into law on December 22, 2017. The new law establishes new tax brackets, essentially doubles the standard deduction, eliminates many itemized deductions, modifies many cost-recovery provisions and changes the corporate tax rate to a flat rate of 21 percent. The legislation also creates a new 20 percent deduction for qualified business income from a pass-through entity. Prior law was also modified concerning cash accounting, the tax rate applicable to commodity gifts made to a non-charitable donee above certain levels of unearned income, the rules surrounding net operating losses, interest deductibility, elimination of the corporate alternative minimum tax (AMT) and modification of the individual AMT, the child tax credit and various international tax provisions. The new law will create many planning questions and opportunities with the structure of perhaps many farm operations being modified to take advantage of the new provisions.
2017 was another active year on the agricultural law and taxation front. It was also the first year in many years where some rather significant federal regulations as applies to agriculture were either rolled back or eliminated. 2018 will be another very busy year. That is certainly to be the case especially on the tax side of things.
Wednesday, January 3, 2018
This week we are looking at the biggest developments in agricultural law and taxation for 2017. On Monday, I discussed those developments that were important but just not quite significant enough based on their national significance to make the top ten. Today I start a two-day series on the top ten developments of 2017 with a discussion of developments 10 through six. On Friday, developments five through one will be covered. To make my list, the development from the courts, IRS and federal agencies must have a major impact nationally on agricultural producers, agribusiness and rural landowners in general.
Without further delay, here we go - the top developments for 2017 (numbers 10 through six).
- 10 – South Dakota Enacts Unconstitutional Tax Legislation. In 2017, the South Dakota Supreme Court gave the South Dakota legislature and Governor what it wanted – a ruling that a recently enacted South Dakota law was unconstitutional. South Dakota’s thirst for additional revenue led it to enact a law imposing sales tax on businesses that have no physical presence in the state. That’s something that the U.S. Supreme Court first said 50 years ago that a state cannot do. Accordingly, the South Dakota Supreme Court struck the law down as an unconstitutional violation of the Commerce Clause. The legislature deliberately enacted the law so that it would be challenged as unconstitutional in order to set up a case in hopes that the U.S. Supreme Court would review it and reverse its longstanding position on the issue. See, e.g., National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967) and Quill Corporation v. North Dakota, 504 U.S. 298 (1992). If that happens, or the Congress takes action to allow states to impose sales (and/or use) tax on businesses with no physical presence in the state, the impact would be largely borne by small businesses, including home-based business and small agricultural businesses all across the country. It would also raise serious questions about how strong the principle of federalism remains. State v. Wayfair, Inc., et al., 901 N.W.2d 754 (S.D. Sup. Ct. 2017), pet. for cert. filed, Oct. 2, 2017.
- 9 - Amendment to Bankruptcy Law Gives Expands Non-Priority Treatment of Governmental Claims. H.R. 2266, signed into law on October 26, 2017, contains the Family Farmer Bankruptcy Act (Act). The Act adds 11 U.S.C. §1232 which specifies that, “Any unsecured claim of a governmental unit against the debtor or the estate that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor's discharge under section 1228, as a result of the sale, transfer, exchange, or other disposition of any property used in the debtor's farming operation”… is to be treated as an unsecured claim that arises before the bankruptcy petition was filed that is not entitled to priority under 11 U.S.C. §507 and is deemed to be provided for under a plan, and discharged in accordance with 11 U.S.C. §1228. The provision amends 11 U.S.C. §1222(a)(2)(A) to effectively override Hall v. United States, 132 Sup. Ct. 1882 (2012) where the U.S. Supreme Court held that tax triggered by the post-petition sale of farm assets was not discharged under 11 U.S.C. §1222(a)(2)(A). The Court held that because a Chapter 12 bankruptcy estate cannot incur taxes by virtue of 11 U.S.C. §1399, taxes were not “incurred by the estate” under 11 U.S.C. §503(b) which barred post-petition taxes from being treated as non-priority. The provision is effective for all pending Chapter 12 cases with unconfirmed plans and all new Chapter 12 cases as of October 26, 2017. H.R. 2266, Division B, Sec. 1005, signed into law on October 26, 2017.
- 8 – “Hobby Loss” Tax Developments. 2017 saw two significant developments concerning farm and ranching activities that the IRS believes are not conducting with a business purpose and are, thus, subject to the limitation on deductibility of losses. Early in 2017, the IRS issued interim guidance on a pilot program for Schedule F expenses for small business/self-employed taxpayer examinations. It set the program to begin on April 1, 2017 and run for one year. The focus will be on “hobby” farmers, and will involve the examination of 50 tax returns from tax year 2015. The program could be an indication that the IRS is looking to increase the audit rate of returns with a Schedule F, and it may be more likely to impact the relatively smaller farming operations. The interim guidance points out that the IRS believes that compliance issues may exist with respect to the deduction of expenses on the wrong form, or expenses that actually belonged to another taxpayer, or that should be subject to the hobby loss rules of I.R.C. §183. Indeed, the IRS notes that a filter for the project will be designed to identify those taxpayers who have W-2s with large income and who also file a Schedule F “and may not have time to farm.” In addition, the guidance informs IRS personnel that the examined returns could have start-up costs or be a hobby activity which would lead to non-deductible losses. The interim guidance also directs examiners to look for deductions that “appear to be excessive for the income reported.” The implication is that such expenses won’t be deemed to be ordinary and necessary business expenses. How that might impact the practice of pre-paying farm expenses remains to be seen. The guidance also instructs examiners to pick through gas, oil, fuel, repairs, etc., to determine the “business and non-business parts” of the expense without any mention of the $2,500 safe harbor of the repair regulations. The interim guidance would appear to be targeted toward taxpayers that either farm or crop share some acres where the income ends up on Schedule F, but where other non-farm sources of income predominate (e.g., W-2 income, income from leases for hunting, bed and breakfast, conservation reserve program payments, organic farming, etc.). In those situations, it is likely that the Schedule F expenses will exceed the Schedule F income. That’s particularly the case when depreciation is claimed on items associated with the “farm” - a small tractor, all-terrain vehicle, pickup truck, etc. That’s the typical hobby loss scenario that IRS is apparently looking for.
The second development on the hobby loss issue was a Tax Court opinion issued by Judge Paris in late 2017. The case involved a diversified ranching operation that, for the tax years at issue, had about $15 million in losses and gross income of $7 million. For those years, the petitioner’s primary expense was depreciation. The IRS claimed that the ranching activity was not engaged in for profit and the expenses were deductible only to the extent of income. The Tax Court determined that all of the petitioner’s activities were economically intertwined and constituted a single ranching activity. On the profit issue, the court determined that none of the factors in the Treasury Regulations §1.183-2(b) favored the IRS. Accordingly, the petitioner’s ranching activity was held to be conducted for-profit and the losses were fully deductible. The court specifically rejected the IRS argument that a profit motive could not be present when millions of dollars of losses were generated. That’s a very important holding for agriculture. Depreciation is often the largest deduction on a farm or ranch operation’s return. Welch, et al. v. Comr., T.C. Memo. 2017-229.
- 7 - Beneficial Use Doctrine Established Water Right That Feds Had Taken. In late 2017, the U.S. Court of Federal Claims issued a very significant opinion involving vested water rights in the Western United States. The court ruled that the federal government had taken the vested water rights of the plaintiff, a New Mexico cattle ranching operation, which required compensation under the Fifth Amendment. The court determined that the plaintiff had property rights by virtue of having “made continuous beneficial use of stock water sources” predating federal ownership. Those water rights pre-dated 1905, and the U.S. Forest Service (USFS) had allowed that usage from 1910 to 1989. The court also agreed with the plaintiff’s claim the water was “physically taken” when the United States Forest Service (USFS) blocked the plaintiff’s livestock from accessing the water that had long been used by the plaintiff and its predecessors to graze cattle so as to preserve endangered species.
More specifically, the plaintiff held all “cattle, water rights, range rights, access rights, and range improvements on the base property, as well as the appurtenant federally-administered grazing allotment known as the Sacramento Allotment” in New Mexico. The plaintiff obtained a permit in 1989 from the USFS to graze cattle on an allotment of USFS land which allowed for the grazing of 553 cows for a 10-year period. At the time the permit was obtained, certain areas of the allotment were fenced off, but the USFS allowed the plaintiff’s cattle access to water inside the fenced areas. However, in 1996, the USFS notified the plaintiff that cattle were not permitted to graze inside the fenced areas, but then later allowed temporary grazing due to existing drought conditions. In 1998, the USFS barred the plaintiff from grazing cattle inside the fenced areas, but then reissued the permit in 1999 allowing 553 cattle to graze the allotment for 10 years subject to cancellation or modification as necessary. The permit also stated that “livestock use” was not permitted inside the fenced area. In 2001, the USFS denied the plaintiff’s request to pipe water from the fenced area for cattle watering and, in 2002, the USFS ordered the plaintiff to remove cattle that were grazing within the fenced area. Again in 2006, the plaintiff sought to pipe water from a part of the fenced area, but was denied. A U.S. Fish and Wildlife Service Biological Opinion in 2004 recommended the permanent exclusion of livestock from the allotment, and the plaintiff sued for a taking of its water rights which required just compensation. While the parties were able to identify and develop some alternative sources of water, that did not solve the plaintiff’s water claims and the plaintiff sued.
The court determined that the plaintiff’s claim was not barred by the six-year statute of limitations because the plaintiff’s claim accrued in 1998 when the USFS took the first “official” action barring the grazing of cattle in the fenced area. The court also determined that under state (NM) law, the right to the beneficial use of water is a property interest that is a distinct and severable interest from the right to use land, with the extent of the right dependent on the beneficial use. The court held that the “federal appropriation of water does not, per se constitute a taking….Instead, a plaintiff must show that any water taken could have been put to beneficial use.” The court noted that NM law recognizes two types of appropriative water rights – common law rights in existence through 1907 and those based on state statutory law from 1907 forward. The plaintiff provided a Declaration of Ownership that had been filed with the New Mexico State Engineer between 1999 and 2003 for each of the areas that had been fenced-in. Those Declarations allow a holder of a pre-1907 water right to specify the use to which the water is applied, the date of first appropriation and where the water is located. Once certified, the Declaration of Ownership is prima facie evidence of ownership. The court also noted that witnesses testified that before 1907, the plaintiff’s predecessor’s in interest grazed cattle on the allotment and made beneficial use of the water in the fenced areas. Thus, the court held that the plaintiff had carried its burden to establish a vested water right. The plaintiff’s livestock watering also constituted a “diversion” required by state law. Thus, the USFS action constituted a taking of the plaintiff’s water right. Importantly, the court noted that a permanent physical occupation does not require in every instance that the occupation be exclusive, or continuous and uninterrupted. The key, the court noted, was that the effects of the government’s action was so complete to deprive the plaintiff of all or most of its interest. The court directed the parties to try to determine whether alternative water sources could be made available to the plaintiff to allow the ranching operation to continue on a viable basis. If not, the court will later determine the value of the water rights taken for just compensation purposes. Sacramento Grazing Association v. United States, No. 04-786 L. 2017 U.S. Claims LEXIS 1381 (Fed. Cl. Nov. 3, 2017).
- 6 – Department of Labor Overtime Rules Struck Down. In 2017, a federal court in Texas invalidated particular Department of Labor (DOL) rules under the Fair Labor Standards Act (FLSA). The invalidation will have a significant impact on agricultural employers. The FLSA exempts certain agricultural employers and employees from its rules. However, one aspect of the FLSA that does apply to agriculture are the wage requirements of the law, both in terms of the minimum wage that must be paid to ag employment and overtime wages. But, an exemption denies persons employed in agriculture the benefit of mandatory overtime payment. 29 U.S.C. § 213(b)(12). The agricultural exemption is broad, defining “agriculture” to include “farming in all its branches [including] the raising of livestock, bees, fur-bearing animals, or poultry,…and the production, cultivation, growing, and harvesting of...horticultural commodities and any practices performed by a farmer or on a farm as an incident to or in conjunction with farming operations.” In addition, exempt are “executive” workers whose primary duties are supervisory and the worker supervises 2 or more employees. Also exempt are workers that fall in the “administrative” category who provide non-manual work related to the management of the business, and workers defined as “professional” whose job is education-based and requires advanced knowledge. Many larger farming and ranching operations have employees that will fit in at least one of these three categories. For ag employees that are exempt from the overtime wage payment rate because they occupy an “executive” position, they must be paid a minimum amount of wages per week.
Until December 1, 2016, the minimum amount was $455/week ($23,660 annually). Under the Obama Administration’s DOL proposal, however, the minimum weekly amount was to increase to $913 ($47,476 annually). Thus, an exempt “executive” employee that is paid a weekly wage exceeding $913 is not entitled to be paid for any hours worked exceeding 40 in a week. But, if the $913 weekly amount was not met, then the employee would generally be entitled to overtime pay for the hours exceeding 40 in a week. Thus, the proposal would require farm businesses to track hours for those employees it historically has not tracked hours for – executive employees such as managers and those performing administrative tasks. But, remember, if the employee is an agricultural worker performing agricultural work, the employee need not be paid for the hours in excess of 40 in a week at the overtime rate. The proposal also imposes harsh penalties for noncompliance. Before the new rules went into effect, many states and private businesses sued to block them. The various lawsuits were consolidated into a single case, and in November of 2016, the court issued a temporary nationwide injunction blocking enforcement of the overtime regulations. Nevada v. United States Department of Labor, 218 F. Supp. 3d 520 (E.D. Tex. 2016).
On Aug. 31, 2017, the court entered summary judgment for the plaintiffs in the case thereby invalidating the regulations. In its ruling, the court focused on the congressional intent behind the overtime exemptions for “white-collar” workers as well as the authority of the DOL to define and implement those exemptions. The court also concluded that the DOL did not have any authority to categorically exclude workers who perform exempt duties based on salary level alone, which is what the court said that the DOL rules did. The court noted that the rules more than doubled the required salary threshold and, as a result, “would essentially make an employee’s duties, functions, or tasks irrelevant if the employee’s salary falls below the new minimum salary level.” The court went on to state that the overtime rules make “overtime status depend predominantly on a minimum salary level, thereby supplanting an analysis of an employee’s job duties.” The court noted that his was contrary to the clear intent of the Congress and, as a result, the rules were invalid. The court’s ruling invalidating the overtime rules is an important victory for many agricultural (and other) businesses. It alleviates an increased burden to maintain records for employees in executive positions (e.g., managers and administrators), and the associated penalties for non-compliance. The case is Nevada v. United States Department of Labor, No. 4:16-cv-731, 2017 U.S. Dist. LEXIS 140522 (E.D. Tex. Aug. 31, 2017).
Those are the "bottom five" of the "top 10" developments of 2017. On Friday I will reveal what I believe to be the top five developments.
Monday, January 1, 2018
This week I will be writing about what I view as the most significant developments in agricultural law and agricultural taxation during 2017. There were many important happenings in the courts, the IRS and with administrative agencies that have an impact on farm and ranch operations, rural landowners and agribusinesses. What I am writing about this week are those developments that will have the biggest impact nationally. Certainly, there were significant state developments, but they typically will not have the national impact of those that result from federal courts, the IRS and federal agencies.
It's tough to get it down to the ten biggest developments of the year, and I do spend considerable time sorting through the cases and rulings get to the final cut. Today’s post examines those developments that I felt were close to the top ten, but didn’t quite make the list. Later this week we will look at those that I feel were worthy of the top ten. Again, the measuring stick is the impact that the development has on the U.S. ag sector as a whole.
Almost, But Not Quite
Those developments that were the last ones on the chopping block before the final “top ten” are always the most difficult to determine. But, as I see it, here they are (in no particular order):
- Withdrawal of Proposed I.R.C. §2704 Regulations. In the fall of 2016, the Treasury Department issued proposed regulations (REG-16113-02) involving valuation issues under I.R.C. §2704. The proposed regulations would have established serious limitations on the ability to establish valuation discounts (e.g., minority interest and lack of marketability) for estate, gift and generation-skipping transfer tax purposes via estate and business planning techniques. In early December of 2016, a public hearing was held concerning the proposed regulations. However, the proposed regulations were not finalized before President Trump took office. In early October of 2017, the Treasury Department announced that it was pulling several tax regulations identified as burdensome under President Trump’s Executive Order 13789, including the proposed I.R.C. §2704 regulations. Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Oct. 4, 2017).
Note: While it is possible that the regulations could be reintroduced in the future with revisions, it is not likely that the present version will ultimately be finalized under the current Administration.
- IRS Says There Is No Exception From Filing a Partnership Return. The IRS Chief Counsel’s Office, in response to a question raised by an IRS Senior Technician Reviewer, has stated that Rev. Prov. 84-35, 1984-2 C.B. 488, does not provide an automatic exemption from the requirement to file Form 1065 (U.S. Return of Partnership Income) for partnerships with 10 or fewer partners. Instead, the IRS noted that such partnerships can be deemed to meet a reasonable cause test and are not liable for the I.R.C. §6698 penalty. IRS explained that I.R.C. §6031 requires partnerships to file Form 1065 each tax year and that failing to file is subject to penalties under I.R.C. §6698 unless the failure to file if due to reasonable cause. Neither I.R.C. §6031 nor I.R.C. §6698 contain an automatic exception to the general filing requirement of I.R.C. §6031(a) for a partnership as defined in I.R.C. §761(a). IRS noted that it cannot determine whether a partnership meets the reasonable cause criteria or qualifies for relief under Rev. Proc. 84-35 unless the partnership files Form 1065 or some other document. Reasonable cause under Rev. Proc. 84-35 is determined on a case-by-case basis and I.R.M. Section 184.108.40.206.3.1 sets forth the procedures for applying the guidance of Rev. Proc. 84-35. C.C.A. 201733013 (Jul. 12, 2017); see also Roger A. McEowen, The Small Partnership 'Exception,' Tax Notes, April 17, 2017, pp. 357-361.
- “Qualified Farmer” Definition Not Satisfied; 100 Percent Deductibility of Conservation Easement Not Allowed. A “qualified farmer” can receive a 100 percent deduction for the contribution of a permanent easement to a qualified organization in accordance with I.R.C. §170(b)(1)(E). However, to be a “qualified farmer,” the taxpayer must have gross income from the trade or business of farming that exceeds 50 percent of total gross income for the tax year. In a 2017, the U.S. Tax Court decided a case where the petitioners claimed that the proceeds from the sale of the property and the proceeds from the sale of the development rights constituted income from the trade or business of farming that got them over the 50 percent threshold. The IRS disagreed, and limited the charitable deduction to 50 percent of each petitioner’s contribution base with respect to the conservation easement. The court agreed with the IRS. The court noted that the income from the sale of the conservation easement and the sale of the land did not meet the definition of income from farming as set forth in I.R.C. §2032A(e)(5) by virtue of I.R.C. §170(b)(1)(E)(v). The court noted that the statute was clear and that neither income from the sale of land nor income from the sale of development rights was included in the list of income from farming. While the court pointed out that there was no question that the petitioners were farmers and continued to be after the conveyance of the easement, they were not “qualified farmers” for purposes of I.R.C. §170(b)(1)(E)(iv)(I). Rutkoske v. Comr., 149 T.C. No. 6 (2017).
- Corporate-Provided Meals In Leased Facility Fully Deductible. While the facts of the case have nothing to do with agriculture, the issues involved are the same ones that the IRS has been aggressively auditing with respect to farming and ranching operations – namely, that the 100 percent deduction for meals provided to corporate employees for the employer’s convenience cannot be achieved if the premises where the meals are provided is not corporate-owned. In a case involving an NHL hockey team, the corporate owner contracted with visiting city hotels where the players stayed while on road trips to provide the players and team personnel pre-game meals. The petitioner deducted the full cost of the meals, and the IRS limited the deduction in accordance with the 50 percent limitation of I.R.C. §274(n)(1). The court noted that the 50 percent limitation is inapplicable if the meals qualify as a de minimis fringe benefit and are provided in a nondiscriminatory manner. The court determined that the nondiscriminatory requirement was satisfied because all of the staff that traveled with the team were entitled to use the meal rooms. The court also determined that the de minimis rule was satisfied if the eating facility (meal rooms) was owned or leased by the petitioner, operated by the petitioner, located on or near the petitioner’s business premises, and the meals were furnished during or immediately before or after the workday. In addition, the court determined that the rules can be satisfied via contract with a third party to operate an eating facility for the petitioner’s employees. As for the business purpose requirement, the court noted that the hotels where the team stayed at while traveling for road games constituted a significant portion of the employees’ responsibilities and where the team conducted a significant portion of its business. Thus, the cost of the meals qualified as a fully deductible de minimis fringe benefit. Jacobs v. Comr., 148 T.C. No. 24 (2017).
Note: The petitioner’s victory in the case was short-lived. The tax bill enacted into law on December 22, 2017, changes the provision allowing 100 percent deductibility of employer-provided meals to 50 percent effective Jan. 1, 2018, through 2025. After 2025, no deduction is allowed.
- Settlement Reached In EPA Data-Gathering CAFO Case. In 2008, the Government Accounting Office (GAO) issued a report stating that the Environmental Protection Agency (EPA) had inconsistent and inaccurate information about confined animal feeding operations (CAFOs), and recommended that EPA compile a national inventory of CAFO’s with NPDES permits. Also, as a result of a settlement reached with environmental activist groups, the EPA agreed to propose a rule requiring all CAFOs to submit information to the EPA as to whether an operation had an NPDES permit. The information required to be submitted had to provide contact information of the owner, the location of the CAFO production area, and whether a permit had been applied for. Upon objection by industry groups, the proposed rule was withdrawn and EPA decided to collect the information from federal, state and local government sources. Subsequent litigation determined that farm groups had standing to challenge the EPA’s conduct and that the EPA action had made it much easier for activist groups to identify and target particular confined animal feeding operations (CAFOs). On March 27, 2017, the court approved a settlement agreement ending the litigation between the parties. Under the terms of the settlement, only the city, county, zip code and permit status of an operation will be released. EPA is also required to conduct training on FOIA, personal information and the Privacy Act. The underlying case is American Farm Bureau Federation v. United States Environmental Protection Agency, 836 F.3d 963 (8th Cir. 2016).
- Developments Involving State Trespass Laws Designed to Protect Livestock Facilities.
- Challenge to North Carolina law dismissed for lack of standing. The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a NC employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act stifled their ability to investigate NC employers for illegal or unethical conduct and restricted the flow of information those investigations provide in violation of the First and Fourteenth Amendments of the U.S. Constitution and various provisions of the NC Constitution. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
- Utah law deemed unconstitutional. Utah law (Code §76-6-112) (hereinafter Act) criminalizes entering private agricultural livestock facilities under false pretenses or via trespass to photograph, audiotape or videotape practices inside the facility. Anti-livestock activist groups sued on behalf of the citizen-activist claiming that the Act amounted to an unconstitutional restriction on speech in violation of the First Amendment. While the state claimed that lying, which the statute regulates, is not protected free speech, the court determined that only lying that causes “legally cognizable harm” falls outside First Amendment protection. The state also argued that the act of recording is not speech that is protected by the First Amendment. However, the court determined that the act of recording is protectable First Amendment speech. The court also concluded that the fact that the speech occurred on a private agricultural facility did not render it outside First Amendment protection. The court determined that both the lying and the recording provisions of the Act were content-based provisions subject to strict scrutiny. To survive strict scrutiny the state had to demonstrate that the restriction furthered a compelling state interest. The court determined that “the state has provided no evidence that animal and employee safety were the actual reasons for enacting the Act, nor that animal and employee safety are endangered by those targeted by the Act, nor that the Act would actually do anything to remedy those dangers to the extent that they exist”. For those reasons, the court determined that the act was unconstitutional. Animal Legal Defense Fund v. Herbert, 263 F. Supp. 3d 1193 (D. Utah 2017).
- Wyoming law struck down. In 2015, two new Wyoming laws went into effect that imposed civil and criminal liability upon any person who "[c]rosses private land to access adjacent or proximate land where he collects resource data." Wyo. Stat. §§6-3-414(c); 40-27-101(c). The appellate court, reversing the trial court, determined that because of the broad definitions provided in the statutes, the phrase "collects resource data" includes numerous activities on public lands (such as writing notes on habitat conditions, photographing wildlife, or taking water samples), so long as an individual also records the location from which the data was collected. Accordingly, the court held that the statutes regulated protected speech under the First Amendment in spite of the fact that they also governed access to private property. While trespassing is not protected by the First Amendment, the court determined that the statutes targeted the “creation” of speech by penalizing the collection or resource data. Western Watersheds Project v. Michael, 869 F.3d 1189 (10th Cir. 2017), rev’g., 196 F. Supp. 3d 1231 (D. Wyo. 2016).
- Challenge to North Carolina law dismissed for lack of standing. The plaintiffs, numerous animal rights activist groups, brought a pre-enforcement challenge to the North Carolina Property Protection Act (Act). The Act creates a civil cause of action for a NC employer against an employee who “captures or removes” documents from the employer’s premises or records images or sound on the employer’s premises and uses the documents or recordings to breach the employee’s duty of loyalty to the employer. The plaintiffs claimed that the Act stifled their ability to investigate NC employers for illegal or unethical conduct and restricted the flow of information those investigations provide in violation of the First and Fourteenth Amendments of the U.S. Constitution and various provisions of the NC Constitution. The court dismissed the case for lack of standing. People for the Ethical Treatment of Animals v. Stein, 259 F. Supp. 3d 369 (M.D. N.C. 2017).
- GIPSA Interim Final Rule on Marketing of Livestock and Poultry Delayed and Withdrawn.In the fall of 2016, the USDA sent to the Office of Management and Budget (OMB) interim final rules that provide the agency’s interpretation of certain aspects of the Packers and Stockyards Act (PSA) involving the buying and selling of livestock and poultry. The interim final rules concern Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) which makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. The “effect” language of the statute would seem to eliminate any requirement that the producer show that the packer acted with the intent to control or manipulate prices. However, the federal courts have largely interpreted the provision to require a plaintiff to show an anti-competitive effect in order to have an actionable claim. Under the proposed regulations, "likelihood of competitive injury" is defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It includes, but is not limited to, situations in which a packer, swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) is stated to depend on the nature and circumstances of the challenged conduct. The proposed regulations specifically note that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations also note that a PSA violation can occur without a finding of harm or likely harm to competition, but as noted above, that is contrary to numerous court opinions that have decided the issue. On April 11, 2017, the USDA announced that it was delaying the effective date of the interim final rule for 180 days, until October 19, 2017. However, on October 18, 2017, GIPSA officially withdrew the proposed rule. Related to, but not part of, the GIPSA Interim Final Rule, a poultry grower ranking system proposed rule was not formally withdrawn.
- Syngenta Settlement. In late 2017, Syngenta publicly announced that it was settling farmers’ claims surrounding the alleged early release of Viptera and Duracade genetically modified corn. While there are numerous cases and aspects of the litigation involving Syngenta, the settlement involves what is known as the “MIR 162 Corn Litigation” and a Minnesota state court class action. The public announcement of the settlement indicated that Syngenta would pay $1.5 billion.
- IRS To Finalize Regulations on the Tax Status of LLC and LLP Members. In its 2017-2018 Priority Guidance Plan, the IRS states that it plans to finalize regulations under I.R.C. §469(h)(2) – the passive loss rules that were initially proposes in 2011. That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations. Those regulations were initially issued in temporary form and became proposed regulations in 2011. Is the IRS preparing to take a move to finalize regulations taking the position that they the Tax Court refused to sanction? Only time will tell, but the issue is important for LLC and LLP members. The issue boils down to the particular provisions of a state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership. That will be the case until IRS issues regulations dealing specifically with LLCs and similar entities. The proposed definition would make it easier for LLC members and some limited partners to satisfy the material participation requirements for passive loss purposes, consistent with the court opinions that IRS has recently lost on the issue. Specifically, the proposed regulations require that two conditions have to be satisfied for an individual to be classified as a limited partner under I.R.C. §469(h)(2): (1) the entity must be classified as a partnership for federal income tax purposes; and (2) the holder of the interest must not have management rights at any time during the entity’s tax year under local law and the entity’s governing agreement. Thus, LLC members of member-managed LLCs would be able to use all seven of the material participation tests, as would limited partners that have at least some rights to participate in managerial control or management of a partnership.
- Fourth Circuit Develops New Test for Joint Employment Under the FLSA. The Fair Labor Standards Act of 1938 (FLSA) (29 U.S.C. §§ 201 et seq.) as originally enacted, was intended to raise the wages and shorten the working hours of the nation's workers. The FLSA is very complex, and not all of it is pertinent to agriculture and agricultural processing, but the aspect of it that concerns “joint employment” is of major relevance to agriculture. Most courts that have considered the issue have utilized an “economic realities” or “control” test to determine if one company’s workers are attributable to another employer for purposes of the FLSA. But, in a 2017 case, the U.S. Court of Appeals for the Fourth Circuit, created a new test for joint employment under the FLSA that appears to expand the definition of “joint employment” and may create a split of authority in the Circuit Courts of Appeal on the issue. The court held that the test under the FLSA for joint employment involved two steps. The first step involved a determination as to whether two or more persons or entities share or agree to allocate responsibility for, whether formally or informally, directly or indirectly, the essential terms and conditions of a worker’s employment. The second step involves a determination of whether the combined influence of the parties over the essential terms and conditions of the employment made the worker an employee rather than an independent contractor. If, under this standard, the multiple employers were not completely disassociated, a joint employment situation existed. The court also said that it was immaterial that the subcontractor and general contractor engaged in a traditional business relationship. In other words, the fact that general contractors and subcontractor typically structure their business relationship in this manner didn’t matter. The Salinas court then went on to reason that separate employment exists only where the employers are “acting entirely independent of each other and are completely disassociated with respect to” the employees. The court’s “complete disassociation” test appears that it could result in a greater likelihood that joint employment will result in the FLSA context than would be the case under the “economic realities” or “control” test. While the control issue is part of the “complete disassociation” test, joint determination in hiring or firing, the duration of the relationship between the employers, where the work is performed and responsibility over work functions are key factors that are also to be considered. Salinas v. Commercial Interiors, Inc., 848 F.3d 125 (4th Cir. 2017), rev’g, No. JFM-12-1973, 2014 U.S. Dist. LEXIS 160956 (D. Md. Nov. 17, 2014).
- Electronic Logs For Truckers. On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) was set to go into effect. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule, which was issued in late 2015, could have a significant impact on the livestock industry and livestock haulers. The new rule will require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18. The devices connect to the vehicle's engine and automatically record driving hours. The Obama Administration pushed for the change to electronic logs purportedly out of safety concerns. The Trump Administration has instructed the FMCSA (and state law enforcement officials) to delay the December 18 enforcement of the final rule by delaying out-of-service orders for ELD violations until April 1, 2018, and not count ELD violations against a carrier’s Compliance, Accountability, Safety Score. Thus, from December 18, 2017 to April 1, 2018, any truck drivers who are caught without an electronic logging device will be cited and allowed to continue driving, as long as they are in compliance with hours-of-service rules. In addition, the FMCSA has granted a 90-day waiver for all vehicles carrying agricultural commodities. Other general exceptions to the final rule exist for vehicles built before 2000, vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)), drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)), and drivers who maintain HOS logs for no more than eight days during any 30-day period. One rule that is of particular concern is an HOS requirement that restricts drive time to 11 hours. This rule change occurred in 2003 and restricts truck drivers to 11 hours of driving within a 14-hour period. Ten hours of rest is required. That is a tough rule as applied to long-haul cattle transports. Unloading and reloading cattle can be detrimental to the health of livestock.
- Dicamba Spray-Drift Issues. Spray-drift issues with respect to dicamba and the use of XtendiMax with VaporGrip (Monsanto) and Engenia (BASF) herbicides for use with Xtend Soybeans and Cotton were on the rise in 2017. , 2017Usage of dicamba has increased recently in an attempt to control weeds in fields planted with crops that are engineered to withstand it. But, Missouri (effective July 7) and Arkansas (as of June 2017) took action to ban dicamba products because of drift-related damage issues. In addition, numerous lawsuits have been filed by farmers against Monsanto, BASF and/or DuPont alleging that companies violated the law by releasing their genetically modified seeds without an accompanying herbicide and that the companies could have reasonably foreseen that seed purchasers would illegally apply off-label, older dicamba formulations, resulting in drift damage. Other lawsuits involve claims that the new herbicide products are unreasonably dangerous and have caused harm even when applicators followed all instructions provided by law. In December of 2017, the Arkansas Plant Board voted to not recommend imposing a cut-off date of April 15 for dicamba applications. Further consideration of the issue will occur in early 2018.