Wednesday, February 28, 2018
Monday’s post on whether the new tax law indicates that a C corporation should be the entity form of choice generated a lot of interest. Some of the questions that came in surrounded what the tax consequences are when a C corporation is formed. That’s a good question. The tax Code does have special rules that apply when forming a C corporation. If those rules are followed, forming a C corporation can be accomplished without tax consequences.
The tax rules surrounding C corporation formation, that’s the topic of today’s post.
Tax-Free Incorporation Rules
Incorporation of an existing business, such as a sole-proprietorship farming or ranching operation, can be accomplished tax-free. A tax-free incorporation is usually desirable. That’s particularly the case for farming and ranching businesses because farm and ranch property typically has a fair market value substantially in excess of basis. That’s usually the result of substantial amounts of depreciation having been taken on farm assets.
For property conveyed to the corporation, neither gain nor loss is recognized on the exchange if three conditions are met. I.R.C. § 351. First, the transfer must be solely in exchange for corporate stock. Second, the transferor (or transferors as a group) must be “in control” of the corporation immediately after the exchange. This requires that the transferors of property end up with at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of the total number of shares of all classes of stock. Third, the transfer must be for a “business purpose.”
Be careful of stock transfers. Because of the 80 percent control test, if it is desirable to have a tax-free incorporation, there can be no substantial stock gifting occurring simultaneously with, or near the time of, incorporation. For example, parents who transfer all of their property to a corporation can destroy tax-free exchange status by gifting more than 20 percent of the corporate stock to children and other family members simultaneously with incorporation or shortly thereafter.
How long is the waiting period before gifts of stock can be made? There is no bright line rule. Certainly, a month is better than a week, and six weeks are better than a month. In addition, care should also be given to avoid shareholder agreements that require stock to be sold upon transfer of property to a corporation. See, e.g., Ltr. Rul. 9405007 (Oct. 19, 1993).
Income Tax Basis Upon Incorporation
The income tax basis of stock received by the transferors is the basis of the property transferred to the corporation, less boot received, plus gain recognized, if any. If the corporation takes over a liability of the transferor, such as a mortgage, the amount of the liability reduces the basis of the stock or securities received. Debt securities are automatically treated as boot on the transfer unless they are issued in a separate transaction for cash. The corporation's income tax basis for property received in the exchange is the transferor's basis plus the amount of gain, if any, recognized to the transferor.
When Is Incorporation A Taxable Event?
If the sum of the liabilities assumed or taken subject to by the corporation exceeds the aggregate basis of assets transferred, a taxable gain is incurred as to the excess. I.R.C. § 357(c). Bonus depreciation and I.R.C. §179 may have been taken on equipment resulting in little-to-no remaining tax basis. This, combined with an operating line, prepaid expenses and deferred income result in taxable income recognition upon the incorporation of a farm. Thus, for those individuals who have refinanced and have increased their debt level to a level that exceeds the income tax basis of the property, a later disposition of the property by installment sale or transfer to a partnership or corporation, will trigger taxable gain as to the excess.
Technique to avoid tax? The liability in excess of basis problem has led to creative planning techniques in an attempt to avoid the taxable gain incurred upon incorporation. One of those strategies involves the transferor giving the corporation a personal promissory note for the difference and claiming a basis in the note equivalent to the note's face value. The IRS has ruled that this technique will not work because the note has a zero basis. Rev. Rul. 68-629, 1968-2 C.B. 154.
While one court, in 1989, held that a shareholder's personal note, while having a zero basis in the shareholder's hands, had a basis equivalent to its face amount in the corporation's hands (Lessinger v. United States, 872 F.2d 519 (2d Cir. 1989), rev'g, 85 T.C. 824 (1985)), that is not a view held by the other courts that have addressed the issue. For example, in Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g, T.C. Memo. 1996-191, the taxpayer contributed two parcels of real estate to the taxpayer's closely-held corporation. The transferred properties were encumbered with liabilities that together exceeded the taxpayer's total basis of the properties by more than $500,000. In order to avoid immediate gain recognition as to the amount of excess liabilities over basis, the taxpayer also executed a promissory note, promising to pay the corporation $1,060,000 over a term of ten years at eleven percent interest. The taxpayer remained personally liable on the encumbrances even though the corporation took the properties subject to the debt. The taxpayer did not make any payments on the note until after being audited, which was approximately three years after the note was executed. The IRS argued that the note was not genuine indebtedness and should be treated as an enforceable gift. In the alternative, the IRS argued that even if the note were genuine, its basis was zero because the taxpayer incurred no cost in issuing the note to the corporation. As such, the IRS argued, the note did not increase the taxpayer's basis in the contributed property.
The Peracchi court held that the taxpayer had a basis of $1,060,000 (face value) in the note. As such, the aggregate liabilities of the property contributed to the corporation did not exceed aggregate basis, and no gain was triggered. The court reasoned that the IRS's position ignored the possibility that the corporation could go bankrupt, an event that would suddenly make the note highly significant. The court also noted that the taxpayer and the corporation were separated by the corporate form, which was significant in the matter of C corporate organization and reorganization. Contributing the note placed a million dollar “nut” within the corporate “shell,” according to the court, thereby exposing the taxpayer to the “nutcracker” of corporate creditors in the event the corporation went bankrupt. Without the note, the court reasoned, no matter how deeply the corporation went into debt, creditors could not reach the taxpayer's personal assets. With the note on the books, however, creditors could reach into the taxpayer's pocket by enforcing the note as an unliquidated asset of the corporation. The court noted that, by increasing the taxpayer's personal exposure, the contribution of a valid, unconditional promissory note had substantial economic effect reflecting true economic investment in the enterprise. The court also noted that, under the IRS's theory, if the corporation sold the note to a third party for its fair market value, the corporation would have a carryover basis of zero and would have to recognize $1,060,000 in phantom gain on the exchange even if the note did not appreciate in value at all. The court reasoned that this simply could not be the correct result. In addition, the court noted that the taxpayer was creditworthy and likely to have funds to pay the note. The note bore a market rate of interest related to the taxpayer's credit worthiness and had a fixed term. In addition, nothing suggested that the corporation could not borrow against the note to raise cash. The court also pointed out that the note was fully transferable and enforceable by third parties.
The court did acknowledge that its assumptions would fall apart if the shareholder was not creditworthy, but the IRS stipulated that the shareholder's net worth far exceeded the value of the note. That seems to be a key point that the court overlooked. If the taxpayer was creditworthy, then a legitimate question exists concerning why the taxpayer failed to make payments on the note before being audited. Clearly, the taxpayer never had any intention of paying off the note. Thus, a good argument could have seemingly been made that the note did not represent genuine indebtedness. The court also appears to have overlooked the different basis rules under I.R.C. § 1012 and I.R.C. § 351. An exchanged basis is obtained in accordance with an I.R.C. § 351 transaction which precludes application of the basis rules of I.R.C. § 1012.
Note: After Lessinger and Peracchi were decided, I.R.C. §357 was amended to include subsection (d). That subsection specifies that a recourse liability is to be treated as having been assumed if the facts and circumstances indicate that the transferee has agreed to, and is expected to, satisfy the liability (or a portion thereof) regardless of whether the transferor has been relieved of the liability. Non-recourse liabilities are to be treated as having been assumed by the transferee of any asset subject to the liability.
What about other entities? The Peracchi court was careful to state that the court's rationale was limited to C corporations. Thus, the opinion will not apply in the S corporation setting for shareholders attempting to create basis to permit loss passthrough. However, Rev. Rul. 80-235, 1980-2 C.B. 229, specifies that a partner in a partnership cannot create basis in a partnership interest by contributing a note. This all means that the IRS is likely to continue challenging “basis creation” cases on the ground that the contribution of a note is not a bona fide transfer.
Different strategy? A similar technique designed to avoid gain recognition upon incorporation of a farming or ranching operation (where liabilities exceed basis) is for the transferors to remain personally liable on the debt assumed by the corporation, with no loan proceeds disbursed directly to the transferors. However, gain recognition is not avoided unless the corporation does not assume the indebtedness. Seggerman Farms, Inc. v. Comm’r, 308 F.3d 803 (7th Cir. 2002), aff’g, T.C. Memo. 2001-99.
As the above discussion indicates, a good rule of thumb is that property should never be transferred to a new entity without first determining whether there is enough basis to absorb the debt. If it is discovered that the debt exceeds the aggregate basis of the property being transferred to the entity, several options should be considered for their potential availability. These include not transferring some of the low basis assets to the new entity or consulting with the lender and leaving some of the debt out of the entity, permitting it instead to run against the individual shareholders, or having the shareholders later pledge their stock to secure the debt. Alternatively, cash can be contributed to the entity in lieu of some of the low basis assets or in addition to the assets. Cash is all basis.
Monday, February 26, 2018
The “Tax Cuts and Jobs Act” (TCJA) enacted in late 2017, cuts the corporate tax rate to 21 percent. That’s 16 percentage points lower than the highest individual tax rate of 37 percent. On the surface, that would seem to be a rather significant incentive to form a C corporation for conducting a business rather than some form of pass-through entity where the business income flows through to the owners and is taxed at the individual income tax rates. In addition, a corporation can deduct state income taxes without the limitations that apply to owners of pass-through entities or sole proprietors.
Are these two features enough to clearly say that a C corporation is the entity of choice under the TCJA? That’s the focus of today’s post – is forming a C corporation the way to go?
The fact that corporations are now subject to a corporate tax at a flat rate of 21 percent is not the end of the story. There are other factors. For instance, the TCJA continues the multiple tax bracket system for individual income taxation, and also creates a new 20 percent deduction for pass-through income (the qualified business income (QBI) deduction). In addition, the TCJA doesn’t change or otherwise eliminate the taxation on income distributed (or funds withdrawn) from a C corporation – the double-tax effect of C-corporate distributions. These factors mute somewhat the apparent advantage of the lower corporate rate.
Under the new individual income tax rate structure, the top bracket is reached at $600,000 for a taxpayer filing as married filing joint (MFJ). For those filing as single taxpayers or as head-of household, the top bracket is reached at $500,000. Of course, not every business structured as a sole-proprietorship or a pass-through entity generates taxable income in an amount that would trigger the top rate. The lower individual rate brackets under the TCJA are 10, 12, 22, 24, 32 and 35 percent. Basically, up to about $75,000 of taxable income (depending on filing status), the individual rates are lower than the 21 percent corporate rate. So, just looking at tax rates, businesses with relatively lower levels of income will likely be taxed at a lower rate if they are not structured as a C corporation.
As noted, under the TCJA, for tax years beginning after 2017 and before 2026, an individual business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20 percent of the individual’s share of business taxable income. However, the deduction comes with a limitation. The limitation is the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. I.R.C. §199A. Architects and engineers can claim the QBI deduction, but other services business are limited in their ability to claim it. For them, the QBI deduction starts to disappear once taxable income exceeds $315,000 (MFJ).
Clearly, the amount of income a business generates and the type of business impacts the choice of entity.
Another factor influencing the choice between a C corporation or a flow-through entity is whether the C corporation distributes income, either as a dividend or when share of stock are sold. The TCJA, generally speaking, doesn’t change the tax rules impacting qualified dividends and long-term capital gains. Preferential tax rates apply at either a 15 percent or 20 percent rate, with a possible “tack-on” of 3.8 percent (the net investment income tax) as added by Obamacare. I.R.C. §1411. So, if the corporate “double tax” applies, the pass-through effective rate will always be lower than the combined rates applied to the corporation and its shareholders. That’s true without even factoring in the QBI deduction for pass-through entities. But, for service businesses that have higher levels of income that are subject to the phase-out (and possible elimination) of the QBI deduction, the effective tax rate is almost the same as the rate applying to a corporation that distributes income to its shareholders, particularly given that a corporation can deduct state taxes in any of the 44 states that impose a corporate tax (Iowa’s stated corporate rate is the highest).
C corporations that have taxable income are also potentially subject to penalty taxes. The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C. §531. The AE tax is designed to prevent a corporation from being used to shield its shareholders from the individual income tax through accumulation of earnings and profits, and applies to “accumulated taxable income” of the corporation (taxable income, with certain adjustments. I.R.C. §535. There is substantial motivation, even in farm and ranch corporations, not to declare dividends because of their unfavorable tax treatment. Dividends are taxed twice, once when they are earned by the corporation and again when corporate earnings are distributed as dividends to the shareholders. This provides a disincentive for agricultural corporations (and other corporations) to make dividend distributions. Consequently, this leads to a build-up of earnings and profits within the corporation.
The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the taxable year. Indeed, the computation of “accumulated taxable income” is a function of the reasonable needs of the business. So, the real issue is the extent to which corporate earnings and profits can accumulate before triggering application of the accumulated earnings tax. To that end, the statute provides for an AE credit which specifies that all corporations are permitted to accumulate earnings and profits of $250,000 without imposition of the tax. I.R.C. §535(c)(2)(A). However, the credit operates to ensure that service corporations (fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting) only have $150,000 leeway. I.R.C. §535(c)(2)(B). But, remember, not every corporation that exceeds $250,000 (or $150,000) of accumulated earnings and profits will trigger application of the accumulated earnings tax. That’s because the tax applies only if a particular corporation has accumulated more than $250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable needs of the business.
The other penalty tax applicable to C corporations is the PHC tax. I.R.C. §§541-547. This tax is imposed when the corporation is used as a personal investor. The PHC tax of 20 percent for tax years after 2012 is levied on undistributed PHC income (taxable income less dividends actually paid, federal taxes paid, excess charitable contributions, and net capital gains).
To be a PHC, two tests must be met. The first test is an ownership test, and is satisfied if five or fewer people own more than 50 percent of the corporate stock during the last half of the taxable year. Most farming and ranching operations automatically meet this test. The second test is an income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross income (reduced by production costs) comes from passive investment sources. See, e.g., Tech. Adv. Memo. 200022001 (Nov. 2, 1991).
What if the Business Will Be Sold?
If the business will be sold, the tax impact of the sale should be considered. Again, the answer to whether a corporation or pass-through entity is better from a tax standpoint when the business is sold is that it “depends.” What it depends upon is whether the sale will consist of the business equity or the business assets. If the sale involves equity (corporate stock), then the sale of the C corporate stock will likely be taxed at a preferential capital gain rate. Also, for a qualified small business (a specially defined term), if the stock has been held for at least five years at the time it is sold, a portion of the gain (or in some cases, all of the gain) can be excluded from federal tax. Any gain that doesn’t qualify to be excluded from tax is taxed at a 28% rate (if the taxpayer is in the 15% or 20% bracket for regular long-term capital gains). Also, instead of a sale, a corporation can be reorganized tax-free if technical rules are followed.
If the sale of the business is of the corporate assets, then flow-through entities have an advantage. A C corporation would trigger a “double” tax. The corporation would recognize gain taxed at 21 percent, and then a second layer of tax would apply to the net funds distributed to the shareholders. Compare this result to the sale of assets of a pass-through entity which would generally be taxed at long-term capital gain rates.
Use of the C corporation may provide the owner with more funds to invest in the business. Also, a C corporation can be used to fund the owner’s retirement plan in an efficient manner. In addition, fringe benefits are generally more advantageous with a C corporation as compared to a pass-through entity (although the TCJA changes this a bit). A C corporation is also not subject to the alternative minimum tax (thanks to the TCJA). There are also other minor miscellaneous advantages.
So, what’s the best entity choice for you and your business? It depends! Of course, there are other factors in addition to tax that will shape the ultimate entity choice. See your tax/legal advisor for an evaluation of your specific facts.
Thursday, February 22, 2018
Leasing is of primary importance to agriculture. Leasing permits farmers and ranchers to operate larger farm businesses with the same amount of capital, and it can assist beginning farmers and ranchers in establishing a farming or ranching business.
Today’s post takes a brief look at some of the issues surrounding farmland leases – economic; estate planning; and federal farm program payment limitation planning.
Common Types of Leases
Different types of agricultural land leasing arrangements exist. The differences are generally best understood from a risk/return standpoint. Cash leases involve the periodic payment of a rental amount that is either a fixed number of dollars per acre, or a fixed amount for the entire farm. Typically, such amounts are payable in installments or in a lump sum. A flexible cash lease specifies that the amount of cash rent fluctuates with production conditions and/or crop or livestock prices. A hybrid cash lease contains elements similar to those found in crop-share leases. For example, a hybrid cash lease usually specifies that the rental amount is to be determined by multiplying a set number of bushels by a price determined according to terms of the lease, but at a later date. The tenant will market the entire crop. The landlord benefits from price increases, while requiring no management or selling decisions or capital outlay. However, the rental amount is adversely affected by a decline in price. The tenant, conversely, will not bear the entire risk of low commodity prices, as would be the case if a straight-cash lease were used, but does bear all of the production risk and must pay all of the production costs.
Under a hybrid-cash lease, known as the guaranteed bushel lease, the tenant delivers a set amount of a certain type of grain to a buyer by a specified date. The landlord determines when to sell the grain, and is given an opportunity to take advantage of price rises and to make his or her own marketing decisions. However, the landlord must make marketing decisions, and also is subject to price decreases and the risk of crop failure. For tenants, the required capital outlay will likely be less, and the tenant should have greater flexibility as to cropping patterns. While the rental amount may be less than under a straight-cash lease, the tenant will continue to bear the risk of crop failure.
Another form of the hybrid-cash lease, referred to as the minimum cash or crop share lease, involves a guaranteed cash minimum. However, the landlord has the opportunity to share in crop production from a good year (high price or high yield) without incurring out-of-pocket costs. For a tenant, the minimum cash payment likely will be less than under a straight-cash lease because the landlord will receive a share of production in good years. The tenant, however, still retains much of the production risk. In addition, the tenant typically does not know until harvest whether the tenant will receive all or only part of the crop. This may make forward cash contracting more difficult.
Under a crop-share leasing arrangement, the rent is paid on the basis of a specified proportion of the crops. The landlord may or may not agree to pay part of certain expenses. There are several variations to the traditional crop-share arrangement. For example, with a crop share/cash lease, rent is paid with a certain proportion of the crops, but a fixed sum is charged for selected acreage such as pasture or buildings, or both. Under a livestock-share leasing arrangement, specified shares of livestock, livestock products and crops are paid as rent, with the landlord normally sharing in the expenses. For irrigation crop-share leases, rent is a certain proportion of the crops produced, but the landlord shares part of the irrigation expenses. Under labor-share leases, family members are typically involved and the family member owning the assets has most of the managerial responsibility and bears most of the expenses and receives most of the crops. The other family members receive a share of yield proportionate to their respective labor and management inputs.
Estate Planning Implications
Leasing is also important in terms of its relation to a particular farm or ranch family's estate plan. For example, with respect to Social Security benefits for retired farm-landlords, pre-death material participation under a lease can cause problems. A retired farm-landlord who has not reached full retirement age (66 in 2018) may be unable to receive full Social Security benefits if the landlord and tenant have an agreement that the landlord shall have “material participation” in the production of, or the managing of, agricultural products.
While material participation can cause problems with respect to Social Security benefits, material participation is required for five of the last eight years before the earlier of retirement, disability or death if a special use valuation election is going to be made for the agricultural real estate included in the decedent-to-be's estate. I.R.C. §2032A. A special use valuation election permits the agricultural real estate contained in a decedent's estate to be valued for federal estate tax purposes at its value for agricultural purposes rather than at fair market value. The solution, if a family member is present, may be to have a nonretired landlord not materially participate, but rent the elected land to a materially participating family member or to hire a family member as a farm manager. Cash leasing of elected land to family members is permitted before death, but generally not after death. The solution, if a family member is not present, is to have the landlord retire at age 65 or older, materially participate during five of the eight years immediately preceding retirement, and then during retirement rent out the farm on a nonmaterial participation crop-share or livestock-share lease.
Farm Program Payments
Leases can also have an impact on a producer's eligibility for farm program payments. In general, to qualify for farm program payments, an individual must be “actively engaged in farming.” For example, each “person” who is actively engaged in farming is eligible for up to $125,000 in federal farm program payments each crop year. A tenant qualifies as actively engaged in farming through the contribution of capital, equipment, active personal labor, or active personal management. Likewise, a landlord qualifies as actively engaged in farming by the contribution of the owned land if the rent or income for the operation's use of the land is based on the land's production or the operation's operating results (not cash rent or rent based on a guaranteed share of the crop). In addition, the landlord's contribution must be “significant,” must be “at risk,” and must be commensurate with the landlord's share of the profits and losses from the farming operation.
A landowner who cash leases land is considered a landlord under the payment limitation rules and may not be considered actively engaged in farming. In this situation, only the tenant is considered eligible. Under the payment limitation rules, there are technical requirements that restrict the cash-rent tenant's eligibility to receive payments to situations in which the tenant makes a “significant contribution” of (1) active personal labor and capital, land or equipment; or (2) active personal management and equipment. Leases in which the rental amount fluctuates with price and/or production (so-called “flex” leases) can raise a question as to whether or not the lease is really a crop-share lease which thereby entitles the landlord to a proportionate share of the government payments attributable to the leased land.
Under Farm Service Agency (FSA) regulations (7 C.F.R. §1412.504(a)(2)), a lease is a “cash lease” if it provides for only a guaranteed sum certain cash payment, or a fixed quantity of the crop (for example, cash, pounds, or bushels per acre).” All other types of leases are share leases. In April 2007, FSA issued a Notice stating that if any portion of the rental payment is based on gross revenue, the lease is a share lease. Notice DCP-172 (April 2, 2007). However, according to FSA, if a flex or variable lease pegs rental payments to a set amount of production based on future market value that is not associated with the farm’s specific production, it’s a cash lease. Id. That was the FSA’s position through the 2008 crop year. Beginning, with the 2009 crop year, FSA has taken the position that a tenant and landlord may reach any agreement they wish concerning “flexing” the cash rent payment and the agreement will not convert the cash lease into a share-rent arrangement.
There are many issues that surround farmland leasing. Today’s post just scratches the surface with a few. Of course, many detailed tax rules also come into play when farmland is leased. The bottom line is that the type of lease matters, for many reasons. Give your leasing arrangement careful consideration and get it in writing.
Tuesday, February 20, 2018
For over the past decade I have conducted at least one summer tax conference addressing farm income tax and farm estate and business planning. The seminars have been held from coast-to-coast in choice locations – from North Carolina and New York in the East to California and Alaska in the West, and also from Michigan and Minnesota in the North to New Mexico in the South. This summer’s conference will be in Shippensburg, Pennsylvania on June 7-8 and is sponsored by the Washburn University School of Law. Our co-sponsors are the Kansas State University Department of Agricultural Economics and the Pennsylvania Institute of CPAs. My teaching partner again this year will be Paul Neiffer, the author of the Farm CPA Today blog. If you represent farm clients or are engaged in agricultural production and are interested in ag tax and estate/succession planning topics, this is a must-attend conference.
Today’s post details the seminar agenda and other key details of the conference.
The first day of the seminar will focus on ag income tax topics. Obviously, a major focus will be centered on the new tax law and how that law, the “Tax Cuts and Jobs Act” (TCJA), impacts agricultural producers, agribusinesses and lenders. One of points of emphasis will be on providing practical examples of the application of the TCJA to common client situations. Of course, a large part of that discussion will be on the qualified business income (QBI) deduction. Perhaps by the time of the seminar we will know for sure how that QBI deduction applies to sales of ag products to cooperatives and non-cooperatives.
Of course, we will go through all of the relevant court cases and IRS developments in addition to the TCJA. There have been many important court ag tax court decisions over the past year, as those of your who follow my annotations page on the “Washburn Agricultural Law and Tax Report” know first-hand.
Many agricultural producers are presently having a tough time economically. As a result, we will devote time to financial distress and associated tax issues – discharged debt; insolvency; bankruptcy tax; assets sales, etc.
We will also get into other issues such as tax deferral issues; a detailed discussion of self-employment tax planning strategies; and provide an update on the repair/capitalization regulations.
On Day 2, the focus shifts to estate and business planning issues for the farm client. Of course, we will go through how the TCJA impacts estate planning and will cover the key court and IRS developments that bear on estate and business planning. We will also get into tax planning strategies for the “retiring” farmer and farm program payment eligibility planning.
The TCJA also impacts estate and business succession planning, particularly when it comes to entity choice. Should a C corporation be formed? What are the pros and cons of entity selection under the TCJA? What are the options for structuring a farm client’s business? We will get into all of these issues.
On the second day we will also get into long-term care planning options and strategies, special use valuation, payment federal estate tax in installments, and the income taxation of trusts and estates.
The seminar will be held at the Shippensburg University Conference Center. There is an adjacent hotel that has established a room block for conference attendees at a special rate. Shippensburg is close to the historic Gettysburg Battlefield and is not too far from Lancaster County and other prime ag production areas. Early June will be a great time of the year to be in Pennsylvania.
Attend In-Person or Via the Web
The conference will be simulcast over the web via Adobe Connect. If you attend over the web, the presentation will be both video and audio. You will be able to interact with Paul and I as well as the in-person attendees. On site seating is limited to the first 100 registrants, so if you are planning on attending in-person, make sure to get your spot reserved.
You can find additional information about the seminar and register here: http://washburnlaw.edu/employers/cle/farmandranchincometax.html
If you have ag clients, you will find this conference well worth your time. We look forward to seeing you at the seminar either in-person or via the web.
Friday, February 16, 2018
I am often asked the questions at lay-level seminars whether a person can write their own will. While the answer is “yes,” it probably isn’t the best idea. Why? One of the primary reasons is because unclear language might be inadvertently used. Some words have multiple meanings in different contexts. Other words may simply be imprecise and not really require the executor or trustee to take any particular action concerning the decedent’s assets. The result could be that the decedent’s property ends up being disposed of in a way that the decedent hadn’t really intended.
Sometimes these problems can still occur when a will or trust is professionally prepared. A recent Texas case involving the disposition of ranch land illustrates the problem. Because of the imprecise language in a will and trust, a ranch ended up being sold without the decedent’s heirs having an option to purchase the property so that the land would stay in the family.
Imprecise language in wills and trusts and the problems that can be created - that’s the topic of today’s post.
The Peril of Precatory Language
In the law of wills and trusts, precatory words are words of wish, hope or desire or similar language that implores an executor or trustee of the decedent’s estate to dispose of property in some particular way. These types of words are not legally binding on the executor or trustee. They are merely “advisory.” However, words such as “shall” or “must” or some similar mandatory-type words are legally binding. Other words such as “money,” “funds,” or “personal property” are broad terms that can mean various things unless they are specifically defined elsewhere in the will or trust. Litigation involving wills and trusts most often involves ambiguous terms.
In Estate of Rodriguez, No. 04-17-00005-CV, 2018 Tex. App. LEXIS 254 (Tex. Ct. App. Jan. 10, 2018), a beneficiary of a trust sued the trustee to prevent the sale of ranchland that was owned by the decedent’s testamentary trust. The decedent died in early 2015 leaving a will benefitting his four children and a daughter-in-law. A son was named as executor and the trustee of a testamentary trust created by the decedent’s will. The primary property of the decedent’s residuary estate (after specific bequests had been satisfied) was the decedent’s ranchland. The residuary estate passed to the testamentary trust. Three of the children and the daughter-in-law were named as beneficiaries of the trust.
The trustee decided to sell the ranchland, and the daughter-in-law attempted to buy the ranch to no avail. She sued, seeking a temporary restraining order and an injunction that would prevent the trustee from selling the ranch to a third party that the trustee had accepted an offer to purchase from. The third party also got involved in the lawsuit, seeking specific performance of the purchase contract. The daughter-in-law claimed that the contract between the trustee and the third party violated a right-of-first-refusal that the trust language created in favor of the trust beneficiaries. The trial court disagreed and ordered the trustee to perform the contract. The daughter-in-law appealed.
The appellate court noted the following will language: “I hereby grant unto my…Executor…full power and authority over any and al of my estate and they are hereby authorized to sell…any part thereof…”. The trust created by the will also gave the trustee the specific power to sell the corpus of the trust, but the language was imprecise. The pertinent trust language stated, “My Trustee can sell the corpus of this Trust, but it [is] my desire my ranch stay intact as long as it is reasonable.” Another portion of the trust stated, “If any of the four beneficiaries of his estate wants to sell their portion of the properties they can only sell it to the remaining beneficiaries.” The daughter-in-law claimed the trust language was mandatory rather than precatory, and the mandatory language granted the trust beneficiaries the right-of-first-refusal to buy the ranchland. She claimed that the decedent desired that the ranchland stay intact, and had mentioned that intent to others during his life.
The appellate court disagreed with the daughter-in-law. Neither of the trust clauses, the court noted, required the trustee to offer to anyone, much less the beneficiaries, the chance to buy the ranchland on the same terms offered to another potential buyer. While the language limited a beneficiary’s power to sell to anyone other than another beneficiary, it didn’t restrict the trustee’s power to sell. There was simply nothing in the will or trust that limited the trustee’s power to sell by creating a right-of-first-refusal in favor of the trust beneficiaries. The decedent’s “desire” to keep the ranchland intact was precatory language that didn’t bar the trustee from selling it to a third party. In addition, there was no right-of-first-refusal created for the beneficiaries. The contract to sell the ranchland to the third party was upheld.
For many farm or ranch families, a major objective is to keep the farmland/ranchland in the family. That might be the case regardless of whether the family members will be the actual operators down through subsequent generations. However, the recent Texas case points out how important precise language in wills and trusts is in preserving that intent.
Wednesday, February 14, 2018
Farmer and ranchers regularly engage in secured transactions. For instance, the typical farmer doesn’t have enough cash on hand to buy high-priced farm machinery and equipment outright. That means that the seller extends credit to finance the purchase or the farmer finds acceptable financing elsewhere to make the purchase. In either situation, the parties execute a security agreement evidenced by a financing statement that is then filed of public record. The filing allows other potential creditors to check if a lien already exists on the debtor’s property before extending credit.
The public filing means that the debtor must be identified. The proper identification of the debtor is key, and many creditors have learned the hard way that a slight slip up in properly identifying the debtor in the financing statement can change their secured interest to an unsecured one.
The property identification of the debtor in a financing statement, that’s the topic of today’s post.
Perfecting a Security Interest
Normally, a security interest in tangible property is perfected (made effective against other creditors) by filing a financing statement or by filing the security agreement as a financing statement. Indeed, filing a financing statement usually is the only practical way to perfect when the debtor is a farmer or rancher. An effective financing statement merely indicates that the creditor may have a security interest in the described collateral and is sufficient if it provides the name of the debtor, (UCC §9-502(a)(1)) gives the name and address of the secured party from which information concerning the security interest may be obtained, gives the mailing address of the debtor and contains a statement indicating the types or describing the items of collateral.
Note: An adequate description of the collateral is critical if there is to be attachment and perfection. UCC §9-108. This is an important point that can arise in an agricultural context with respect to real estate, livestock and equipment that can be used either directly or indirectly in agricultural production activities.
Name of the debtor. The name of the debtor is the key to the notice system and priority. The financing statement is indexed under the debtor’s name. If the debtor is a registered organization, only the name indicated on the public record of the debtor’s jurisdiction or organization is sufficient. For example, in In re EDM Corporation, 431 B.R. 459 (B.A.P. 8th Cir. 2010), a bank identified a corporate debtor on the financing statement as "EDM Corporation D/B/A EDM Equipment” and the court held that the identification was seriously misleading because a search conducted by using standard search logic did not reveal the bank's interest. The court also held that the addition of the debtor's trade name to its registered organization name violated Rev. UCC 9-503. But, federal tax liens appear not to be subject to the same exact match standard. The test is whether a reasonable searcher would find the lien notwithstanding the use of on abbreviation. See, e.g., In re Spearing Tool and Manufacturing Co., 412 F.3d 653 (6th Cir. 2005), rev’g, 302 B.R. 351 (E.D. Mich. 2003), cert. den.sub nom, ,Crestmark Bank v. United States, 127 S. Ct. 41 (2006). Under UCC § 9-506, a financing statement is effective even if it has minor errors or omissions unless the errors or omissions make the financing statement seriously misleading. A financing statement containing an incorrect debtor’s name is not seriously misleading if a search of the records of the filing office under the debtor’s correct legal name, using the filing office’s standard search logic, if any, discloses the financing statement filed under the incorrect name. However, some states have regulations defining the search logic to be used and may require that the debtor’s name be listed correctly. See, e.g., In re Kinderknecht, 308 B.R. 47 (Bankr. 10th Cir. 2004), rev’g, 300 B.R. 47 (Bankr. D. Kan. 2003); Pankratz Implement Co. v. Citizens National Bank, 130 P.3d 57 (Kan. 2006), aff’g, 33 Kan. App. 2d 279, 102 P.3d 1165 (2004); In re Borden, 353 B.R. 886 (Bankr. D. Neb. 2006), aff’d, No. 4:07CV3048, 2007 U.S. Dist. LEXIS 61883 (D. Neb. Aug. 20, 2007); Corona Fruits & Veggies, Inc. v. Frozsun Foods, 143 Cal. App. 4th 319, 48 Cal. Rptr. 3d 868 (2006).
Theissue of the property identification of the debtor came up again in a recent case. In In re Pierce, No. 17060154, 2018 Bankr. LEXIS 287 (Bankr. S.D. Ga. Feb. 1, 2018), a bank financed a debtor’s purchase of a manure spreader. The bank properly filed a financing statement listing the debtor’s name as “Kenneth Pierce.” At the time of the filing, the debtor’s driver’s license identified him as “Kenneth Ray Pierce, but the debtor would always sign his licenses as either “Kenneth Pierce” or as “Kenneth Ray Pierce.” Approximately two years after the bank filed, the debtor filed Chapter 12 bankruptcy. The bank filed a proof of claim in the amount of $14,459.81 and attached the financing statement. The debtor filed an objection claiming that because the bank failed to correctly identify him as “Kenneth Ray Pierce” on the financing statement, the bank’s security interest was unsecured along with its claim. After determining that the debtor had standing to use the trustee’s avoidance powers and bring an action under 11 U.S.C. §544, the court found the bank’s interest to be unsecured. The court noted that Georgia Code §11-9-503(a)(1)-(4) required an individual debtor’s name on a financing statement to match the debtor’s name on the debtor’s driver’s license. The court noted that such imprecise match was seriously misleading and that Georgia law required that debtor’s name on the financing statement match the typed name on the debtor’s driver’s license. The court also pointed out that had the bank followed the Georgia UCC-1 Financing Statement Form which instructs the use of the debtor’s exact full name, the debtor would have been identified the same as the typed name on the debtor’s driver’s license.
Properly identifying the debtor on a filed financing statement is critical to ensuring that a creditor has perfected its interest in the collateral. An exact match is required. Lenders must be careful.
Monday, February 12, 2018
Although the loss of livestock due to disease does not occur that frequently, when it occurs the loss can be large. Fortunately, the tax Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold on account of weather-related conditions.
Today’s post takes a look at the tax rule for handling sale of livestock on account of disease.
Treatment as an Involuntary Conversion
Gain deferral. Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not lead to taxable gain if the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (in other words, dairy cows for dairy cows, for example) within two years of the close of the tax year in which the diseased animals were sold or exchanged. I.R.C. §1033(d). More specifically, the replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized. I.R.C. §1033(a)(2)(B)(i). In that event, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the new animals must be reduced by the unrecognized gain on the old animals that were either destroyed, sold or exchanged. Treas. Reg. §1.1033(b)-1.
Note: Involuntary conversion treatment is available for losses due to death of livestock from disease. It doesn’t matter whether death results from normal death loss or a disease causes massive death loss. Rev. Rul. 61-216, 1961-2 C.B. 134. In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they have been exposed to disease. Treas. Reg. §1.1033(d)-1.
When is gain recognized? Gain is realized to the extent money or dissimilar property is received in excess of the tax basis of the livestock. For farmers on the cash method of accounting, raised livestock has no tax basis. Therefore, gain is realized upon the receipt of any compensation for the animals. See, e.g., Decoite v. Comr., T.C. Memo. 1992-665. Thus, if there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property. I.R.C. §1033(a)(2)(A). The gain (or loss) is reported on Form 4797. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received). Treas. Reg. 1.1033(a)-2(c)(2). The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the two-year period.
Disease is not a casualty. Under the casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Rev. Rul. 72-592, 1972-2 C.B. 101. Livestock losses because of disease generally would not be eligible for casualty loss treatment because the loss is progressive rather than sudden. Thus, casualty loss treatment under I.R.C. §165(c)(3) does not apply. However, this provision doesn’t apply to losses due to livestock disease. I.R.C. §1033(d). Stated another way, the “suddenness” test doesn’t have to be satisfied to have involuntary conversion treatment apply. See Rev. Rul. 59-102, 1959-1 C.B. 200.
What is a “disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease. Rev. Rul. 59-174, 1959-1 C.B. 203. However, livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules. Rev. Rul. 54-395, 1954-2 C.B. 143.
What qualifies as “replacement animals”? I.R.C. §1033(d) says that if “livestock” are destroyed, sold or exchanged on account of disease then involuntary conversion treatment can apply. But, what is the definition of “livestock” for involuntary conversion purposes? The definition of “livestock” under I.R.C. §1231 applies for involuntary conversion treatment. Treas. Reg. §1.1231-2(a)(3). Under that regulation, “livestock” includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.” It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.” The IRS has ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment. Rev. Rul. 75-381, 1975-2 C.B. 25.
Environmental contamination. If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into non-like-kind farm property or real estate used for farming purposes. I.R.C. §1033(f). A communicable disease may not be considered to be an environmental contaminant. Miller v. United States, 615 F. Supp. 160 (E.D. Ky. 1985).
While the destruction, sale or exchange of livestock on account of disease is uncommon, it does occur. When it does, the financial impact on the farming or ranching business can be substantial. Fortunately, there is a tax rule that helps soften the blow.
Thursday, February 8, 2018
The Spousal Qualified Joint Venture – Implications for Self-Employment Tax and Federal Farm Program Payment Limitations
As noted in Part 1 of this two-part series on the spousal qualified joint venture (QJV), some spousal business ventures can elect out of the partnership rules for federal tax purposes as a QJV. I.R.C. §761(f). In Part 1, I looked at the basics of the QJV election and how it can ease the tax reporting requirements for spousal joint ventures that can take advantage of the election. Today, in Part 2, I look at how the election impacts self-employment tax and, for farmers, eligibility for federal farm program payments.
The QJV Election and Self-Employment Tax
Under I.R.C. §1402(a), net earnings from self- employment are subject to self-employment tax. Net earnings from self-employment are defined as income derived by an individual from any trade or business carried on by such individual. But, real estate rental income is excluded from the general definition of net earnings from self-employment. I.R.C. §1402(a)(1). Thus, for rental property in a partnership (or rental real estate income of an individual), self- employment tax is not triggered.
The QJV election and rental real estate. I.R.C. §1402(a)(17) specifies that when a QJV election has been made, each spouse’s share of income or loss is taken into account as provided for in I.R.C. §761(f) in determining self-employment tax. I.R.C. §761(f)(1)(C) specifies that, “each spouse shall take into account such spouse’s respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor.” That means that the QJV election does not avoid the imposition of self-employment tax.
However, the exception from self-employment tax for rental real estate income remains intact. The IRS instructions to Form 1065 state that if the QJV election is made for a spousal rental real estate business, "you each must report your share of income and deductions on Schedule E. Rental real estate income generally isn’t included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive loss limitation rules. Electing qualified joint venture status doesn’t alter the application of the self-employment tax or the passive loss limitation rules.” See also CCA Ltr. Rul. 200816030 (Mar. 18, 2008).
While the QJV election may not be a problem in a year when a loss results, the self-employment tax complication can be problematic when there is positive income for the year. That’s because it is not possible to simply elect out of QJV treatment in an attempt to avoid self-employment tax by filing a Form 1065. The QJV election cannot be revoked without IRS consent. Likewise, it’s probably not possible to intentionally fail to qualify for QJV status (by transferring an interest in the business to a non-spouse, for example) to avoid self-employment tax in an income year after a year (or years) of reducing self-employment by passed-through losses. Such a move would allow IRS to assert that the transfer of a minimal interest to a disqualified person or entity violates the intent of Subchapter K
Tax Reporting and Federal Farm Program Participation - The "Active Engagement" Test
For farm couples that participate in federal farm programs where both spouses satisfy the “active
engagement” test, each spouse may qualify for a payment limitation. 7 U.S.C. §§1308-1(b); 1308(e)(2)(C)(ii); 1400.105(a)(2). To be deemed to be actively engaged in farming as a separate person, a spouse must satisfy three tests: (1) the spouse’s share of profits or losses from the farming operation must be commensurate with the spouse’s contribution to the operation; (2) the spouse’s contributions must be “at risk;” and (3) the spouse must make a significant contribution of capital, equipment or land (or a combination thereof) and active personal labor or active personal management (or a combination thereof). For the spouse’s contribution to be “at risk,” there must be a possibility that a non-recoverable loss may be suffered. Similarly, contributions of capital, equipment, land, labor or management must be material to the operation to be “significant contribution.” Thus, the spouse’s involvement, to warrant separate person status, must not be passive.
While the active engagement test is relaxed for farm operations in which a majority of the “persons” are individuals who are family members, it is not possible for a spouse to sign up for program payments as a separate person from the other spouse based on a contribution of land the spouse owns in return for a share of the program payments. That’s because, the use of the spouse’s contributed land must be in return for the spouse receiving rent or income for the use of the land based on the land’s production or the farming operation’s operating results.
What this all means is that for spouses who sign up for two separate payment limitations under the farm programs, they are certifying that they each are actively involved in the farming operation. Under the farm program rules, for each spouse to be actively involved requires both spouses to be significantly involved in the farming operation and bear risk of loss.
From a tax standpoint, however, the couple may have a single enterprise the income from which is reported on Form 1040 as a sole proprietorship or on a single Schedule F with the income split into two equal shares for self- employment tax purposes. In these situations, IRS could assert that a partnership filing is required (in common-law property states). That’s where the QJV election could be utilized with the result that two proprietorship returns can be filed. As mentioned above that’s a simpler process than filing a partnership return, and it avoids the possibility of having penalties imposed for failing to file a partnership return. But, the filing of the QJV election will subject the income of both spouses (including each spouse’s share of government payments) to self-employment tax. That will eliminate any argument that at least one spouse’s income should not be subjected to self-employment tax on the basis that the spouse was only actively involved (for purposes of the farm program eligibility rules), but not engaged in a trade or business (for self-employment tax purposes).
Separate “person” status and material participation. Can both spouses qualify for separate “person” status for federal farm program purposes, but have only one of them be materially participating in the farming operation for self-employment tax purposes? While the active engagement rules are similar to the rules for determining whether income is subject to self-employment tax, their satisfaction is meaningless on the self-employment tax issue according to the U.S. Tax Court.
In Vianello v. Comr., T.C. Memo. 2010-17, the taxpayer was a CPA that, during the years in issue, operated an accounting firm in the Kansas City area. In 2001, the petitioner acquired 200 acres of cropland and pasture in southwest Missouri approximately 150 miles from his office. At the time of the acquisition, a tenant (pursuant to an oral lease with the prior owner) had planted the cropland to soybeans. Under the lease, the tenant would deduct the cost of chemicals and fertilizer from total sale proceeds of the bean and pay the landlord one- third of the amount of the sale. The petitioner never personally met the tenant during the years at issue, but the parties did agree via telephone to continue the existing lease arrangement for 2002. Accordingly, the tenant paid the expenses associated with the 2001 and 2002 soybean crops, and provided the necessary equipment and labor. The tenant made all the decisions with respect to raising and marketing the crop, and paid the petitioner one-third of the net proceeds. As for the pasture, the tenant mowed it and maintained the fences. Ultimately, a disagreement between the petitioner and the tenant resulted in the lease being terminated in early 2003, and the petitioner had another party plow under the fall-planted wheat in the spring of 2004 prior to the planting of Bermuda grass. Also, the petitioner bought two tractors in 2002 and a third tractor and hay equipment in 2003, and bought another 50 acres from in late 2003.
The petitioner did not report any Schedule F income for 2002 or 2003, but did claim a Schedule F loss for each year - as a result of depreciation claimed on farm assets and other farming expenses. The petitioner concluded, based on a reading of IRS Pub. 225 (Farmer’s Tax Guide) that he materially participated in the trade or business of farming for the years at issue. The petitioner claimed involvement in major management decisions, provided and maintained fences, discussed row crop alternatives, weed maintenance and Bermuda grass planting with the tenant. The petitioner also pointed out that his revocable trust was an eligible “person” under the farm program payment limitation rules as having satisfied the active engagement test. The petitioner also claimed he bore risk of loss under the lease because an unsuccessful harvest would mean that he would have to repay the tenant for the tenant’s share of chemical cost.
The Tax Court determined that the petitioner was not engaged in the trade or business of farming for 2002 or 2003. The court noted that the tenant paid all the expenses with respect to the 2002 soybean crop, and made all of the cropping decisions. In addition, the court noted that the facts were unclear as to whether the petitioner was responsible under the lease for reimbursing the tenant for input costs in the event of an unprofitable harvest. Importantly, the court noted that the USDA’s determination that the petitioner’s revocable trust satisfied the active engagement test and was a co- producer with the tenant for farm program eligibility purposes “has no bearing on whether petitioner was engaged in such a trade or business for purposes of section 162(a)…”. The Tax Court specifically noted that the Treasury Regulations under I.R.C. §1402 “make it clear that petitioner’s efforts do not constitute production or the management of the production as required to meet the material participation standard” [emphasis added]. That is a key point. The petitioner’s revocable trust (in essence, the taxpayer) satisfied the active engagement test for payment limitation purposes (according to the USDA), but the petitioner was not engaged in the trade or business of farming either for deduction purposes or self-employment tax purposes. As noted below, however, the USDA’s determination of participation is not controlling on the IRS.
Vianello reaffirms the point that the existence of a trade or business is determined on a case-by-case basis according to the facts and circumstances presented, and provides additional clarity on the point that satisfaction of the USDA’s active engagement test does not necessarily mean that the taxpayer is engaged in the trade or business of farming for self-employment tax purposes. In spousal farming operations, Vianello supports the position that both spouses can be separate persons for payment eligibility purposes, but only one of them may be deemed to be in the trade or business of farming for self-employment tax purposes. The case may also support an argument that satisfaction of the active engagement test by both spouses does not necessarily create a partnership for tax purposes. But that is probably a weaker argument – Vianello did not involve a spousal farming situation.
So, while Vianello may eliminate the need to make a QJV election in spousal farming situations, without the election it is possible that IRS could deem spouses to be in a partnership triggering the requirement to file a partnership return.
The QJV election can be used to simplify the tax reporting requirement for certain spousal businesses that would otherwise be required to file as a partnership. That includes spousal farming operations where each spouse qualifies as a separate person for payment limitation purposes. But, the election does not eliminate self-employment tax on each spouse’s share of income.
Tuesday, February 6, 2018
Some spousal business ventures can elect out of the partnership rules for federal tax purposes as a qualified joint venture (QJV). I.R.C. §761(f). While the election will ease the tax reporting requirements for husband-wife joint ventures that can take advantage of the election, the Act also makes an important change to I.R.C. §1402 as applied to rental real estate activities that can lay a trap for the unwary.
When is making a QJV election a good planning move? When should it be avoided? Are their implications for spousal farming operations with respect to farm program payment limitation planning? Is there any impact on self-employment tax? This week I am taking a look at the QJV. Today’s post looks at the basics of the election. On Thursday, I will look at its implications for farm program payment limitation planning as well as its impact on self-employment tax.
The QJV election is the topic of today’s post.
Joint Ventures and Partnership Returns
A joint venture is simply an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. That is similar to the Uniform Partnership Act’s definition of a partnership. UPA §101(6). The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership (I.R.C. §§761(a) and 7701(a)(2)), and the IRS follows the UPA definition of a partnership by specifying that a business activity conducted in a form jointly owned by spouses (including a husband-wife limited liability company (LLC)) creates a partnership that requires the filing of an IRS Form 1065 and the issuance to each spouse of separate Schedules K-1 and SE, followed by the aggregation of the K-1s on the 1040 Schedule E, page 2. The Act does not change the historic IRS position.
Note: Thus, for a spousal general partnership, each spouse’s share of partnership income is subject to self-employment tax. See, e.g., Norwood v. Comr., T.C. Memo. 2000-84.
While the IRS position creates a tax compliance hardship, in reality, a partnership return does not have to be filed for every husband-wife operation. For example, if the enterprise does not meet the basic requirements to be a partnership under the Code (such as not carrying on a business, financial operation or venture, as required by I.R.C. §7701(a)(2)), no partnership return is required. Also, a spousal joint venture can elect out of partnership treatment if it is formed for “investment purposes only” and not for the active conduct of business if the income of the couple can be determined without the need for a partnership calculation. I.R.C. §761(a).
A spousal business activity (in which both spouses are materially participating in accordance with I.R.C. §469(f)) can elect to be treated as a QJV which will not be treated for tax purposes as a partnership. In essence, the provision equates the treatment of spousal LLCs in common-law property states with that of community property states. In Rev. Proc. 2002-69, 2002-2 C.B. 831, IRS specified that husband-wife LLCs in community property states can disregard the entity.
Note: The IRS claims on its website that a qualified joint venture, includes only those businesses that are owned and operated by spouses as co-owners, and not those that are in the name of a state law entity (including a general or limited partnership or limited liability company). So, according to the IRS website, spousal LLCs, for example, would not be eligible for the election. However, this assertion is not made in Rev. Proc. 2002-69. There doesn’t appear to be any authority that bars a spousal LLC from making the QJV election.
With a QJV election in place, each spouse is to file as a sole proprietor to report that spouse’s proportionate share of the income and deduction items of the business activity. To elect QJV status, five criteria must be satisfied: (1) the activity must involve the conduct of a trade or business; (2) the only members of the joint venture are spouses; (3) both spouses elect the application of the QJV rule; (4) both spouses materially participate in the business; and (5) the spouses file a joint tax return for the year I.R.C. §761(f)(1).
Note: “Material participation” is defined in accordance with the passive activity loss rules of I.R.C. §469(h), except I.R.C. §469(h)(5). Thus, whether a spouse is materially participating in the business is to be determined independently of the other spouse.
The IRS instructions to Form 1065 (the form, of course, is not filed by reason of the election) provide guidance on the election. Those instructions specify that the election is made simply by not filing a Form 1065 and dividing all income, gain, loss, deduction and credit between the spouses in accordance with each spouse’s interest in the venture. Each spouse must file a separate Schedule C, C-EZ or F reporting that spouse’s share of income, deduction or loss. Each spouse also must file a separate Schedule SE to report their respective shares of self-employment income from the activity with each spouse then receiving credit for their share of the net self-employment income for Social Security benefit eligibility purposes. For spousal rental activities where income is reported on Schedule E, a QJV election may not be possible. That’s because the reporting of the income on Schedule E constitutes an election out of Subchapter K, and a taxpayer can only come back within Subchapter K (and, therefore, I.R.C. §761(f)) with IRS permission that is requested within the first 30 days of the tax year.
In general, electing QJV status won’t change a married couple’s total federal income tax liability or total self-employment tax liability, but it will eliminate the need to file Form 1065 and the related Schedules K-1. In that regard, the QJV election can provide a simplified filing method for spousal businesses. It can also remove a potential penalty for failure to file a partnership return from applying. That penalty is presently $200 per partner for each month (or fraction thereof) the partnership return is late, capped at 12 months.
Friday, February 2, 2018
On April 16, 1677, the English Parliament passed the “Statute of Frauds.” The new law required that certain contracts for the sale of goods be in writing to be enforceable. In the United States, nearly every state has adopted, and retained, a statute of frauds. Most recently, state legislatures have had to amend existing laws to account for electronic communications and specify whether those communications satisfy the writing requirement.
A type of contract that must be in writing to be enforceable is one that involves the sale of goods worth $500 or more. Obviously, this type of contract will involve many contracts involving the sale agricultural commodities and other agricultural goods. But, there are exceptions to the writing requirement for contracts that would otherwise have to be in writing to be enforceable. One of those exceptions turns on whether a farmer is a merchant or not, and the rule involving the matter is known as the “merchant’s confirmatory memo rule.” It often comes up in situations involving the sale of grain under a forward contract.
That’s the focus of today’s post – the merchant’s confirmatory memo rule.
The Writing Requirement and the UCC
The writing requirement for sales of goods is found in a particular state’s version of § 2-201 of the Uniform Commercial Code (UCC). The official version, adopted by most states, is applicable only when the goods have a price of $500 or more. In addition, under UCC § 1-206, there is an overall statute of frauds for every contract involving a contract for the sale of personal property having a value in excess of $5,000. Thus, for personal property except “goods” a contract is not enforceable beyond $5,000 unless there is some writing signed by the party against whom enforcement is sought.
Contracts involving merchants. As indicated above, a contract for the sale of goods for $500 or more is generally not enforceable unless there is some writing signed by the party against whom enforcement is sought sufficient to indicate that the contract had been made between the parties. For contracts between merchants, it is common for one merchant to send the other merchant a letter of confirmation, or a pre-printed form contract. This confirmation will be signed by the party who sent it, thus leaving one party at the other party’s mercy. The UCC remedies this situation by providing that unwritten contracts between merchants are enforceable if a writing in confirmation of the contract is received within a reasonable time unless written notice of objection to the contents of the writing is given within ten days. UCC § 2-201(2); see also Topflight Grain Cooperative, Inc. v. RJW Williams Farms, Inc., No. 4-12-1079, 2013 Ill. App. Unpub. LEXIS 1753 (Ill. Ct. App. Aug. 13, 2012).
Thus, the effect of this “merchants” exception is to take away from a merchant who receives a writing in confirmation of a contract the statute of frauds defense if the merchant does not object to the confirmation. In any event, the sender of the written confirmation must still be able to persuade a jury that a contract was in fact made orally, to which the written confirmation applies.
Consider the following example:
In December of 2017, Jesse telephoned his local elevator for a price quote on wheat. During their telephone conversation, Jesse and the elevator agreed that Jesse would sell the elevator 25,000 bushels of wheat at a specified quality at the December price next June, with performance to be completed no later than June 30, 2018. The elevator sent Jesse a written confirmation asking that it be signed and returned within ten days. Jesse did not sign the written confirmation. Because of unexpected market conditions, the June 2018 wheat price was substantially higher than the December 2017 price. Jesse refused to perform in accordance with the forward contract, preferring instead to sell his wheat crop at the higher current market price. The elevator sued to enforce the forward contract. Jesse asserted the statute of frauds as a defense – because they didn’t have a written contract, he didn’t have to deliver.
If Jesse is a merchant with respect to the kind of goods contemplated in the forward contract (wheat), he will be bound by the oral contract. If Jesse is not a merchant, the elevator might be able to recover if it can establish that it changed its position in reliance on Jesse’s conduct, that Jesse knew or reasonably should have known the elevator would sell the forward contract, or can demonstrate that Jesse’s nonperformance was based on his desire to benefit from a higher market price.
When Is A Farmer a Merchant?
A “merchant” is defined as one who deals in goods of the kind being sold, or one who by occupation holds himself or herself out as having knowledge or skill peculiar to either the goods involved or the practice of buying and selling such goods. Courts are divided on the issue of whether a farmer or rancher is a merchant, with the outcome depending on the jurisdiction and the facts of the particular case. See, e.g., Huprich v. Bitto, 667 So.2d 685 (Ala. 1995); Smith v. General Mills, Inc., 968 P. 2d 723 (Mont. 1998); Brooks Cotton Co., Inc. v. Wilbine, 381 S.W.3d 414 (Tenn. Ct. App. 2012).
Unfortunately, in many instances, farmers and ranchers cannot know with certainty whether they are merchants without becoming involved in legal action on the issue. Courts consider several factors in determining whether a particular farmer is a merchant. These factors include (1) the length of time the farmer has been engaged in marketing products on the farm; (2) the degree of business skill demonstrated in transactions with other parties; (3) the farmer’s awareness of the operation and existence of farm markets; and (4) the farmer’s past experience with or knowledge of the customs and practices unique to the marketing of the product sold. For a couple of courts opinions on the issue of whether a farmer is a merchant that reached different outcomes, see Nelson v. Union Equity Co-Operative Exchange, 548 S.W.2d 352 (Tex. 1977) and Harvest States Cooperatives v. Anderson, 217 Wis. 2d 154 (Wis. Ct. App. 1998)
Whether a farmer is a merchant or not is the key to determining whether an oral conversation involving the sale of goods is enforceable. Just another one of those interesting aspects of agricultural law – with its roots dating back to 1677.