Friday, March 30, 2018

Tax Issues Associated With Oil and Gas Production

Overview

The increased production of oil and gas on privately owned property in recent years means that an increasing number of landowners are receiving payments from oil and gas companies. It is important to understand the various types of payments that a landowner might receive and the tax consequences that may apply due to the nature of the income received.

Sorting through the various types of payments associated with an oil and gas lease and their tax implications is the topic of today’s post.

Relationship of the Parties

The income from the oil and gas property is commonly divided between the mineral interest owner (the royalty owner) and the operator (the working interest owner). In the typical lease arrangement, the royalty owner retains one-eighth (12.5 percent) and the working interest owner holds the other 87.5 percent (the balance of the portion of production or income that remains after the royalty interest owner’s share is satisfied).

The working interest owner bears the entire cost of exploration for minerals, as well as the development and production costs. The royalty owner bears none of the exploration, development, or operational costs. The funding necessary for the working interest owner to develop the oil and gas property is provided by investors who receive an interest in the activity in exchange for their capital investment. The costs of the activity borne by the working interest owner are allocated to the investors. These include geological survey costs, tangible costs (the drilling equipment and well), and intangible drilling costs (IDC).  These costs can be currently deducted rather than capitalized.

This relationship between the working interest owner and the investors is typically a joint venture that is classified as a partnership for tax purposes. Thus, the partnership passes through the costs separately to the investors on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. In the early years of the activity, the partnership typically passes through large losses to the partners. Because the partners are merely investors in the activity, the losses in their hands are passive losses. These losses are limited under the passive loss rules (I.R.C. §1411) such that they are only deductible to the extent the investor has passive income.

The working interest owner (who owns the interest either directly or through an entity that does not limit liability for the interest), however, is treated as being engaged in a non-passive activity regardless of the participation of the working interest owner. Temp. Treas. Reg. §1.469-1T(e)(4)(i).   Likewise, for an investor who holds both a general and limited partnership interest, the investor’s entire interest in each well drilled under the working interest is treated as an interest in a non-passive activity regardless of whether the investor is materially participating.

Note:  Investors in the working interest activity, given the broad definition of “partnership” contained in the Code, will likely have income from the activity that is subject to self-employment tax even though they are not materially participating in the activity.  See, e.g., Methvin v. Comm’r, T.C. Memo 2015-81, aff’d., 653 Fed. Appx. 616 (10th Cir. 2016). 

Types of Payments

Bonus payment.  The lessee typically pays a lump-sum cash bonus during the initial lease term (pre-drilling) for the rights to acquire an economic interest in the minerals. This is the basic consideration that the lessee pays to the lessor when the lease is executed. The lessor reports the bonus payment on Schedule E, Supplemental Income and Loss. It constitutes net investment income (NII) that is potentially subject to the additional 3.8 percent NII tax (NIIT) of I.R.C. §1411.  A bonus payment is ordinary income and not capital gain because it is not tied to production.  See, e.g., Dudek v. Comr., T.C. Memo. 2013-272, aff’d., 588 Fed. Appx. 199 (3d Cir. 2014)

For the lessee, a bonus payment is not deductible even if it is paid in installments. It must be capitalized as a leasehold acquisition cost. However, the bonus payment may be subject to cost depletion.

Installment bonus payments. A bonus payment may be paid annually for a fixed number of years regardless of production. If the lessee cannot avoid the payments by terminating the lease, the payments are termed a lease bonus payable in installments. These payments are also consideration for granting a lease. They are an advance payment for oil, and each installment is typically larger than a normal delay rental.

A cash-basis lessee must capitalize such payments, and the fair market value (FMV) of the contract in the year the lease is executed is ordinary income to the lessor if the right to the income is transferable.  Rev. Rul. 68-606, 1968-2 CB 42.  However, if the bonus payments are made under a contract that is nontransferable and nonnegotiable, a cash-basis lessor can defer recognizing the payments until they are received.  See, e.g., Kleberg v. Comm’r, 43 BTA 277 (1941), non. acq. 1952-1 CB 5. 

Delay rentals.  A delay rental is paid for the privilege of deferring development of the property by extending the primary term to allow additional time for drilling operations to begin. It can be avoided either by abandonment of the lease or by starting development operations (i.e., drilling for oil or obtaining production). A delay rental payment is “pure rent.” It is simply a payment to defer development rather than a payment for oil.

Delay rentals are ordinary income regardless of whether they are based on production. However, if they are not based on production, they are not depletable gross income to the lessor.  Treas. Reg. §1.612-3(c)(2).    Depletable gross income for the lessor is the royalty income received. Royalty income is based on production.  If the delay rentals paid are not based on production, they do not reduce the lessee’s depletable gross income.  Treas. Reg. §1.613-2(c)(5).

Delay rental payments are reported in the same manner as bonus payments. They are reported to the lessor in box 1 of Form 1099-MISC and constitute NII potentially subject to the additional 3.8 percent NIIT. The lessor reports the payments on Schedule E, with the amount flowing to line 17 of Form 1040, and are potentially subject to the NIIT.

Under Treas. Reg. §1.612-3(c), delay rentals are in the nature of rent that the lessee can deduct as a current expense.  However, the IRS maintains that I.R.C. §263A applies to delay rentals, which requires that the payments be capitalized.  The only exception to capitalization applies if the taxpayer has credible evidence establishing that the leasehold was acquired for some reason other than development.

Royalty income.  A landowner royalty is the right to the oil, gas, or minerals “in place” that entitles the owner to a specified percentage of gross production (if and when production occurs) free of the expenses of development and operations. A royalty interest is a continuing non-operating interest in oil and gas. Thus, a royalty payment is a payment for oil and gas.

Royalty payments are payments received for the extraction of minerals from the property that the landowner, as lessor, owns.   Royalties are paid as an agreed-upon percentage of the resource extracted (i.e., based on production).

Royalty payments are ordinary income that is reported to the lessor in box 2 of Form 1099-MISC. Royalty payments may be reduced by percentage or cost depletion. The lessor reports the royalty income on Schedule E, are they are included in NII and are subject to the additional 3.8 percent NIIT if the taxpayer’s gross income is above the applicable threshold ($200,000 single; $250,000 MFJ).

The lessee can deduct royalty payments as a trade or business expense. In addition, if the lessee pays the ad valorem taxes (taxes based on the property’s value) on mineral property, the payment constitutes an additional royalty to the lessor to the extent that income from production covers the tax payment.

Advance royalties. Although it is not commonly included in oil and gas leases, the lease may contain a provision providing the mineral owner with an advance royalty of the operating interest. Thus, an advance royalty is paid before the production of minerals occurs, and can be paid to the lessor either in a lump sum or periodically until production begins. The lessee deducts the advance royalty payments in the year in which the mineral production (on account of which it was paid) is sold.

Advance royalties are ordinary income to the lessor, and the lessor is not entitled to percentage depletion on the payments. However, the lessor is entitled to cost depletion in the year the payments are made to the extent they exceed production.

Advance minimum royalties. Advance minimum royalties meet the same conditions as an advanced royalty, but there is also a minimum royalty provision in the contract. This provision requires that a substantially uniform amount of royalties be paid at least annually over the life of the lease or for a period of at least 20 years.

The tax treatment to the lessor for advance minimum royalties is the same as with advanced royalties.  The lessee can deduct the advance royalties from gross income in the year the oil or gas is sold or recovered. The lessee also has the option to deduct the payments in the year they are paid or accrued.

Shut-in royalties. The lease may provide for payments to be made to the lessor when a well is shut- in (turned off because of lack of market or marketing facilities) but the well is still capable of producing in commercial quantities. The lessee is entitled to deduct the shut-in royalty payment and the lessor must report the payment as income.

Damage payments.  When a well is drilled, the nearby surface area can suffer damages that may entitle the landowner to compensation. To determine the income tax consequences of any payment for surface damages, the governing instrument (lease, etc.) may provide guidance.

Compensatory damages associated with lost profit (e.g., crop damage payments) are taxable as ordinary income (treated as a sale of the crop). To the extent the damage payment represents damages for destruction of business goodwill, the payment is nontaxable up to the taxpayer’s basis in the affected property. The amount of the damage payment that exceeds the taxpayer’s basis is taxable as I.R.C. §1231 gain. Payments for anticipated damages (but when no actual damage occurs) are reported as ordinary income.  See, e.g., Gilbertz v. U.S., 808 F.2d 1374 (10th Cir. 1987), rev’g 574 F. Supp. 177 (Wyo. 1983).

Production payments.  Most landowners retain only a royalty interest in minerals. However, landowners who have a working (operating) interest in the production may also receive a “production payment.” A production payment arises from a transaction in which the owner of an oil and gas interest sells a specific volume of production from an identifiable property until a specified amount of money or minerals has been received. A production payment is payable only out of the working interests’ share of production.

There are two types of production payments.  Retained production payments result when the mineral interest owner assigns the interest and retains a production payment. The payment is payable out of future production from the assigned property interest.  A carved-out production payment is created when an owner of a mineral interest assigns a production payment to another person but retains the interest in the property from which the production payment is assigned.

Generally, a carved-out production payment is treated under I.R.C. §636 as a mortgage (nonrecourse) loan on the property. As such, it does not qualify as an economic interest in the property. The lessee treats the payments as principal repayment and interest expense, and the lessor treats the payments received as principal and interest income. Thus, the producer does not recognize taxable income at the time the transaction is entered into. The lessor continues to be treated as the owner of the burdened properties. As the production occurs and is delivered to the holder of the production payment, the lessor is treated as having sold the production for its FMV and having applied the proceeds to repay the principal and interest due to the holder.

However, if the consideration given for the production payment is pledged for development of the property or if the production payment is retained when the property is leased, the payment qualifies as an economic interest. In this situation, the payments that the lessor receives via the production payment agreement are ordinary income that are subject to cost or percentage depletion.  The lessee capitalizes the payments.  The transaction may be treated as the sale of an overriding royalty interest in some instances, however.

Treas. Reg. §1.636-3 requires that the life of the production payment be shorter than the life of the property. Thus, for an unexplored property, if no minerals are discovered or the reserves are in such small quantities that they will never pay off the production payment, the production payment’s life will exist until the lease is abandoned.  Once the lease is abandoned, the transaction is treated by the lessee as a purchase of an overriding royalty interest. It is capitalized by the lessee and treated as capital gain by the lessor.

Payments for “shooting rights.”  In some situations, an operator may not want to incur the costs of entering into a lease on the property (to avoid lease bonuses, for example). Consequently, the operator may enter into a contract with the landowner to pay a smaller amount under a contract that gives the operator a right to enter onto the property to conduct exploration activities. The contract does not grant any drilling or production rights. The payments that the landowner receives under this type of arrangement are reportable as ordinary income.

Conclusion

Sorting out the proper tax treatment of various payments associated with an oil and gas lease is important and can be somewhat complex.  For those receiving (or paying) such amounts, competent tax counsel should be consulted to ensure proper reporting.  Today's post was just a quick summary of some of the tax issues associated with oil and gas production.  

March 30, 2018 in Income Tax | Permalink | Comments (0)

Wednesday, March 28, 2018

IRS Collections – The Basics

Overview

An issue that I sometimes get into when dealing with practitioner questions concerns the IRS collections process.  What can the IRS reach?  What’s the process for establishing an IRS lien?  What’s the levy process?  What planning steps should a taxpayer take to protect assets within the limits of applicable law?  These, and similar questions are important when a taxpayer finds themselves on the wrong end of an IRS audit.

The basics of the IRS collection process and related issues – that’s the topic of today’s post.  This is not intended as a comprehensive review of the IRS procedures.  Instead, today’s post is merely a primer dealing with some of the more common questions.  Also, not discussed is a taxpayer’s option of contesting an IRS determination in Tax Court.

Basics

IRS notices.  When the IRS, upon audit, determines that a tax liability exists for any individual or taxpaying entity, the IRS collection process begins.  The process is basically the same for an individual taxpayer as it is for any taxpaying entity.  The IRS will send at least two notices requesting payment.  The verbiage becomes increasingly urgent with each notice.  The last notice sent before any action can be taken will be labeled “Final” and will sent via certified mail.  It is important to note that the IRS cannot take any action or file a notice of federal tax lien until 30 days have expired from that final notice. 

The IRS automated collection system.  After the final notice goes out and the 30-day period elapses, regardless of whether a lien is filed, the initial IRS contact will be by IRS collection personnel in what is known as the Automated Collection System (ACS).  The ACS will provide notice and make demand for payment and try to get as much financial information from the taxpayer as possible to document possible sources for future collection actions.  Depending on personnel resources and workload priorities, if ACS cannot resolve the delinquency, it would be assigned to a “queue” of collection cases that would then be assigned to field collection personnel for face-to-face contact.  Cases are assigned to the field based on workload priorities.  There are maximum caseload inventories for collection personnel, so the case could conceivably sit dormant for a period of time before being assigned to the field.  Of course, the collection statute of limitations (10 years from the date of assessment) continues to toll even though the case is not being actively pursued.

Tax lien.  Subsequent to the final IRS notice and the expiration of the 30-day period, if the delinquent taxes remain unpaid, the IRS will provide notice of an intent to levy and notice of a Collection Due Process hearing.  Typically, the IRS provides taxpayers with notice of each of these steps by sending multiple letters as part of the ACS.  Once the last notice is received (it will signify that it is the last) and the unpaid tax balance isn’t paid (or other arrangements aren’t made to pay the balance), the IRS can levy the taxpayer’s income or other assets.  This levy power also includes the ability to garnish wages as well as self-employment income and the seizure of bank accounts.

A federal tax lien can be filed with the appropriate office determined by the taxpayer’s residence.  Where that lien is filed is determined by state law.  In general, filing will be in the office of the County Recorder for the county of the taxpayer’s residence.  Once the asserted tax liability reaches a certain point, the filing of the lien is a foregone conclusion and it will likely be an automated process.  Where that point is at is discretionary with the IRS, but certainly if the asserted tax liability is $50,000 and greater, a federal tax lien will be filed.   

The lien is a general lien and attaches to all property, both personal and real.  The lien must be filed in the jurisdiction where the real property is located.   Thee lien is good for 10 years from the date of assessment and will not be extended, although exceptions do exist in the event of bankruptcy or mutual agreement between the taxpayer and IRS. 

What about a lien on the taxpayer’s personal residence?  The likelihood of IRS seizing a personal residence and offering it for sale is extremely small unless, of course, the taxpayer is living an opulent lifestyle.  But, unless there are exigent circumstances, there is a virtually no chance that the IRS would take enforcement action against the taxpayer’s personal residence.  That’s because there are several layers of authorization that an IRS Revenue Officer must receive to get approval to proceed to enforce a tax lien on a taxpayer’s personal residence by virtue of a tax sale.  The IRS simply doesn’t operate like a county does for nonpayment of real estate taxes. The IRS will collect on the lien, however, if the taxpayer sells the residence.

Offers in Compromise

Offer in Compromise (OIC) acceptances, contrary to all the media advertisements, are generally not accepted unless it works to the government’s best interests for collection.  When determining whether to compromise a tax debt, the IRS takes into consideration numerous factors.  The taxpayer’s age is one of those as it relates to the likelihood that the taxpayer will outlive the collection statute and make payment.  In general, the IRS will always determine to what extent the taxpayer has equity in their assets. In general, if the taxpayer has equity in the property that gave rise to the tax liability, that property could be subject to enforcement actions.  But, not only must the taxpayer have equity in the property, there must be a market for the property. 

The IRS will also see whether the taxpayer has income in excess of necessary living expenses.  Those are all factors that the IRS will use to determine an acceptable amount to compromise a tax debt.  All of the factors are tied to the likelihood of the ability of the IRS to collect on the tax debt. 

Note:  The IRS Collection Financial Standards should can be reviewed to help determine what goes into the IRS calculation of the collectability of a tax debt:  https://www.irs.gov/businesses/small-businesses-self-employed/collection-financial-standards.

Other Points

Social Security benefits are subject to levy actions on a monthly basis, but are limited to 15 percent of the individual taxpayer’s Social Security benefit.  Disability payments under Social Security are not subject to levy.  If the taxpayer has only social security and pension benefits, then it is probably in the taxpayer’s best interest to complete a Collection Information Statement to determine if there is any monthly income after allowable living expenses.  If there is, it may be possible for the taxpayer to enter into an installment agreement to pay-off the tax debt.  If there is no excess income or assets, the IRS will report the account as “currently not collectible” and the taxpayer’s case would be designated as having a “dormant” status (with the collection statute still running).  At the end of 10 years, the lien would be automatically released.

 The IRS can also levy pension benefits, but they are limited to allow for necessary living expenses.  The amounts of the limitation are generally revised annually to take into account cost of living variations. 

Note:  The IRS chart for the income exemption from levies can be found at the following link: https://www.irs.gov/pub/irs-pdf/p1494.pdf.

Tax overpayments will almost always be utilized to offset a tax delinquency.

Conclusion

A taxpayer, in general, doesn’t ever want communication from the IRS.  That’s especially the case for communication asserting a tax deficiency.  But, if it occurs, knowledge of the basics of the IRS collection process is important in order to determine the best course of action to take in getting the alleged tax debt eliminated.

March 28, 2018 in Income Tax | Permalink | Comments (1)

Monday, March 26, 2018

Congress Modifies the Qualified Business Income Deduction

Overview

Late last week, the Congress passed, and the President signed, the Consolidated Appropriations Act of 2018, H.R. 1625.  This 2,232-page Omnibus spending bill, which establishes $1.3 trillion of government spending for fiscal year 2018, contains a provision modifying I.R.C. §199A that was included in the Tax Cuts and Jobs Act (TCJA) enacted last December and which became effective for tax years after 2017.  I.R.C. §199A , known as the qualified business income (QBI) deduction, created a 20 percent deduction for sole proprietorships and pass-through businesses.  However, the provision created a tax advantage for sellers of agricultural products sold to agricultural cooperatives.  Before the technical correction, those sales generated a tax deduction from gross sales for the seller.  But if those same ag goods were sold to a company that was not an agricultural cooperative, the deduction could only be taken from net business income.  That tax advantage for sales to cooperatives was deemed to be a drafting error and has now been technically corrected. 

The modified provision removes the TCJA’s QBI deduction provision for ag cooperatives and replaces it with the former (pre-2018) I.R.C. §199 for cooperatives.  In addition, the TCJA provision creating a 20 percent deduction for patronage dividends also was eliminated.  Also, the modified language limits the deduction to 20 percent of farmers’ net income, excluding capital gains. The Joint Committee on Taxation estimates that the provision modifying I.R.C. §199A will raise $108 million over the next decade.

Today’s blog post examines the modification to I.R.C. §199A. 

The Domestic Production Activities Deduction

In general.  I.R.C. §199, the Domestic Production Activities Deduction (DPAD) was enacted as part of the American Jobs Creation Act of 2004 effective for tax years beginning after 2004.  While often referred to as a “manufacturing” deduction, the DPAD was available to many businesses including those engaged in agricultural activities.   Except for domestic oil-related production activities (for which the deduction is limited to six percent), for tax years beginning after 2009 and before 2018, the DPAD is equal to the lesser of 9 percent of the taxpayer’s qualified production activities income for the year; 9 percent of the taxable income of the taxpayer (for an individual, this limitation is applied to AGI); and 50 percent of the Form W-2 (FICA) wages of the taxpayer for the taxable year.  Former I.R.C. §§199(a)(1) and (b)(1).  The deduction was from taxable income, subject to an overall limit of 50 percent of current year Form W-2 wages that were associated with qualifying activity employment.  The DPAD was allowed for both regular tax and alternative minimum tax (AMT) purposes (including adjusted current earnings). However, it was not allowed in computing SE income, and it could not create a loss.

Pass-Through Entities.  In general, the DPAD was not claimed by pass-through entities (such as S corporations, partnerships, estates or trusts) when computing taxable income.  Instead, the DPAD was applied at the shareholder, partner or beneficiary level.  The pass-through entity would provide the necessary information required to compute the DPAD as a footnote on Schedule K-1.  A taxable income limitation applied at the shareholder/partner level with each shareholder/partner separately computing the DPAD on its individual income tax return.

Note:  While the DPAD was not claimed by a pass-through entity, estates and trusts were eligible for the DPAD if the income was not passed through to the beneficiaries.

Agricultural Cooperatives.  Agricultural cooperatives could also claim the DPAD. However, the amount of any patronage dividend or per-unit retain allocations to a member of the cooperative that were allocable to qualified production activities were deductible from the member’s gross income.

Members of agricultural cooperatives included the DPAD for their distributions from the cooperative. The rules for cooperatives provided in §199(d)(3) and Treas. Reg. §1.199-6 applied to any portion of the DPAD that is not passed through to the cooperative’s patrons. In addition, a cooperative’s qualified production activities income was computed without taking into account any deduction allowable under IRC §1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions. 

The TCJA Provision As Applied to Agricultural Cooperatives

For tax years beginning after 2017, the DPAD is repealed.  In it place, for taxable years beginning after December 31, 2017, and before January 1, 2026, the TCJA creates (as applied to an agricultural or horticultural cooperative) a deduction equal to the lesser of (a) 20 percent of the excess (if any) of the cooperative’s gross income over the qualified cooperative dividends paid during the taxable year for the taxable year, or (b) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. I.R.C. §199A(g).  The cooperative’s section 199A(g) deduction may not exceed its taxable income (computed without regard to the cooperative’s deduction under I.R.C. §199A(g)) for the taxable year.

As for the impact of I.R.C. §199A on patrons of ag cooperatives, effective for tax years beginning after 2017, there is no longer a DPAD that a cooperative can pass through to a patron.  However, as noted above, the deduction is 20 percent of the total of payments received from the cooperative (including non-cash qualified patronage dividends).  The only limit is 100 percent of net taxable income less capital gains.  For sales to a non-cooperative, the deduction is 20 percent of net farm income. 

The Modification     

Impact on cooperatives.  The provision in the Omnibus bill removes the QBI deduction for agricultural or horticultural cooperatives.  In its place, the former DPAD provision (in all practical essence) is restored for such cooperatives.  Thus, an ag cooperative can claim a deduction from taxable income that is equal to nine percent of the lesser of the cooperative’s qualified production activities income or taxable income (determined without regard to the cooperative’s I.R.C. § 199A(g) deduction and any deduction allowable under section 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the taxable year. The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such taxable year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A (which is not repealed as applied to non-cooperatives), except that “wages” do not include any amount that is not properly allocable to domestic production gross receipts.  A cooperative’s DPAD is reduced by any amount passed through to patrons. 

Under the technical correction, the definition of a “specified agricultural or horticultural cooperative” is limited to organizations to which part I of subchapter T applies that either manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product; or market any agricultural or horticultural product that their patrons have manufactured, produced, grown, or extracted in whole or significant part. The technical correction notes that Treas Reg. §1.199-6(f) is to apply such that agricultural or horticultural products also include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are manufactured, produced, grown, or extracted by the cooperative. 

Note:  As modified, a “specified agricultural or horticultural cooperative” does not include a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.

Impact on patrons.  Under the new language, an eligible patron that receives a qualified payment from a specified agricultural or horticultural cooperative can claim a deduction in the tax year of receipt in an amount equal to the portion of the cooperative’s deduction for qualified production activities income that is: 1) allowed with respect to the portion of the qualified production activities income to which such payment is attributable; and 2) identified by the cooperative in a written notice mailed to the patron during the payment period described in I.R.C. §1382(d).

Note:  The cooperative’s I.R.C. §199A(g) deduction is allocated among its patrons on the basis of the quantity or value of business done with or for the patron by the cooperative.

The patron’s deduction may not exceed the patron’s taxable income for the taxable year (determined without regard to the deduction, but after accounting for the patron’s other deductions under I.R.C. §199A(a)). What is a qualified payment?  It’s any amount that meets three tests:  1) the payment must be either a patronage dividend or a per-unit retain allocations; 2) the payment, must be received by an eligible patron from a qualified agricultural or horticultural cooperative; and 3) the payment must be attributable to qualified production activities income with respect to which a deduction is allowed to the cooperative.

An eligible patron cannot be a corporation and cannot be another ag cooperative.   In addition, a cooperative cannot reduce its income under I.R.C. §1382 for any deduction allowable to its patrons by virtue of I.R.C. §199A(g).  Thus, the cooperative must reduce its deductions that are allowed for certain payments to its patrons in an amount equal to the I.R.C. §199A(g) deduction allocated to its patrons.

Transition rule.  A transition rule applies such that the repeal of the DPAD does not apply to a qualified payment that a patron receives from an ag cooperative in a tax year beginning after 2017 to the extent that the payment is attributable to qualified production activities income with respect to which the deduction is allowed to the cooperative under the former DPAD provision for the cooperative’s tax year that began before 2018.  That type of qualified payment is subject to the pre-2018 DPAD provision, and any deduction allocated by a cooperative to patrons related to that type of payment can be deducted by patrons in accordance with the pre-2018 DPAD rules.  In that event, no post-2017 QBI deduction is allowed for those type of qualified payments.

Conclusion

With the technical correction to I.R.C. §199A, where do things now stand for farmers? 

  • The overall QBI deduction cannot exceed 20 percent of taxable income. That restriction applies to all taxpayers regardless of income.  If business income exceeds $315,000 (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation test is phased-in.
  • The prior I.R.C. 199 DPAD no longer exists, except as resurrected for agricultural and horticultural cooperatives as noted above. The 20 percent QBI deduction of I.R.C. §199A is available for sole proprietorships and pass-through businesses.  For farming businesses structured in this manner, the tax benefit of the 20 percent QBI deduction will likely outweigh what the DPAD would have produced. 
  • While those operating in the C corporate form can’t claim a QBI deduction, the corporate tax rate is now a flat 21 percent. That represents a tax increase only for those corporations that would have otherwise triggered a 15 percent rate under prior law.
  • For C corporations that are also patrons of an agricultural cooperative, the cooperative’s DPAD does not pass through to the patron.
  • For a Schedule F farmer that is a patron of an agricultural cooperative and pays no wages, there are two steps to calculate the tax benefits. First, the cooperative’s DPAD that is passed through to the patron can be applied to offset the patron’s taxable income regardless of source.  Second, the farmer/patron is entitled to a QBI deduction equal to 20 percent of net farm income derived from qualified non-cooperative sales, subject to the taxable income limitation ($315,000 MFJ; $157,000 all others).
  • For farmers selling to ag cooperatives that also pay W-2 wages, the QBI deduction is calculated on the sales to cooperatives by applying the lesser of 50 percent of W-2 wages or 9 percent reduction limitation. Thus, for a farmer that has farm income beneath the $315,000 threshold (MFJ; $157,500 all others), the QBI deduction will never be less than 11 percent (i.e., 20 percent less 9 percent).  If the farmer is above the $315,000 amount (MFJ; $157,500 all others), the 50 percent of W-2 wages limitation will be applied before the 9 percent limitation.  This will result in the farmer’s QBI deduction, which cannot exceed 20 percent of taxable income.  To this amount is added any pass-through DPAD from the cooperative to produce the total deductible amount.   
  • For farmers that sell ag products to non-cooperatives and pay W-2 wages, a deduction of 20 percent of net farm income is available. If taxable income is less than net farm income, the deduction is 20 percent of taxable income less capital gains.  If net farm income exceeds $315,000 (MFJ; $157,500 single), the deduction may be reduced on a phased-in basis.
  • The newly re-tooled cooperative DPAD of I.R.C. 199A may incentivize more cooperatives to pass the DPAD through to their patrons.

March 26, 2018 in Income Tax | Permalink | Comments (0)

Thursday, March 22, 2018

The Tax Treatment of Farming Net Operating Losses

Overview

In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result.  Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income.  A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040. 

Special rules apply to farm NOLs.  Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA). 

Farm NOLs – The Basics

Carryback rule.  Until the changes contained in legislation enacted in late 2017, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years.  Those were the rules in place through 2017.   A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up.  Whether a loss is carried back two years instead of five depends on the farmer’s level of income in those carryback years and the applicable tax bracket.  

Another beneficial rule can apply when an NOL is carried back to a prior year.  Because two years back (as opposed to five) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election.  By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made.  That will allow the taxpayer to claim future depreciation deductions.  This is the case, at least, on the taxpayer’s federal return.  Some states don’t “couple” with the federal I.R.C. §179 provision.

Taxpayers may elect to forego an NOL carryback in favor of a carryforward (for 20 years).  However, if a taxpayer elects not to carry a net operating loss back to offset income in prior years, the taxpayer will be limited to a carryforward of the NOL. 

The TCJA and The Impact on Farm NOLs

For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.

An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount.  The NOL carried over from other years may not be used in calculating the NOL for the year in question.  In addition, capital losses may not exceed capital gains.  Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses.  In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.

The TCJA made changes to how farmers can treat NOLs.  For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year.  For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC.  In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form). 

Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset).  In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). This effective date provision has an immediate impact on any farm corporation that has a fiscal year ending in 2018 insomuch as the corporation will not be allowed to carry back an NOL for five years.  Instead, the NOL can only be carried back two years.  All other corporate taxpayers can only carry an NOL forward.

Instead, under the TCJA, farmer NOLs can only be carried back two years and all others must be carried forward.  NOLs that are carried back can only offset 80 percent of taxable income.   However, NOLs that are carried forward will not expire after 20 years (as they did under prior law).  Similar to the carryback rule, NOLs that are carried forward can only offset

In the case of a partnership or S corporation, the TCJA applies the NOL rules at the partner or shareholder level.  Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. 

Marital Status Changes

There are additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward.  In that case, only the spouse who had the loss can claim the NOL deduction.  On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss.  Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return.  The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.

Change in Filing Status

Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years.

NOLs and Death

A NOL that has been carried forward is deductible on a decedent’s final income tax return.  It cannot be carried over to a decedent’s estate.  Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.

Conclusion

Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow.  That's where the NOL rules come into play.  

March 22, 2018 in Income Tax | Permalink | Comments (0)

Tuesday, March 20, 2018

Prescriptive Easements and Adverse Possession – Obtaining Title to Land Without Paying For It

Overview

Normally land is acquired in a transaction where a buyer pays a sum to buy the property and obtain legal title to it.  However, if a person without legal title to a tract can claim legal ownership by showing that the person has possessed it for a certain amount of time without the permission of the tract’s true owner.  This is known as “adverse possession” and it has been recognized for several centuries, dating back to early English common law. 

A concept similar to adverse possession is that of a prescriptive easement.  A prescriptive easement is an implied easement for usage of another person’s tract of land where the use occurs without the true owner’s permission, and has lasted for a time period set by statute in the particular jurisdiction.  A prescriptive easement can result in title ownership over the area subject to the easement resting in the party (or parties) using the easement.   

Adverse possession and prescriptive easements are important to rural landowners.  Many cases are brought every year concerning boundary disputes that involve these concepts.  Once title is successfully obtained by adverse possession (or by prescription), the party obtaining title can bring a court action to quiet title.  A quiet title action ensures that the land records properly reflect the true owner of the property.

Obtaining title to land by adverse possession or by a prescriptive easement.  That’s the topic of today’s post. 

General Points

Obtaining title to property either by adverse possession or easement by prescription has some common requirements.  The possession must be “open and notorious” which means the possession is obvious to anyone.  In addition, the possession must be actual and continuous.  This means that the usage of the property must be uninterrupted for the applicable statutory timeframe (generally from 5 to 20 years, depending on state law).  The possession must also be adverse to the rights of the true property owner.  Also, in many states, the possession must be hostile – in opposition to the claim of someone else.  Also, adverse possession commonly requires that the possession be exclusive, but a prescriptive easement typically only requires that the prescriptive user use the easement in a way that differs from the general public. 

There are other points to both adverse possession and easement by prescription such as whether title can be obtained adverse to the government (it generally cannot) or a railroad (again, the answer is generally negative).  In addition, a negative easement cannot be created by prescription. 

Prescription may also be used to end an existing legal easement. For example, if a servient tenement (estate) holder were to erect a fence blocking a legally deeded right-of-way easement, the dominant tenement holder would have to act to defend their easement rights during the statutory period or the easement might cease to have legal force, even though it would remain a deeded document. Failure to use an easement leading to loss of the easement is sometimes referred to as "non-user."

Recent Case

The adverse possession/prescriptive easement issue came up recently in an Idaho case.  In Lemhi County v. Moulton, No. 24 2018, Ida. LEXIS 60 (Idaho Sup Ct. Mar. 13, 2018), the plaintiff, a county, sought declaratory relief to prevent flooding on the Lemhi County Backroad. The Backroad runs generally north-to-south, dividing two ranches - the Skinner Ranch (uphill property) and the Hartvigson Ranch (downhill property). The downhill property spans approximately 200 acres and is situated on the Lemhi Valley floor near the Lemhi River. Most of the downhill property is on the west side of the Backroad, but a small portion extends into a steep draw on the east side (the "Hartvigson Draw"). The water flowing through the draw runs under the Lemhi County Backroad through one of two culverts, across the downhill property, and into a draw that feeds into the Lemhi River. The uphill property is on higher ground on the east side of the Backroad. The uphill property has three drainages, one of which feeds into the Hartvigson draw.

In its declaratory judgment action, the plaintiff claimed that in November 2010, the downhill property obstructed the flow of water from the Hartvigson Draw through the culverts, which caused flooding along that area of the Backroad.  The plaintiff noted in its complaint that the failure to allow the water to pass unobstructed was based at least in part on the allegation that the uphill property sent too much water down the draw, which caused damage to the downhill property.  

The trial court entered a judgment that the downhill property allow drainage of natural surface water in the amount of 3.25 cubic feet per second (CFS) through the culverts and across its lands. However, that judgment left unresolved how much water, if any, the uphill property could legally send down the Hartvigson Draw. After a three-day bench trial, the court found that the channel through the basin, down the Hartvigson Draw, across the downhill property, and eventually into the Lemhi River was a natural waterway. Additionally, the trial court found that this water flow met the requirements for the uphill property to establish a prescriptive easement. The court entered a judgment permitting the uphill property to send water in the amount of 3.25 CFS down the basin drainage that flowed through the Hartvigson Draw under both an easement and natural servitude theory.

The downhill property owners timely appealed.  They claimed that the trial court erred in its prescriptive easement determination on two fronts: (1) the uphill property's water use was not adverse to them; and (2) the plaintiff failed to prove the scope of the easement.  They claimed that the use was not adverse because they had a wastewater right for water out of the Hartvigson draw. However, the state Supreme Court determined that the trial court’s factual findings established that the uphill landowners had been sending water down the draw for decades, before and after the established wastewater right. Thus, the Court held that the practice of the uphill landowners of sending water down the draw was under a claim of right and adverse to the downhill property owners. In addition, downhill owners claimed that no witness at trial could testify as to the exact amount of water that had regularly been sent down the Hartvigson Draw, and absent that testimony the trial court lacked clear and convincing evidence to support an easement for 3.25 CFS. However, the Court pointed to testimony by the owner of uphill property that the approximate quantity sent down the draw was between 3 and 3.5 CFS. Thus, the Court held that the trial court did not err in limiting the easement to 3.24 CFS.

The Supreme Court also determined that the trial court’s judgment was not sufficiently clear with respect to the location of the drainage. Therefore, Court remanded the case to the trial court in order to clear up the judgment with regards to the location of the drainage.

Conclusion

Property usage and boundary disputes are, unfortunately, too common in rural settings.  Many times, the problem stems from a fundamental lack of communication.  But, that’s not always the case.  Sometimes, issues can arise through the fault of no one.  It is those times that its good to have an experienced ag lawyer in tow.

March 20, 2018 in Real Property | Permalink | Comments (0)

Friday, March 16, 2018

Chapter 12 Bankruptcy – Feasibility of the Reorganization Plan

Overview

From an economic standpoint, recent years have not been friendly to many agricultural producers.  Low commodity prices for various grains and milk and increasing debt loads have made it difficult for some farmers to continue.  Chapter 12 bankruptcy filings have been on the rise.  In parts of the Midwest, for instance, filings have been up over 30 percent in the past couple of years compared to prior years. 

There are 94 bankruptcy judicial districts in the U.S.  In 2017, the Western District of Wisconsin led all of them with 28 Chapter 12 cases filed.  Next was Kansas and the Middle District of Georgia with 25 each.  Nebraska was next with 20 Chapter 12 filings.  Minnesota had 19.  Both the Eastern District of Wisconsin and the Eastern District of California had 17.  In the “leader” – the Western District of Wisconsin – filings were up over 30 percent from the prior year for the second year in a row. 

One of the requirements that must be satisfied for a bankruptcy court to get a Chapter 12 reorganization plan confirmed by the bank.  However, it’s becoming a more difficult proposition for some of the Chapter 12 filers. 

The feasibility of a Chapter 12 reorganization plan – that’s the focus of today’s post.   

Chapter 12 Plan Confirmation

Unless the time limit is extended by the court, the confirmation hearing is to be concluded not later than 45 days after the plan is filed. The court is required to confirm a plan if—(1) the plan conforms to all bankruptcy provisions; (2) all required fees have been paid; (3) the plan proposal was made in good faith without violating any law; (4) unsecured creditors receive not less than the amount the unsecured creditors would receive in a Chapter 7 liquidation; (5) each secured creditor either (a) accepts the plan, (b) retains the lien securing the claim (with the value of the property to be distributed for the allowed amount of the claim, as of the effective date of the plan, to equal not less than the allowed amount of the claim), or (c) the creditor receives the property securing the claim; and (6) the debtor will be able to comply with the plan.

Also, under a provision added by The Bankruptcy Act of 2005, an individual Chapter 12 debtor must be current on post-petition domestic support obligations as a condition of plan confirmation.

Feasibility of the Reorganization Plan 

If the court determines that the debtor will be unable to make all payments as required by the plan, the court may require the debtor to modify the plan, convert the case to a Chapter 7, or request the court to dismiss the case.  Over the years, numerous Chapter 12 cases have involved the feasibility issue.  Most recently, a Chapter 12 case from (you guessed it) the Western District of Wisconsin, involved the question of whether a debtor’s reorganization plan was feasible. 

Recent Case

In In re Johnson, No. 17-11448-12, 2018 Bankr. LEXIS 74 (Bankr. W.D. Wisc. Jan. 12, 2018), the debtor was a farmer who primarily raised corn and soybeans. He also was the sole owner of grain farming LLC. The debtor filed a Chapter 12 petition on April 25, 2017, and a Chapter 12 plan on August 22, 2017. On September 25, 2017 a bank objected to plan confirmation. The debtor filed an amended Chapter 12 plan on November 3, 2017 and a second amended Chapter 12 plan on December 14, 2017.

The amended plan proposed payments of $8,150 per month for 12 months, then $11,700 per month for 36 months, and finally $13,700 per month for 12 months. In total the plan proposed payments of $683,400 over 60 months. The debtor claimed that this would pay the creditors in full. However, the court determined that the debtor’s plan was not feasible. At confirmation, the debtor would be required to immediately pay $67,155.70 to cure defaults on leases to be assumed and $40,000 to another creditor. Other than vague testimony that funds were available to satisfy the immediate payments to the other creditor, there was no evidence presented that supported any ability to make the lease cure payments. In addition, the evidence to which the debtor pointed supporting his ability to make payments were his tax returns for the years 2012 through 2015. However, those returns also included crop insurance payments which the debtor was no longer eligible to receive. Yet, according to the debtor’s estimates, he would do better in each of the next three years than he did at any time between 2012 and 2015. The bankruptcy court determined that, based on the picture presented by the debtor’s tax returns and testimony, the debtor’s projections were unpersuasive and lacked credibility.

The debtor also estimated that his gross income from crop sale would swell over the next three years and that his expenses would be less than any of the last four years. Yet, the debtor offered no explanation for how he arrived at these estimates. The debtor claimed that his expenses would decrease because he was no longer paying for crop insurance. However, that would only lower his expenses by approximately $30,000 and there was no reserve for crop loss in the projections, which had ranged from $39,210 to $274,933 in the past. For these reasons, the court determined that the debtor failed to meet his burden in showing that the plan was feasible.

In addition, the debtor’s plan proposed paying the bank’s various secured claims at a 5.5 percent interest rate. The court determined that under Till v. SCS Credit Corp., 541 U.S. 465 (2004), the bank was entitled to a “prime-plus” interest rate. Moreover, in the context of chapter 12 cases, the court noted that risk is often heightened due to the unpredictable nature of the agricultural economy. The court found that the interest rate proposed for the bank in the debtor’s plan was inadequate under Till. The court noted that the current national interest rate was 4.5 percent and the debtor proposed the minimum risk adjustment of 1 percent. The fact that the debtor’s tax returns show that he was consistently reporting losses or barely breaking-even in addition to the many other risk factors led the court to hold that the bank would be subject to a significant degree of risk under the plan and that the debtor’s proposed interest rate was insufficient.

Finally, the court held that because the debtor’s projections lacked any credibility or support it would be impossible for the debtor to propose a confirmable plan. As such, the court dismissed the case. 

Conclusion

Chapter 12 bankruptcy is a difficult experience for a farm debtor to experience.  But, putting a feasible reorganization plan together is essential for getting a plan confirmed.  In the current economic environment, that’s becoming more difficult for many farmers.

March 16, 2018 in Bankruptcy | Permalink | Comments (0)

Wednesday, March 14, 2018

When Does a Rule of Strict Liability Apply on the Farm?

Overview

Most liability events that occur on a farm or ranch are judged under a standard of negligence.  However, some are deemed to be so dangerous that a showing of negligence is not required to obtain a recovery.  Under a strict liability approach, the defendant is liable for injuries caused by the defendant's actions, even if the defendant was not negligent in any way or did not intend to injure the plaintiff. In general, those situations reserved for resolution under a strict liability approach involve those activities that are highly dangerous.  When these activities are engaged in, the defendant must be prepared to pay for all resulting consequences, regardless of the legal fault.

What are those situations that are common to the operation of a farm or ranch, or simply being a rural landowner that can lead to the application of the strict liability rule?  That’s the focus of today’s post.

Application of a Strict Liability Rule

Wild animals.  In general, landowners are not strictly liable for the acts of wild animals on their property.  But, some courts have held that a landowner could be found negligent with regard to the indigenous wild animals that are found on the landowner’s property if the landowner knows or has reason to know of the unreasonable risk of harm posed by the animals. See, e.g., Vendrella v. Astriab Family Limited Partnership, 87 A.3d 546, 311 Conn. 301 (2014).

If an individual keeps wild animals on his or her premises, the individual will be strictly liable for any damages that the animals cause to other persons or their property.  In many jurisdictions, the owner or possessor of hard-hoofed animals, such as cattle, horses and donkeys, may also be strictly liable for injuries caused by those animals, at least if known to have a vicious propensity.

Dogs and other domestic animals.  Injuries or other damages caused by dogs are handled differently.  The owner or possessor of a dog is normally not liable unless the owner knows the animal to be dangerous.  Historically, a dog was entitled to its first bite.  The dog's owner would not be liable for injuries from the dog's bite until the dog had already bitten someone.  Until the dog has bitten someone, it is not known to be dangerous.  In recent years, many states have passed statutes changing the common law rule and holding a dog owner (or a person who “harbors” a dog) responsible for the injuries caused by the dog.  But see, Augsburger v. Homestead Mutual Insurance Company, et al., 856 N.W.2d 874, 359 Wis. 2d 385 (2014)An exception is usually made, however, for personal injuries caused by a dog if the defendant was trespassing or was committing an unlawful act at the time of the injury.  Some state statutes also make a distinction on the basis of whether the dog would attack or injure someone without provocation. Also, under Restatement (Second) of Torts § 518, the owner of a domestic animal who does not know or have reason to know that the animal is more dangerous than others of its class may still be liable for negligently failing to prevent the animal from inflicting an injury. Approximately 20 states follow the Restatement approach.

Of importance to agriculture is that some state “dog-bite” statutes contain a “working dog exception.”  The exception contained in the Colorado statute, for example, applies if the bite occurs while the dog is on its owner’s property or while the dog was working under the control of its owner.  See, e.g., Legro v. Robinson, 369 P.3d 785, (Colo. Ct. App. 2015).

Maintaining dangerous conditions on property.  Strict liability is imposed on persons responsible for activities or conditions on their property that are unreasonably dangerous and cause injury or damage to other persons or their property.  For example, if a farmer or rancher decides to create a drainage ditch with explosives, and the resulting rock debris causes damages to a neighbor, the farmer will be strictly liable.

Unnatural land uses.  The strict liability approach also includes most activities that are extremely dangerous.  Perhaps the most frequent application of the doctrine to agriculture is in situations involving the aerial application of pesticides and other chemicals to crops. See, e.g., Pride of San Juan, Inc. v. Pratt, 548 Ariz. Adv. Rep. 20 (2009); Yancey v. Watkins, 708 S.E.2d 539, 308 Ga. App. 695 (2011)Most states utilize a strict liability rule if damage occurs.  A few states purport to require a showing of negligence, but, in reality, even in these jurisdictions it may be difficult for a farmer to escape liability if damage occurs. For example, in Arkansas, violation of aerial crop spraying regulations constitutes evidence of negligence and the negligence of crop sprayers can be imputed to landowners because aerial crop spraying is viewed as an inherently dangerous activity. McCorkle Farms, Inc. v. Thompson, 84 S.W.3d 884 (Ark. Ct. App. 2003). However, the rule remains in Arkansas that the aerial application of chemicals commonly used in farming communities that are available for sale to the general public is not an ultrahazardous activity triggering application of strict liability.  See, e.g., Mangrum v. Pique, et al., 359 Ark. 373, 198 S.W.3d 496 (2006).

 Also, what is abnormally dangerous can depend on the circumstances and characteristics surrounding the complained-of activity.  For example, in Crosstex North Texas Pipeline, L.P. v. Gardiner, 505 S.W.3d 580 (Tex. Sup. Ct. 2016), the Texas Supreme Court held that the operation of an oil and gas pipeline does not constitute an abnormally dangerous activity that would trigger the application of strict liability.

Arguably, if a farmer plants a genetically modified (GM) crop with knowledge that the crop is likely to cross-pollinate conventional crops in adjacent fields, the farmer could be held strictly liable for any resulting damages.  The situation could be viewed as similar to the problem of pesticide drift.  The damages in a cross-pollination case could include, among other things, loss of organic certification, costs associated with breaches of identity preserved crop contracts, and litigation costs of neighboring farmers who are sued by seed companies for “theft” of genetic intellectual property that was actually present in their fields due to wind and cross-pollination.  See, e.g., Schmeiser v. Monsanto Canada, Inc., [2004] S.C.C. 34; Monsanto v. Trantham, 156 F.Supp. 2d 855 (W.D. Tenn. 2001); Monsanto v. McFarling, 302 F.3d 1291 (Fed. Cir. 2002); cert. den., 545 U.S. 1139 (2005).  But, if the GM crop at issue had already received appropriate regulatory approval, the plaintiff could be required to prove that the GM crop was unnatural or abnormally dangerous.

Conclusion

While most liability events that occur on a farm ranch are judged based on a negligence standard, strict liability can apply in certain situations.  In addition to those events mentioned above, certain environmental violations carry a strict liability standard of liability also.  It’s helpful to know the applicable legal standard.

March 14, 2018 in Civil Liabilities | Permalink | Comments (0)

Monday, March 12, 2018

Trade Issues and Tariffs – Are Agriculture’s Concerns Legitimate?

Overview

Since the enactment of the Tariff Act of 1789 (signed by President Washington) along with the Collection Act also enacted on the same day, the U.S. has been engaged in protecting trade.  Those two 1789 laws were not only designed to protect trade.  They were also enacted with the purpose of raising revenue for the federal government. As the soon-to-be first Secretary of the Treasury, Alexander Hamilton took the position that tariffs would encourage industry in the newly-formed country and pointed out that other countries subsidized their industries and that tariffs would protect U.S. businesses from the negative impacts of those subsidies.  Later on, the Tariff Act of 1816 addressed concerns about other countries “dumping” their goods in the U.S. at less than fair value to damage U.S. domestic production. 

This history points out that the federal government has imposed tariffs practically from the founding of the country.  Presently, massive trade deficits with various countries (particularly Mexico and China) and currency manipulation (by China) have posed a serious problem that a pragmatic President is determined to solve.

But, what are the potential implications of the Trump Administration’s recent trade measures on agriculture?  Are the recently announced tariffs part of a bigger overall picture?  Are they a bargaining chip in negotiating improvements to existing trade deals?  These are all important questions.

For today’s post, I have asked Prof. Amy Deen Westbrook, the Kurt M. Sager Memorial Distinguished Professor of International and Commercial Law at Washburn University School of Law, for her thoughts on the matter.  She graciously accepted my invitation and is today’s guest blogger.  As you will see, Prof. Westbrook is another example of the fine legal instruction that is provided at Washburn Law.  I will sum things up in the conclusion at the end.

Multiple Moving Parts – Trade Deals and Tariffs

Renegotiation of NAFTA.  Fulfilling one of President Trump’s campaign promises, the Administration launched a renegotiation process of the North American Free Trade Agreement (NAFTA) last August.  The United States is seeking a more favorable deal, and has threatened to withdraw from NAFTA if it cannot come to a satisfactory arrangement with Mexico and Canada. 

U.S. NAFTA negotiating priorities center on increased minimum regional content requirement for autos to qualify for NAFTA treatment, access to U.S. government procurement opportunities, revised dispute resolution options, an automatic five-year sunset provision for NAFTA, and more advantageous agriculture provisions.  In particular, the United States has requested that Canada dismantle its system of tariffs and quotas in the dairy sector.  The United States is also seeking authorization for stronger protections for seasonal U.S. produce against Mexican imports. 

U.S. agricultural demands reflect the current NAFTA agricultural trade deficit.  Although the deficit largely results from the weaker Mexican and Canadian currencies, it also reflects the increasing volume of imports of fruits and vegetables into the United States, particularly counter-seasonal imports of products like tomatoes, peppers and asparagus from Mexico. 

Note:  Negotiators from all three NAFTA parties wrapped up their seventh round of talks in early March of 2018 in Mexico City, and anticipate an eighth round in Washington, D.C. beginning in April.  However, it is unclear when, or even if, a revised agreement will be ironed out.

Use of trade remedies against U.S. trading partners.  The Trump Administration has various remedies at its disposal with respect to trade disputes.  Recently, for example, the Trump Administration has imposed several different measures on foreign imports.  U.S. law, the World Trade Organization (WTO) agreement, and other international obligations provide the United States with an array of remedies to protect U.S. producers from trade practices by other countries.  As noted below, the Administration has utilized each of these remedies to-date. 

    Dumping, subsidies, and other unfair trade practicesIn response to a petition by or on behalf of a U.S. industry, U.S. trade regulators can levy anti-dumping duties on foreign goods sold in the United States at unfairly low prices if the sale of those goods materially injures, or threatens to injure, or even retards the establishment of, the domestic industry.  Similarly, "countervailing duties" may be levied on foreign goods sold in the United States at unfairly low prices as a result of an impermissible subsidy by the exporting nation.  The United States currently has 164 antidumping and countervailing duty orders in effect for steel alone, with another 20 in the pipeline.

    Section 301.  Section 301 of the Trade Act of 1974 empowers the U.S. Trade Representative (USTR) to impose duties or suspend concessions against a foreign country that takes actions that are unjustifiable, unreasonable or discriminatory and burden or restrict U.S. commerce.  In 2017, the United States launched a Section 301 investigation into Chinese practices relating to forced technology transfer, unfair licensing and other intellectual property policies.

    Section 201.  In addition to remedies for unfair trade practices, the United States can also impose protections for domestic industries against fair trade practices by our trade partners.  On January 22, 2018, President Trump approved the imposition of safeguards under Section 201 of the Trade Act of 1974 against foreign solar panels and washing machines.  Section 201 relief, which was last granted by the United States 16 years ago, provides temporary protection to a U.S. industry that is being injured by a surge of foreign imports.  The measures are intended to last for a couple of years, and in fact the U.S. plan for solar panels is to start tariffs at 30% and let them gradually fall to 15% over four years.

    Section 232.  Perhaps more significant, at least to the financial markets, than the anti-dumping, anti-subsidy, Section 301 or Section 201 actions, however, was the announcement in early March of 2018 that the U.S. would take measures under Section 232 of the Trade Expansion Act of 1962.  An almost-never-used provision, Section 232 enables the President to restrict foreign trade in the interests of national security.  In April of 2017, President Trump requested the Secretary of Commerce to review the impact of imported steel and aluminum under Section 232.  The Department of Commerce produced its reports in January of 2018, and made them public in February.  Unlike the last time the Administration considered Section 232 measures with respect to steel (in 2001), this time the Department of Commerce recommended tariffs be imposed on foreign imports in order to safeguard national security.  Upon receipt of the report, the President had 90 days to decide whether to impose measures.  On March 8, the President imposed “flexible,” global tariffs (25 percent on steel and 10 percent on aluminum). It is important to note that the President announced the tariffs in the middle of the NAFTA negotiations.   

Note:  The Section 232 measures have resulted in substantial diplomacy and lobbying by U.S. industries that will be directly affected by the Section 232 measures - such as the auto industry.  U.S. industries indirectly affected by the measures, such as agriculture, have also voiced concern, as have U.S. foreign trading partners. 

The Section 232 tariffs are seen largely as a measure against China.  The United States is the world’s top steel importer.  China is the world’s largest producer of both steel and aluminum.  Although China accounts for just a fraction of U.S. steel imports, the United States believes that China has flooded the global market for steel and is dragging down prices as a result.  In addition, Canada (the largest U.S. source of foreign steel and aluminum) and Mexico (the fourth largest U.S. source of foreign steel and 11th largest aluminum source) are currently exempted from the tariffs, contingent upon successful completion of the NAFTA negotiations.  President Trump has also indicated that Australia may be exempted (by virtue of a pending security agreement) and the USTR met in early March of 2018 with representatives of the European Union and Japan about the possibility of exclusion from the tariffs. 

Normally, Section 232 tariffs take effect 15 days after the President’s official announcement.  That means that right now, and over the next few days, negotiations could occur with a number of U.S. trading partners as they argue for exemptions.  The negotiations may be made more dramatic by the fact that the Administration has pledged to block a certain volume of foreign steel from the market, meaning that each time a country is exempted from the tariffs, tariffs presumably must rise on the remaining/non-exempted countries.

Foreign Reactions To The Tariffs – Including Agricultural Impacts

U.S. Secretary of Agriculture Sonny Perdue has expressed concern that U.S. trading partners impacted by the U.S. trade measures, particularly the steel tariffs, will retaliate against U.S. agricultural exports.  As expected, foreign reactions to the U.S. measures have not been positive.  The European Union (EU) announced a list of $3.5 billion of U.S. products against which it will impose 25% retaliatory tariffs if the U.S. imposes the steel and aluminum measures on the EU.  The EU list targeted Harley Davidson motorcycles, jeans, and bourbon, as well as orange juice, corn, cranberries, peanut butter and a variety of other agricultural products.  The EU’s announcement echoes its reaction to U.S. Section 201 safeguard measures for steel in 2002, which the EU ultimately successfully challenged at the WTO, resulting in the U.S. removal of the measures before the EU retaliated. 

China has also reacted negatively to the Administration's announcement of new U.S. measures.  On February 4, 2018 (two weeks after the Section 201 measures on solar panels and washing machines were announced). China announced that it would launch anti-dumping and anti-subsidy investigations of U.S. sorghum exports.  U.S. grain sorghum exports to China have increased since 2013, and China currently accounts for approximately 80 percent of U.S. grain sorghum exports.  

In addition, on February 7, 2018, Chinese agricultural producers met to study the possibility of launching anti-dumping or anti-subsidy investigations into U.S. exports of soybeans.  U.S. soybean exports are particularly vulnerable to Chinese measures.  The 30 million tons of soybeans China purchases from the United States represent a third of U.S. production, and make China the largest market for U.S. soybeans.  With Brazilian (and, to a lesser extent, Argentinian) beans in plentiful, and relatively cheap, supply, there is concern that China could curb U.S. imports and replace them with South American soybeans (at least for 6-7 months).  Other concerns center on U.S. beef exports to China, which restarted only last year after a ban imposed in 2003 because of concerns over bovine spongiform encephalopathy.  

The WTO and Other Legal Actions

China, the EU, Japan and South Korea sought consultations with the United States at the WTO following the U.S. imposition of the Section 201 measures against solar panels and washing machines.  Canada also sought an injunction against the imposition of the Section 201 safeguards, but its request was rejected by the U.S. Court of International Trade on March 6, 2018.

However, it is unclear whether U.S. trading partners will challenge the Section 232 national security safeguards at the WTO.  The EU is reported to be considering a WTO challenge, pending the outcome of its request for an exemption from the Section 232 tariffs.  The WTO agreement includes an exception from members’ trade obligations for actions necessary for the protection of a member’s essential security interests.  However, key terms such as “necessary” and “essential security interests” are undefined.  Countries are reluctant to use and even more reluctant to second-guess their trading partners’ use of the exception for essential security interests.  Sovereign countries generally do not want to infringe on the national-security-based policy decisions of other sovereign countries.  In addition, there has been a tacit recognition that if the exception is indiscriminately invoked, it has the potential to undermine the entire WTO system.  If anything can be an essential security interest, then any country can use the exception at anytime. 

Conclusion

Currency manipulation, trade deficits, unfair trade practices, theft and misuse of intellectual property rights, and related issues are not problems that are unique to a particular political party or political ideology.  They are American problems that threaten the financial stability of the U.S. and the production of U.S. products and commodities.  The open borders trade agenda for at least the past 25 years has negatively impacted U.S. families.  For example, just from 2000-2010 (post-NAFTA) the U.S. lost 55,000 factories and 6,000,000 manufacturing jobs across numerous sectors, U.S. wages stagnated, and the associated ingenuity was lost.  These are problems that President Trump has identified that need to be fixed in a pragmatic way.  These are also problems that hit at the core of the United States as a country – as President Washington identified over 200 years ago.

Should the agricultural industry be concerned?  Of course.  However, there is a significant chance that the potential for tariffs and other sanctions on other countries is part of an overall attempt to renegotiate existing trade deals for the benefit of America, including agriculture

March 12, 2018 in Regulatory Law | Permalink | Comments (0)

Thursday, March 8, 2018

Deductible Repairs Versus Capitalization

Overview

The rules as to what is a “repair” and, therefore, is deductible, and what must be capitalized and depreciated have never provided a bright line for determining how an expense should be handled.  The basic issue is finding the line between I.R.C. §162(a) and I.R.C. §263(a).  I.R.C. §162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business, including amounts paid for incidental repairs.  Conversely, I.R.C. §263(a) denies a current deduction for any amount paid for new property or for permanent improvements or betterments that increase the value of any property, or amounts spent to restore property.

The line between a currently deductible repair and an expense that must be capitalized is one that farmers and ranchers often deal with.  A recent court decision involving a Colorado grape-growing operation illustrates the difficulty in determining the correct tax classification of expenses.

Basic Principles

In general, any expense of a farmer associated with the business with a useful life of less than one year is deductible against gross income.  Depreciation is required if an asset has a useful life of more than one year.  Expenses are current costs, and any cost that produces a benefit lasting for more than one year (such as expenses for improvements that increase the property’s value) is generally not currently deductible.  Instead, those items must be depreciated or amortized over the period of benefit or use.  Indeed, Treas. Reg. §§1.263(a)-1, (b)-2, 1.461-1(a)(2), an expense must be capitalized if the item has a benefit to the taxpayer extending substantially over one year or adapts the property to a new or different use.

A big issue for farmers and ranchers is whether major engine or transmission overhauls are currently deductible as repairs.  Fortunately, there are cases that provide useful authority for the position that major engine or transmission overhauls should be currently deductible as repairs. See, e.g., Ingram Industries, Inc. & Subs. v. Comm’r, T.C. Memo. 2000-323; FedEx Corp. & Subs. v. United States, 121 Fed. Appx. 125 (6th Cir. 2005), aff’g, 291 F. Supp. 2d 699 (W.D. Tenn. 2003).  Under these court opinions, engines and transmissions are generally treated as part of the larger machine.  This means that the economic life of the engine or transmission is to be treated as co-extensive with the economic life of the larger machine (e.g., a tractor or combine).  Because the larger machine cannot function without an engine or transmission, overhaul of the engine or transmission while affixed to the machine can give rise to a current deduction.

Recent Case

In Wells v. Comr., T.C. Memo. 2018-11, the petitioner owned and lived on a 265-acre farm.  She had lived there off-and-on since 1965, but continuously from 1983 forward.  Before the petitioner came into ownership of the property, her father owned it.  She cultivated about 700 white French hybrid rind grapevines on a part of the property.  In the good years, the vines produced up to four tons of grapes, but in the lean years production could be as low as one-half ton.  The petitioner normally sold the grapes, but when production declined, she began crushing the grapes and selling the juice to local buyers.  She grazed animals on other parts of the farm.  Her gross farm income for 2010 and 2011 was $305 and $255 in 2010 and 2011 respectively, and her total farming expenses were $208,265 in 2010 and $54,734 in 2011.  Many of those claimed deductible expenses were associated with her grape growing activity.  Upon audit, the IRS denied a large portion of the petitioner’s claimed expenses, asserting that the they were improvements that should be capitalized. 

Underground water line.  In 1965, the petitioner’s father installed an underground pipe to convey water from a spring on one part of the farm to supply water to a pasture where animals were grazed as well as to irrigate the grapes.  Over time, portions of the two-inch pipe were replaced with new two-inch pipe that was of higher quality and could withstand higher water pressure.  The pipeline was completely replaced in 2009 with new pipe, but then started leaking and a section of it was replaced later in 2009.  More leaks occurred in 2010 and additional sections of the pipe were replaced and joints repaired.  The court determined that the entire water line was replaced at least one time during 2009 and 2010. 

The petitioner claimed that neither the pipeline’s useful life was extended nor the value increased.  Instead, the petitioner asserted that the pipeline replacement cost was deductible because floods destroyed parts of the pipeline in 2009 and 2010 and she had no other option but to replace the pipeline, and that doing so was simply an accumulation of repairs into 2009 and 2010.  She claimed to not have the funds in prior years to make repairs in those earlier years. 

The IRS maintained that the pipeline “repair” expense was properly capitalized as an improvement, and the court agreed.  The court determined that the pipeline work was part of a “general plan of rehabilitation, modernization, and improvement” to completely repair the pipeline.  The court noted that the pipeline was completely replaced, its life was extended and its value was increased (because of the use of higher quality pipe).  It was immaterial, the court held, that flooding might have destroyed part of the pipeline leaving replacement as the petitioner’s only option.  The court noted that an analogous situation was present in Hunter v. Comr., 46 T.C. 477 (1966), where the cost of a replacement dam had to be capitalized when the old dam had been washed out by flooding.   

The court also held that costs associated with work on “road maintenance” and around a barn were also not currently deductible expenses.  However, the IRS conceded that $9,000 allocated to repair a culvert, cut trees and spread manure were currently deductible.

Storage yard.  The petitioner also deducted over $16,000 for the construction of a storage yard, including funds for fencing work related to the storage yard.  The storage yard did not previously exist.  The IRS claimed that the amounts expended to create the storage yard was a capital improvement which had to be capitalized.  The court agreed.  It was new construction on top of previously unimproved land and, as such, was an improvement.  The associated costs were not currently deductible. 

Burn area.  In 2010, a wildfire burned about 26 acres of the petitioner’s property that the petitioner had used, at least in part, for grazing animals.  After the fire, it was determined that the fire had made the burned area unable to absorb water.  As a result, the petitioner, paid to have burned tree stumps removed along with boulders.  The soil of the burned area was cultivated so that the tract could be used for forage.  The cost of this work was slightly less than $50,000, which the petitioner deducted on her 2011 return.  The IRS denied the deduction claiming instead that the amount was an expense that had to be capitalized as a “plan of rehabilitation.” 

The court agreed with the IRS.  The evidence, the court determined, showed that the petitioner had a plan to rehabilitate the burn area, and believed that the expenses would improve the land and its value.  In addition, the court noted that the work on the burn area was extensive and that a large portion of the burn area, before the fire, had no relation to the petitioner’s business.  After the fire, the court noted that the petitioner testified that the entire area would be used as forage.  Thus, the burn area was adapted for a new use which meant that the expenses associated with it had to be capitalized. 

Conclusion

The case points out how expenses that a taxpayer thinks might be currently deductible may actually be expenses that must be capitalized.  The Wells case is a good illustration of how these issues can play out with respect to an agricultural set of facts.         

March 8, 2018 in Income Tax | Permalink | Comments (0)

Tuesday, March 6, 2018

Is a CWA Permit Needed For Pollution Discharges Via Groundwater?

Overview

Under the Clean Water Act (CWA), a National Pollution Discharge Elimination System (NPDES) permit is required to discharge a “pollutant” from a point source into the “navigable waters of the United States” (WOTUS).  Clearly, a discharge directly into a WOTUS is covered.  But, is an NPDES permit necessary if the discharge is directly into groundwater which then finds its way to a WOTUS?  Are indirect discharges from groundwater into a WOTUS covered?   If so, does that mean that farmland drainage tile is subject to the CWA and an NPDES discharge permit is required?  The federal government has never formally taken that position, but if that’s the case it’s a huge issue for Midwest and other areas of agriculture. 

Recently, a federal court determined that some discharges into groundwater require an NPDES permit. But, other courts have ruled differently.  Now the Environmental Protection Agency (EPA) has opened a comment period on whether pollutant discharges from point sources that reach jurisdictional surface waters via groundwater should be subject to CWA regulation.

Possible NPDES discharge permits for groundwater discharges – that’s the focus of today’s post.

CWA Discharge Permit Basics

The CWA recognizes two sources of pollution. Point source pollution is pollution which comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation.  Under the CWA, point source pollution is the concern of the federal government.  Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field.  Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.

Under 1977 amendments, tile drainage systems were exempted from CWA regulation via irrigation return flows.  See, e.g., Pacific Coast Federation of Fishermen’s Associations, et al. v. Glaser, et al., No. CIV S-2:11-2980-KJM-CKD, 2013 U.S. Dist. LEXIS 132240 (E.D. Cal. Sept. 16, 2013).  They aren’t considered to be point sources.  In addition, several courts have held that the NPDES system only applies to discharges of pollutants into surface water.  These courts have held that discharges of pollutants into groundwater are not subject to the NPDES permit requirement even if the groundwater is hydrologically connected to surface water.  See, e.g., Umatilla Water Quality Protective Association v. Smith Frozen Foods, 962 F. Supp. 1312 (D. Ore. 1997); United States v. ConAgra, Inc., No. CV 96-0134-S-LMB, 1997 U.S. Dist. LEXIS 21401 (D. Idaho Dec. 31, 1997).  Likewise, in another case, the court determined that neither the CWA nor the EPA covered groundwater solely on the basis of a hydrological connection with surface water.  Village of Oconomowoc Lake v. Dayton Hudson Corporation, 24 F.3d 962 (7th Cir. 1994), cert. denied, 513 U.S. 930 (1994).  See also Rice v. Harken Exploration Co., 250 F.3d 264 (5th Cir. 2001); Cape Fear River Watch v. Duke Energy Progress, Inc., 25 F. Supp. 3d 798 (E.D. N.C. 2014).

But, other courts have taken a different view, finding that the CWA covers pollution discharges irrespective of whether the discharge is directly into a WOTUS or indirectly via groundwater with some sort of hydrological connection to a WOTUS.   See, e.g., Idaho Rural Council v. Bosma, 143 F. Supp. 2d 1169 (D. Idaho 2001); Northern California River Watch v. Mercer Fraser Co., No. 04-4620 SC, 2005 U.S. Dist. LEXIS 42997 (N.D. Cal. Sept. 1, 2005); United States v. Banks, 115 F.3d 916 (11th Cir. 1997), cert. denied, 522 U.S. 1075 (1998); Mutual Life Insurance Co. of New York v. Mobil Corp., No. 96-CV-1781 (RSP/DNH), 1998 U.S. Dist. LEXIS 4513 (N.D. N.Y. Mar. 31, 1998).

Recent Case

The issue came up again in a recent case.  In Hawai’i Wildlife Fund v. County of Maui, 881 F.3d 754 (9th Cir. 2018), the defendant owned and operated four wells at the Lahaina Wastewater Reclamation Facility (LWRF), which is the principal municipal wastewater treatment plant for a city. Although constructed initially to serve as a backup disposal method for water reclamation, the wells ultimately became the defendant’s primary means of effluent disposal into groundwater and, ultimately, the Pacific Ocean. The LWRF received approximately four million gallons of sewage per day from a collection system serving approximately 40,000 people. That sewage was treated at LWRF and then either sold to customers for irrigation purposes or injected into the wells for disposal.

The defendant injected approximately 3 to 5 million gallons of treated wastewater per day into the groundwater via its wells. The defendant conceded, and its expert, confirmed that wastewater injected into wells 1 and 2 enters the Pacific Ocean. In addition, in June 2013 the EPA, the Hawaii Department of Health, the U.S. Army Engineer Research and Development Center, and researchers from the University of Hawaii conducted a study on wells 2, 3 and 4. The study involved placing tracer dye into Wells 2, 3, and 4, and monitoring the submarine seeps off Kahekili Beach to see if and when the dye would appear in the Pacific Ocean. This study, known as the Tracer Dye Study, found that 64 percent of the treated wastewater from wells 3 and 4 discharged into the ocean.  The plaintiff sued, claiming that the defendant was in violation of the Clean Water Act (CWA) by discharging pollutants into navigable waters of the United States without a CWA National Pollution Discharge Elimination System (NPDES) permit.  The trial court agreed, holding that an NPDES permit was required for effluent discharges into navigable waters via groundwater. 

On appeal, the appellate court held that the wells were point sources that could be regulated through CWA permits despite the defendant’s claim that an NPDES permit was not required because the wells discharged only indirectly into the Pacific Ocean via groundwater.  Specifically, the appellate court held that “a point source discharge to groundwater of “more than [a] de minimis” amount of pollutants that is “fairly traceable from the point source . . . such that the discharge is the functional equivalent of a discharge into a navigable water” is regulated under the CWA.”  The appellate court reached this conclusion by citing cases from other jurisdictions that determined that an indirect discharge from a point source into a navigable water requires an NPDES discharge permit.  The defendant also claimed its effluent injections are not discharges into navigable waters, but rather were disposals of pollutants into wells, and that the CWA categorically excludes well disposals from the permitting requirements. However, the court held that the CWA does not categorically exempt all well disposals from the NPDES requirements because doing so would undermine the integrity of the CWA’s provisions. Lastly, the plaintiff claimed that it did not have fair notice because the state agency tasked with administering the NPDES permit program maintained that an NPDES permit was unnecessary for the wells. However, the court held that the agency was actually still in the process of determining if an NPDES permit was applicable. Thus, the court found the lack of solidification of the agency’s position on the issue did not affirmatively demonstrate that it believed the permit was unnecessary as the defendant claimed.  Furthermore, the court held that a reasonable person would have understood the CWA as prohibiting the discharges, thus the defendant’s due process rights were not violated. 

Pending Court Cases and EPA Action

The Ninth Circuit’s decision further illustrates the different conclusions that the courts have reached on the matter.  In addition, at the present time, the U.S. Circuit Court of Appeals for both the Second and Fourth circuits have cases before them on the issue of whether the CWA applies to indirect discharges of pollutants into a WOTUS from subsurface discharges.  This all could lead to an eventual case before the U.S. Supreme Court on the matter.

On February 20, 2018, the EPA issued a Request for Comment on whether pollutant discharges from point sources that reach jurisdictional surface waters via groundwater may be subject to Clean Water Act (“CWA”) regulation. Specifically, EPA seeks comment on whether EPA should consider clarification or revision of previous EPA statements regarding the Agency’s mandate to regulate discharges to surface waters via groundwater under the CWA.   As noted above, the EPA has never stated that CWA permits are required for pollutant discharges to groundwater in all cases. Rather, EPA’s position has been that pollutants discharged from point sources that reach jurisdictional surface waters via groundwater or other subsurface flow that has a direct hydrologic connection to the jurisdictional water may be subject to CWA permitting requirements.

As part of its request, EPA seeks comment by May 21, 2018, on whether it should review and potentially revise its previous positions.  In particular, the EPA is seeking comment on whether it is consistent with the CWA to require a CWA permit for indirect discharges into jurisdictional surface waters via groundwater.  The EPA also seeks comment on whether some or all of such discharges are addressed adequately through other federal authorities, existing state statutory or regulatory programs or through other existing federal regulations and permit programs.  Comments can be submitted by identifying them as Docket ID No. EPA-HQ-QW-2018-0063 at http://www.regulations.gov.  Follow the online instructions for submitting comments. 

Conclusion

Whether an NPDES discharge permit is required for pollution discharges that only indirectly find their way to a WOTUS via groundwater is an important issue for agriculture.  It’s a particularly big issue in the Midwest where many farm fields are drained to make crop production possible.  The purpose of drain tile is to control groundwater levels by relocating groundwater to surface water. Nitrates in excess of drinking water standards are prevalent in many parts of the Midwest. 

Interested farmers, ranchers and rural landowners should give serious consideration to submitting comments on or before May 21.    

March 6, 2018 in Environmental Law | Permalink | Comments (0)

Friday, March 2, 2018

Landlord Liability For Injuries Occurring on Leased Premises

Overview

A significant concern for landlords is the extent of possible liability for injuries that occur on the leased premises.  After all, the landlord is the owner of the leased property.  Does liability follow legal ownership?  If it does, that has serious implications for farm landlords, particularly because farming tends to be a hazardous occupation.  Machinery, livestock, chemical application and similar farming activities and features such as farm ponds have the potential for injury. 

Landlord liability for injuries occurring on leased premises, that’s the topic of today’s post.

General Principles

Non-liability.  In general, a landlord is not liable for injuries to third parties that occur on premises that are occupied by a tenant.  For example, in Leopold v. Boone, No. 06A04-0904-CV-205, 2009 Ind. App. Unpub. LEXIS 1291 (Ind. Ct. App. Sept. 4, 2009), the plaintiff suffered a severe brain injury from a bicycle crash caused by dogs owned by the defendant’s tenant that ran from the leased property onto a public highway where the plaintiff was bicycling.  The trial court judgment for the defendant was affirmed because the defendant did not owe a duty to the plaintiff.  Importantly, the plaintiff failed to raise a nuisance claim at trial and was thereby precluded from raising the issue on appeal.  

Exceptions.  The reason for the rule of landlord non-liability is that the tenant has the possession over the leasehold premises during the tenancy and has control over what occurs on the leased property. However, there are at least six well recognized exceptions to this general rule.  For example, if the landlord conceals dangerous conditions or defects that cause the third party's injury, then the landlord will be liable. Likewise, if conditions are maintained on the premises that are dangerous to persons outside of the premises, the landlord is liable for any resulting injury.  A landlord will also be liable if the premises is leased for admission of the public or if the landlord retains control over part of the leased premises that the tenant is entitled to use.  In addition, if the landlord makes an express covenant to repair the leased premises, but fails to do so resulting in injury, the landlord is liable.  Similarly, a landlord is liable for injuries resulting from the landlord's negligence in making repairs to items located on the leased premises.

Another exception to the general rule of landlord non-liability for a tenant’s acts is if the landlord knows that the tenant is harming the property rights of adjacent landowners and does nothing to modify the tenant’s conduct or terminate the lease. In that situation, the landlord can be held liable along with the tenant. See, e.g., Tetzlaff v. Camp, et al., 715 N.W.2d 256 (Iowa 2006). 

Other principles.  In general, a licensee or invitee of the tenant has no greater claim against the landlord than has the tenant.  Thus, a landlord's duty to not wantonly or willfully injure a trespasser is usually passed to the tenant who has control of the property.  However, a landlord can be held liable where the landlord knew of defects that were likely to injure known trespassers.

A landlord is also usually not held responsible for injuries occurring on the leased premises caused by animals that belong to the tenant.  With respect to dogs, it must generally be proven that the landlord had actual knowledge of the animal’s dangerous propensities.  See, e.g., Seeley v. Derr, et al., No. 4:12-CV-917, 2013 U.S. Dist. LEXIS 99506 (M.D. Pa. Jul. 17, 2013);  Bryant v. Putnam, 908 S.W.2d 338 (Ark. 1995). 

Recent Case

A

recent Kentucky case illustrates some of the legal principles involved when an injury occurs on leased premises.  In Groves v. Woods, No. 2016-CA-001546-MR 2018 Ky. App. LEXIS 59 (Ky. Ct. App. Jan. 26, 2018), the plaintiff and her husband entered into a verbal lease with the defendant for a lease of the defendant’s property. The plaintiff claimed that the lease covered the entire property, but the defendant asserted that the lease only was for the house and abutting yard. Adjacent to the home, the defendant had a pasture and a barn where the defendant boarded a Tennessee Walking Horse. The horse spent time both in the pasture and in the barn. The defendant claimed that he informed the plaintiffs not to go near the horses and to keep their children out of the barn.

Nine days after moving in, the plaintiff and her children went for a walk to see an old graveyard. They cut through the pasture to get to the site. It was disputed whether the plaintiff and the children crossed a fence into the pasture where the horses spend time. The defendant claimed that they crossed onto the pasture, but the plaintiff claimed that they never crossed onto the pasture or traversed the fence. The plaintiff maintained that the horse was running loose, chased her, and stomped her thigh after she fell. The plaintiff filed a complaint against the defendant and the defendant counterclaimed that the plaintiff was contributorily negligent. The defendant moved for summary judgment, which the trial court granted and also denied the plaintiff’s motion to alter, amend, or vacate the summary judgment.

The plaintiff appealed. The court held that the number of lengthy depositions in the case provided no certain evidence to indicate whether the plaintiffs rented the house and the yard or the entire property. With this uncertainty and the fact that the lease was verbal the court decided to accept the assertion that the family rented the entire property. The court held that because the plaintiff testified of knowing about the horse, the defendant could not be liable for failure to warn the plaintiffs about a known latent defect. Thus, the trial court’s grant of the motion for summary judgment was appropriate. In addition, the court held that because the horse’s owner did not know or have reason to know that the horse was abnormally dangerous, the defendant would be liable for the horse’s actions only if the defendant intentionally caused the horse to do harm or was negligent in failing to prevent harm. The court held that the plaintiff did not provide proof that the horse’s owner was negligent under this standard. Thus, the district court’s decision granting summary judgment was affirmed. 

Conclusion

While a landlord will generally not be liable for injuries that occur on leased premises, there are situations where liability could result.  Understanding what those situations are, taking steps to avoid their application and making sure appropriate insurance coverage is in place will go along way to avoiding an unhappy result for a landlord.

March 2, 2018 in Civil Liabilities | Permalink | Comments (0)