Friday, April 27, 2018
When a farmer sells an harvested crop, the tax rules surrounding the reporting of the income from the sale are fairly well understood. But, what happens when a farmer dies during the growing season? The tax issues are more complicated with the tax treatment of the sale tied to the status of the decedent at the time of death – whether the decedent was a farmer or a landlord. If the decedent was a landlord, the type of lease matters.
The tax rules involving the post-death sale of crops and livestock – that’s the focus of today’s post.
For income tax purposes, the basis of property in the hands of the decedent’s heir or the person otherwise acquiring the property from a decedent is the property’s FMV as of the date of the decedent’s death. I.R.C. §1014(a)(1). But, there is an exception to this general rule. Income in respect of decedent (IRD) property does not receive any step-up in basis. I.R.C. §691. IRD is taxable income the taxpayer earned before death that is received after death. IRD is not included on the decedent’s final income tax return because the taxpayer was not eligible to collect the income before death.
In Estate of Peterson v. Comm’r, 667 F.2d 675 (8th Cir. 1981), the Tax Court set forth four requirements for determining whether post-death sales proceeds are IRD.
- The decedent entered into a legal agreement regarding the subject matter of the sale.
- The decedent performed the substantive acts required as preconditions to the sale (i.e., the subject matter of the sale was in a deliverable state on the date of the decedent’s death).
- No economically material contingencies that might have disrupted the sale existed at the time of death.
- The decedent would have eventually received (actually or constructively) the sale proceeds if he had lived.
The case involved the sale of calves by a decedent’s estate. Two-thirds of the calves were deliverable on the date of the decedent’s death. The other third were too young to be weaned as of the decedent’s death and the decedent’s estate had to feed and raise the calves until they were old enough to be delivered. The court held that the proceeds were not IRD because a significant number of the calves were not in a deliverable state as of the date of the decedent’s death. In addition, the estate’s activities with respect to the calves were substantial and essential. The Tax Court held that all four requirements had to be satisfied for the income to be IRD, and the second requirement was not satisfied.
Farmer or Landlord?
Classifying income as IRD depends on the status of the decedent at the time of death. The following two questions are relevant.
- Was the decedent an operating farmer or a farm landlord at the time of death? If the decedent was a farm landlord, the type of lease matters.
- If the decedent was a farm landlord, was the decedent a materially participating landlord or a non-materially participating landlord?
For operating farmers (including materially participating farm landlords), unsold livestock, growing crops, and grain inventories are not IRD. Rev. Rul. 58-436, 1958-2 CB 366. See also Estate of Burnett v. Comm’r, 2 TC 897 (1943). The rule is the same if the decedent was a landlord under a material participation lease. These assets are included in the decedent’s gross estate and receive a new basis equal to their FMV as of the decedent’s date of death under IRC §1014. No allocation is made between the decedent’s estate and the decedent’s final income tax return. Treas. Reg. §20.2031-1(b).
From an income tax perspective, all of the growing costs incurred by the farmer before death are deducted on the decedent's income tax return. At the time of death, the FMV of the growing crop established in accordance with a formula is treated as inventory and deducted as sold. The remaining costs incurred after death are also deducted by the decedent's estate. In many cases, it may be possible to achieve close to a double deduction.
If a cash-basis landlord rents out land under a non-material participation lease, the landlord normally includes the rent in income when the crop share is reduced to cash or a cash equivalent, not when the crop share is first delivered to the landlord. In this situation, a portion of the growing crops or crop shares or livestock that are sold post-death are IRD and a portion are post-death ordinary income to the landlord’s estate. That is the result if the crop share is received by the landlord before death but is not reduced to cash until after death. It is also the result if the decedent had the right to receive the crop share, and the share is delivered to the landlord’s estate and then reduced to cash. In essence, for a decedent on the cash method, an allocation is made with the portion of the proceeds allocable to the pre-death period (in both situations) being IRD in accordance with a formula set forth in Rev. Rul. 64-289, 1964-2 CB 173 (1964). That formula splits out the IRD and estate income based on the number of days in the rental period before and after death with the IRD portion being attributable to the days before death. If the decedent dies after the crop share is sold (but before the end of the rental period), the proceeds would have been reported on the decedent’s final return. No prorations would have been required. If the decedent’s crop share is held until death, when the heirs sell the crop share, the proceeds are allocated between IRD and ordinary income of the decedent’s estate under the formula.
IRD results from crop share rents of a non-materially participating landlord that are fed to livestock before the landlord’s death if the animals are also owned on shares. If the decedent utilized the livestock as a separate operation from the lease, the in-kind crop share rents (e.g., hay, grain) are treated as any other asset in the farming operation — included in the decedent’s gross estate and entitled to a date-of-death FMV basis.
Crop share rents fed to livestock after the landlord’s death are treated as a sale at the time of feeding with an offsetting deduction. Rev. Rul. 75-11, 1975-1 CB 27.
Character of Gain
Sale of grain. Grain that is raised by a farmer and held for sale or for feeding to livestock is inventory in the hands of the farmer. Upon the subsequent sale of the grain, the proceeds are treated as ordinary income for income tax purposes. I.R.C. §§61(a)(2), 63(b). However, when a farmer dies and the estate sells grain inventory within six months after death, the income from the sale is treated as long-term capital gain if the basis in the crops was determined under the IRC §1014 date-of-death FMV rule. I.R.C. §1223(9). However, ordinary income treatment occurs in the crop was raised on land that is leased to a tenant. See, e.g., Bidart Brothers v. U.S., 262 F.2d 607 (9th Cir. 1959).
If the decedent operated the farming business in a partnership or corporation and the entity is liquidated upon the decedent’s death, the grain that is distributed from the entity may be converted from inventory to a capital asset. See, e.g., Greenspon v. Comm’r, 229 F.2d 947 (8th Cir. 1956). However, to get capital asset status in the hands of a partner or shareholder, the partner or shareholder cannot use the grain as inventory in a trade or business. Baker v. Comm’r, 248 F.2d 893 (5th Cir. 1957). That status is most likely to be achieved, therefore, when the partner or shareholder does not continue in a farming business after the entity’s liquidation.
The sale of crops and livestock post-death are governed by specific tax rules. Because death often occurs during a growing period, it’s important to know these unique rules.
Wednesday, April 25, 2018
Cash method farm proprietors have had several situations where gifts of farm commodities to family members are advantageous. The commodity gifts can be used to shift income to minor children to take advantage of their lower tax rates. Likewise, they could be used to assist with a child’s college costs or made to a child in return for the child support the donor-parents.
How should commodity gift transactions be structured? What are the tax consequences? What is the impact of the Tax Cuts and Jobs Act (TCJA) on commodity gifts to children.
Ag commodity gifts to children. That’s the topic of today’s post.
Tax Consequences to the Donor.
Avoid income and self-employment tax. A donor does not recognize income upon a gift of unsold grain inventory. Rev. Rul. 55-138, 1955-1 C.B. 223; Rev. Rul. 55-531, 1955-2 C.B. 520. Instead, a gift of unsold raised farm commodities represents a transfer of an asset (i.e., inventory) rather than an assignment of income. Estate of Farrier v. Comr., 15 T.C. 277 (1950); SoRelle v. Comr., 22 T.C. 459 (1954); Romine v. Comr., 25 T.C. 859 (1956). That means that the farmer, as the donor, sidesteps the income tax on commodities that are transferred by gift to another taxpayer. Further, self-employment tax is also eliminated on the commodities. That’s because excludable gross income is not considered in determining self-employment income. Treas. Reg. 1.1402(a)-2(a). This is particularly beneficial for donor-parents that have income under the Social Security wage base threshold.
Prior year’s crop. The gifted commodities should have been raised or produced in a prior tax year. If this is not the case, the IRS takes the position that a farmer is not 100 percent in the business of raising agricultural commodities for profit and will require that a pro rata share of the expenses of raising the gifted commodity will not be deductible on the farmer’s tax return. According to the IRS, if a current year’s crop is gifted, the donor’s opening inventory must be reduced for any costs or undeducted expenses relating to the transferred property. Rev. Rul. 55-138, 1955-1, C.B. 223. That means that the donor cannot deduct current year costs applicable to the commodity. See also Rev. Rul. 55-531, 1955-2 C.B. 522. However, costs deducted on prior returns are allowed. Thus, a farmer reporting on a calendar year basis under the cash method is allowed full deductibility of expenses if a gift of raised commodity is not made until the tax year after harvest (i.e., the grain which is the subject of the gift was raised in a year prior to the gift, and all associated expenses would have been deducted in the prior year).
Tax consequences to the Donee.
The donor's tax basis in the commodity carries over to the donee. I.R.C. §1015(a). Thus, in the case of raised commodities given in the year after harvest by a cash method producer, the donee receives the donor’s zero basis. Conversely, an accrual method farmer will have an income tax basis in raised commodities. If this tax basis approaches the market value of the commodity, there will be little income shifting accomplished from a gift.
Assuming that the donee has not materially participated in the production of the commodity, the income from the sale of the commodity by the donee is treated as unearned income that is not subject to self-employment tax. Even though the raised farm commodity was inventory in the hands of the farmer-donor, the asset will typically not have inventory status in the hands of the done. That means the sale transaction is treated as the sale of a capital asset that is reported on Schedule D.
The holding period of an asset in the hands of a donee refers back to the holding period of the donor. I.R.C. §1223(2). So, if the donee holds the commodity for more than a year after the harvest date, the donee has long-term capital gain or loss.
Gifts of Livestock?
A donee who receives raised animals and takes responsibility for the care and feeding of these animals after the date of gift may face the risk of materially participating in the raising of the animals, and thus be subject to self-employment tax. To help avoid that result, physical segregation of the livestock at the time of gift is helpful, and any post-gift maintenance expenses for the animals should be paid by the donees. See, e.g., Smith v. Comr., T.C. Memo. 1967-229; Alexander v. Comr., 194 F.2d 921 (5th Cir. 1952); Jones Livestock Feeding Co., T.C. Memo. 1967-57; Urbanovsky v. Comr., T.C. Memo. 1965-276.
Structuring the Transaction
Cash-method farm proprietors intending to gift raised commodities to a child or other non-charitable donee should structure the transaction in two distinct steps. First, the donor makes a gift of unsold inventory, using prior year crop or commodity, and documents the transfer of the title/ownership in the commodity as transferred to the donee. Second, the donee independently and at a later date accomplishes a sale of the commodity, recognizing income because of the zero basis in the commodity. The income is reported typically as a short-term capital gain. The donee, as the owner of the sold commodity, must retain full ownership and control of the sale proceeds from the commodity. Make sure that the transaction is not a loan.
“Kiddie Tax” Complications
Unearned income of a dependent child includes items such as interest, dividends and rents, as well as income recognized from the sale of raised grain received as a gift and not as compensation for services. The “Kiddie Tax” has a small inflation-indexed exemption. I.R.C. §1(g). For dependent children who sell commodities received as a gift and are subject to the” Kiddie Tax,” a standard deduction offsets the first $1,000 of unearned income (2017 amount). Then the next $1,000 of unearned income is subject to tax at the child’s single tax rate of 10 percent. That means that the child’s unearned income in excess of $2,100 is taxed at the parents’ top tax rate.
The Kiddie Tax applies to a child who has not attained age 18 before the close of the year. It also applies to a child who has not attained the age of 19 as of the close of the year or is at least age 19 and under 24 at the close of the year and is a full-time student at an educational organization during at least five months of the year and the child’s earned income didn’t exceed one-half of the child’s own support for the year (excluding scholarships).
TCJA modification. As noted above, under pre-TCJA law, the child who receives a commodity gift and then sells the commodity usually pays income taxes based on the parent’s tax rates (there is a smaller amount taxed at lower rates) on unearned income. Earned income, such as wages, is always taxed at the child’s tax rates. But, under the TCJA for tax years beginning after 2017, the child’s tax rates on unearned income are the same as the tax rates (and brackets) for estates and trusts. That means that once the child’s unearned income reaches $12,500, the applicable tax rate is 37 percent on all unearned income above that amount. This will make it much costlier for farm families to gift grain to their children or grandchildren and receive any tax savings.
Gifting commodities to a family member can produce significant tax savings for the donor, and also provide assistance to the donee. That was much more likely to be the result pre-2018. The TCJA removes much of the tax benefit of commodity gifting to children. In any event, however, the commodity gifting transactions must be structured properly to achieve the intended tax benefits.
Monday, April 23, 2018
The Tax Cuts and Jobs Act (TCJA) constituted a major overhaul of the tax Code for both individuals and businesses. In previous posts, I have examined some of those provisions. In particular, I have taken a look at the new I.R.C. §199A and its impact on agricultural producers and cooperatives. Recently the IRS Commissioner told the Senate Finance Committee that it would take “years” to finish writing all of the rules needed to clarify the many TCJA provisions and provide the interpretation of the IRS. But, recently the IRS did clarify how “alimony trusts” are to work for divorces entered into before 2019.
The alimony tax rules and “alimony trusts”, that’s the focus of today’s blog post.
Tax treatment of alimony. For divorce agreements entered into before 2019, “alimony or separate maintenance payment” is taxable to the recipient and deductible to the payor. I.R.C. §71. What is an alimony or separate maintenance payment? It’s any payment received by or on behalf of a spouse (or former spouse) of the payor under a divorce or separate maintenance agreement that meets certain basic requirements: 1) the payment is made in cash (checks and money orders) pursuant to a decree, court order or written agreement; 2) the payment is not designated as a payment which is excludible from the gross income of the payee and non-deductible by the payor; 3) for spouses legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time payment is made; 4) the payor has no liability to continue to make any payment after the payee’s death and the divorce or separation instrument states that there is no such liability. I.R.C. §71(b)(1). It’s also possible that a settlement requiring or allowing the paying spouse to make payments directly to third parties for the benefit of the other spouse (such as for medical treatment, life insurance premiums or mortgage payments, for example) can result in the payments being treated as alimony as long as they do not benefit the paying spouse or property owned by the paying spouse.
It is possible, however, to specify in a separation agreement or divorce decree that such payments escape taxation in the hands of the recipient (and not give rise to a deduction in the hands of the payor-spouse). Conversely, child support and property settlements are tax neutral – neither party pays tax nor gets a deduction. I.R.C. §71(c).
Another rule specifies that if the payor owes both alimony and child support, but pays less than the total amount owed, the payments apply first to child support and then to alimony. If the separation agreement does not specify separate alimony and child support payments, general “family support” payments are treated as child support for tax purposes, unless the alimony qualifications are met.
Planning point. This tax treatment raises an interesting planning point. In general, when the higher income spouse makes payments to the lower-income spouse, the payments should be structured as alimony because the deduction can be available to the spouse in the higher tax bracket and, concomitantly, the income will be taxable to the spouse in the lower tax bracket. If the spouse making payments is not in the higher income tax bracket (perhaps because of high levels of tax-exempt income such as disability payments), it makes more sense to structure the payments as child support or as a property settlement, or simply specify in the agreement that the alimony is not taxable to the recipient.
What about trusts? During marriage, one spouse may have created an irrevocable trust for the benefit of the other spouse. In that situation, I.R.C. §672(e)(1)(A) makes the trust a “grantor” trust with the result that the income of the trust is taxed to the spouse that created the trust. If the couple later divorces, the trust remains. It’s an irrevocable trust. The divorce doesn’t change the nature or tax status of the trust – the spouse (now ex-spouse) that created the trust must continue to pay tax on trust income. That’s probably both an unexpected and unhappy result for the spouse that created the trust. That’s why (at least through 2018) I.R.C. §682(a) provides that the spouse that didn’t create the trust is taxed on the trust income, except for capital gain. Capital gain income remains taxable to the spouse that created the trust. In essence, then, the “payee” spouse is considered to be the trust beneficiary. I.R.C. §682(b).
Reversing tax treatment of alimony. Under the TCJA, for agreements entered into after 2018, alimony and separate maintenance payments are not deductible by the payor- spouse, and they are not included in the recipient-spouse’s income. Title I, Subtitle A, Part V, Sec. 11051. This modification conforms alimony tax provisions to the U.S. Supreme Court’s opinion in Gould v. Gould, 245 U.S. 151 (1917). In that case, the Court held that alimony payments are not income to the recipient.
Under the TCJA, income that is used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse. The treatment of child support remains unchanged.
Impact on “alimony trusts.” However, the TCJA also struck I.R.C. §682 from the Code as applied to any divorce or separation instrument executed after 2018, and any divorce or separation agreement executed before the end of 2018 that is modified after 2018 if the modification provides that the TCJA amendments are to apply to the modification.
With the coming repeal of I.R.C. §682, what will happen to “alimony trusts” that were created before the repeal? IRS has now answered that question. According to IRS Notice 2018-37, IRB 2018-18, regulations will be issued stating that I.R.C. §682 will continue to apply to these trusts. That means that the “beneficiary” spouse will continue to be taxed on the trust income. But, the IRS points out that this tax treatment only applies to couples divorced (or legally separated) under a divorce or separation agreement executed on or before December 31, 2018. The only exception is if such an agreement is modified after that date and the modification says that the TCJA provisions are to apply to the modification.
What happens to “alimony trusts” executed after 2018? The spouse that creates the trust will be taxed on the trust income under the “grantor trust” rules. That’s because I.R.C. §672(e)(1) will continue to apply. Some taxpayers finding themselves in this position may want to terminate grantor trust treatment in the event of divorce. A qualified terminable interest property (QTIP) trust may be desired. Another approach may be to have a provision drafted into the language of the trust that says that the spouse creating the trust will be reimbursed for any tax obligation post-divorce attributable to the trust.
The IRS is requesting comments be submitted by July 11, 2018.
The TCJA changed many tax Code provisions. The alimony rules are only a small sample of what was changed. If you haven’t done so already, find a good tax practitioner and get to know them well. Tax planning for 2018 and beyond has already begun.
Thursday, April 19, 2018
It is not uncommon for a farmer or a higher-income taxpayer to invest in various activities in which they do not materially participate (as determined by a seven-factor test under Treas. Reg. §1.469-5T(a). Examples of passive investments for farmers include rental activities, “condominium” grain storage LLCs and interests in ethanol and bio-diesel plants. These investments generate either passive income or passive losses. Passive income is subject to ordinary income tax and may also be subject to an additional 3.8 percent passive tax. I.R.C. §1411. When a passive activity generates losses, however, the passive activity rules limit the ability to deduct the losses to the extent the taxpayer has passive income in the current year. Otherwise, they are deducted in the taxpayer’s final year of the investment.
When a farmer (or other taxpayer) has investments in which they don’t materially participate and, hence, potentially face the impact of the passive activity rules can those investment activities be combined with an activity in which the taxpayer materially participates so that the limitation on deducting losses can be avoided? There might be. It might be possible to group activities. A recent case shows how the grouping rules work.
That’s the topic of today’s post – grouping activities under the passive loss rules.
An election can be made on the tax return to group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. Treas. Reg. §1.469-4. Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.” But, how is an appropriate economic unit determined? The Treasury Regulations state that a taxpayer may use any reasonable method to make the grouping determination, although the following factors set forth in Treas. Reg. 1.469‑4(c)(2) are given the greatest weight:
- Similarities and differences in types of business;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependence between the activities
Grouping disclosure. The IRS has issued final guidance on the disclosure reporting requirements of groupings (and regroupings). Rev. Proc. 2010-13, 2010-1 C.B. 329. A grouping statement is to be filed with the tax return stating that the taxpayer is electing to group the listed activities together so that they are treated as a single activity for the tax year, and all years thereafter. The taxpayer should also represent in the grouping statement that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.
A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, since 2013, a 3.8 percent net investment income tax applies to net rental income and other passive business income of upper income taxpayers.
Under the guidance, a written tax return statement is required for:
- New groupings, such as in the first year of grouping two activities;
- The addition of a new activity to an existing grouping; and
- Regroupings, such as for an error or change in facts.
However, no written statement is required for:
- Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
- The disposition of an activity from a grouping; and
- Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.
If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity.
Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer. However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure.
Special Grouping Rules
A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity. Treas. Reg. §1.469-4(d)(1).
An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business. Treas. Reg. §1.469-4(d)(5)(ii).
An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. Treas. Reg. §1.469-4(d)(2).
A recent case illustrates the how the factors for grouping are applied. In Brumbaugh v. Comr. T.C. Memo. 2018-40, the petitioner owned 60 percent of a C corporation that was engaged in developing real estate. The balance of the stock was owned by two others. The business had its headquarters in southern California and the plaintiff participated in the business for more than 500 hours in 2007, the year in issue. The business had a development project in 2007 in northern California several hundred miles away. The shareholders discussed buying an airplane for the trips to the project and back to southern California.
Ultimately, instead of the corporation buying the plane, the plaintiff bought it personally through his LLC. In 2006, the plaintiff had formed and LLC (taxed as a partnership) in which he owned 51 percent and his wife owned 49 percent. The LLC entered into a management agreement with an aviation company that provided that the aviation company was responsible for all managerial duties related to the plane and had the exclusive right to charter the plane for commercial flights by third parties whenever the petitioner did not need to use the plane. The plaintiff was also given access to other planes when his was being chartered. In 2007, the plaintiff used the plane on only one occasion. On four other occasions he used a different plane because his was being chartered. On petitioner’s 2007 return, he reported a $683,000 loss. Upon audit, the IRS recharacterized the loss as a passive loss on the basis that the plaintiff had not materially participated in the LLC’s activities.
The Tax Court agreed with the IRS and also concluded that the petitioner could not group the airplane activity with the real estate development activity because none of the Treas. Reg. §1.469-4(c)(2) factors favored grouping the two activities together. There was no functional similarity between the two activities and the plane was not integrated into the real estate activity in any way. While the factors for extent of common ownership and common control were neutral (the petitioner held controlling interests in both entities, but the interests were very different), there was no interdependence between the two businesses. In addition, the court noted that the petitioner did not materially participate in the aviation activity because there was no evidence to support the petitioner’s contention that he participated for at least 100 hours including no contemporaneous logs, appointment books, calendars or narrative summaries. In any event, the petitioner did not devote 500 or more hours in the aggregate to “significant participation activities.” In addition, the real estate development activity did not qualify as a significant participation activity (another issue not discussed in this post).
Farmers, ranchers and other taxpayers often engage (invest) in passive activities in addition to their business activity in which they materially participate. While it is possible to group the investment activities with a farming business, for example, the factors set forth in the regulations for grouping must be satisfied. The recent Tax Court case illustrates that it can be rather difficult to satisfying those factors.
Tuesday, April 17, 2018
Trusts are a popular part of an estate plan for many people. Trusts also come in different forms. Some take effect during life and can be changed whenever the trust grantor (creator or settlor) desires. These are revocable trusts. Other trusts, known as irrevocable trusts, also take effect during life but can’t be changed when desired. Or, at least not as easily. That’s an issue that comes up often. People often change their minds and circumstances also can change. In addition, the tax laws surrounding estates and trust are frequently modified by the Congress as well as the courts. Also, sometimes drafting errors occur and aren’t caught until after the irrevocable trust has been executed.
So how can a grantor of an irrevocable accomplish a “do over” when circumstances change? It involves the concept of “decanting” and it’s the topic of today’s post.
Trying to change the terms of an irrevocable trust is not a new concept. “Decanting” involves pouring one trust into another trust with more favorable terms. To state it a different way, decanting involves distributing the assets of one trust to another trust that has the terms that the grantor desires with the terms that the grantor no longer wants remaining in the old trust.
The ability to “decant” comes from either an express provision in the trust, or a state statute or judicial opinions (common law). Presently, approximately 20 states have adopted “decanting” statutes, and a handful of others (such as Iowa and Kansas) allow trust modification under common law. In some of the common law jurisdictions, courts have determined that decanting is allowed based upon the notion that the trustee’s authority to distribute trust corpus means that the trustee has a special power of appointment which allows the trustee to transfer all (or part) of the trust assets to another irrevocable trust for the same beneficiaries.
In terms of a step-by-step approach to decanting, the first step is to determine whether an applicable state statute applies. If there is a statute, a key question is whether it allows for decanting. Some statutes don’t so provide. If it does, the statutory process must be followed. Does the statute allow the trustee to make the changes that the grantor desires? That is a necessary requirement to being able to decant the trust. If there is no governing statute, or there is a statute but it doesn’t allow the changes that the grantor desires, a determination must be made as to what the state courts have said on the matter, if anything. But, that could mean that litigation involving the changes is a more likely possibility with a less than certain outcome.
If conditions are not favorable for decanting in a particular jurisdiction, it may be possible under the trust’s terms (or something known as a “trust protector”) to shift the trust to a different jurisdiction where the desired changes will be allowed. Absent favorable trust terms, it might be possible to petition a local court for authority to modify the trust to allow the governing jurisdiction of the trust to be changed.
If decanting can be done, the process of changing the trust terms means that documents are prepared that will result in the pouring of the assets of the trust into another trust with different terms. Throughout the process, it is important to follow all applicable statutory rules. Care must be taken when preparing deeds, beneficiary forms, establishing new accounts and conducting any other related business to complete the change.
IRS Private Ruling
In the fall of 2015, the IRS released a Private Letter Ruling that dealt with the need to change an error in the drafting of an irrevocable trust in order to repair tax issues with the trust. Priv. Ltr. Rul. 201544005 (Jun. 19, 2015). The private ruling involved an irrevocable trust that had a couple of flaws. The settlors (a married couple) created the trust for their children, naming themselves as trustees. One problem was that the trust terms gave the settlors a retained power to change the beneficial interests of the trust. That resulted in an incomplete gift of the transfer of the property to the trust. In addition, the retained power meant that I.R.C. §2036 came into play and would cause inclusion of the property subject to the power in the settlors’ estates. The couple intended that their transfers to the trust be completed gifts that would not be included in their gross estates, so they filed a state court petition for reformation of the trust to correct the drafting errors. The drafting attorney submitted an affidavit that the couple’s intent was that their transfers of property to the trust be treated as completed gifts and that the trust was intended to optimize their applicable exclusion amount. The couple also sought to resign as trustees. The court allowed reformation of the trust. That fixed the tax problems. The IRS determined that the court reformation would be respected because the reformation carried out the settlors’ intent.
When to Decant
So, it is possible that an irrevocable trust can be changed to fix a drafting error and for other reasons if the law and facts allow.
What are common reasons decant an irrevocable trust? Some of the most common ones include the following:
- To achieve greater creditor protection by changing, for example, a support trust to a discretionary trust (this can be a big issue, for example, with respect to long-term health care planning);
- To change the situs (jurisdiction where the trust is administered) to a location with greater pro-trust laws;
- To adjust the terms of the trust to take into account the relatively larger federal estate exemption applicable exclusion and include power of appointment language that causes inclusion of the trust property in the settlor’s estate to achieve an income tax basis “step-up” at death (this has become a bigger issue as the federal estate tax exemption has risen substantially in recent years);
- To provide for a successor trustee and modify the trustee powers;
- To either combine multiple trusts or separate one trust into a trust for each beneficiary;
- To create a special needs trust for a beneficiary with a disability;
- To permit the trust to be qualified to hold stock in an S corporation and, of course;
- To correct drafting errors that create tax problems and, perhaps, in the process of doing so create a fundamentally different trust.
The ability to modify an irrevocable trust is critical. This is particularly true with the dramatic change in the federal estate and gift tax systems in recent years. Modification may also be necessary when desires and goals change or to correct an error in drafting. Fortunately, in many instances, it is possible to make changes even though the trust is “irrevocable.” If you need to “decant” a trust, see an estate planning professional for help.
Friday, April 13, 2018
Many readers of this blog are tax preparers. Many focus specifically on returns for clients engaged in agricultural production activities. As tax season winds down, at least for the time being, another season is about to begin. For me, that means that tax seminar season is just around the corner. Whether it’s at a national conference, state conference, in-house training for CPAs or more informal meetings, I am about to begin the journey which will take me until just about Christmas of providing CPE training for CPAs and lawyers across the country.
CPAs and lawyers are always looking for high-quality and relevant tax and legal education events. In today’s post I highlight some upcoming events that you might want to attend.
Calendar of Events
Shortly after tax preparers come back from a well-deserved break from the long hours and weekends of preparing returns and dealing with tax client issues, many will be ready to continue accumulating the necessary CPE credits for the year. This is an important year for CPE tax training with many provisions of the Tax Cuts and Jobs Act taking effect for tax years beginning after 2017.
If you are looking for CPE training the is related to agricultural taxation and agricultural estate and business planning below is a run-down of the major events I will be speaking at in the coming months. Washburn Law School is a major player in agricultural law and taxation, and more details on many of these events can be found from the homepage of WALTR, my law school website – www.washburnlaw.edu/waltr.
May 9 – CoBank, Wichita KS
May 10 – Kansas Society of CPAs, Salina, KS
May 14 - Lorman, Co. Webinar
May 16 – Quincy Estate Planning Council, Quincy, IL
May 18 – Iowa Bar, Spring Tax Institute, Des Moines, IA
May 22 – In-House CPA Firm CPE training, Indianapolis, IN
June 7-8 – Summer Tax/Estate & Business Planning Conference, Shippensburg, PA
June 14-15 – In-House CPA Firm CPE training, Cedar Rapids, IA
June 22 - Washburn University School of Law CLE Event, Topeka, KS
June 26 - Washburn University School of Law/Southwest KS Bar Assoc, Dodge City, KS
June 27 – Kansas Society of CPAs, Topeka, KS
July 10 – Univ. of Missouri Summer Tax School, Columbia, MO
July 16-17 – AICPA Farm Tax Conference, Las Vegas, NV
July 19 – Western Kansas Estate Planning Council, Hays, KS
July 26 – Mississippi Farm Bureau Commodity Conference, Natchez, MS
August 14 – In-House training, Kansas Farm Bureau, Manhattan, KS
August 15 - Washburn University School of Law/KSU Ag Law Symposium, Manhattan, Kansas
August 16-17 – Kansas St. Univ. Dept. of Ag Econ. Risk and Profit Conference, Manhattan, KS
September 17-18 – North Dakota Society of CPAs, Grand Forks, ND
September 19 – North Dakota Society of CPAs, Bismarck, ND
September 21 – University of Illinois, Moline, IL
September 24 – University of Illinois, Champaign-Urbana, IL
September 26-27 – Montana Society of CPAs, Great Falls, MT
October 3 – CoBank, Wichita, KS
October 11-12 – Notre Dame Estate Planning Institute, South Bend, IN
The events listed above are the major events geared for practitioners as of this moment. I am continuing to add others, so keep watching WALTR for an event near you. Of course, I am doing numerous other events geared for other audiences that can also be found on WALTR’s homepage. Once I get into mid-late October, then the annual run of tax schools begins with venues set for Kansas, North Dakota, Iowa and South Dakota. Added in there will also be the Iowa Bar Tax School in early December.
Special Attention – Summer Seminar
I would encourage you to pay particular attention to the upcoming summer seminar in Shippensburg, PA. This two-day conference is sponsored by Washburn University School of Law and is co-sponsored by the Pennsylvania Institute of CPAs and the Kansas State University Department of Agricultural Economics. I will be joined for those two days by Paul Neiffer, Principal with CliftonLarsonAllen, LLP. On-site seating for that event is limited to 100 and the seminar is filling up fast. After those seats are taken, the only way to attend will be via the simultaneous webcast. More information concerning the topics we will cover and how to register can be found at: http://washburnlaw.edu/employers/cle/farmandranchincometax.html. We will be spending the first four hours on the first day of that conference on the new tax legislation, with particular emphasis on how it impacts agricultural clients. We will also take a look at the determination of whether a C corporation is now a favored entity in light of the new, lower 21 percent rate. On Day 2 of the conference, we will take a detailed look at various estate and business planning topics for farm and ranch operators. The rules that apply to farmers and ranchers are often uniquely different from non-farmers, and those different rules mean that different planning approaches must often be utilized.
If your state association has interest in ag-tax CPE topics please feel free to have them contact me. I have some open dates remaining for 2018, and am already booking into 2019 and beyond. The same goes for your firm’s in-house CPE needs. In any event, I hope to see you down the road in the coming months at an event. Push through the next few days and take that well-deserved break. When you get back at it, get signed up for one of the events listed above.
Wednesday, April 11, 2018
Economic conditions in much of agriculture have deteriorated in recent years. Prices for many crops have dropped, livestock prices have come down from recent highs, and cash rents and land values have leveled off or fallen. In some instances, agricultural producers leveraged to expand their operations during the good times, only to find that the tougher farm economy has made things financially difficult.
In the downturn, legal and tax issues become critically important for many farmers and ranchers. One of those involves the distinction between a capital lease and an operating lease. That distinction and why it matters is the topic of today’s post.
A capital lease is a lease in which the only thing that the lessor does is finance the “leased” asset, and all other rights of ownership transfer to the lessee. Conversely, with an operating lease the asset owner (lessor) transfers only the right to use the property to the lessee. Ownership is not transferred as it is with a capital lease, and possession of the property reverts to the lessor at the end of the lease term. As a result, if the transaction is a capital lease, the asset is the lessee’s property and, for accounting purposes, is recorded as such in the lessee’s general ledger as a fixed asset. For tax purposes, the lessee deducts the interest portion of the capital lease payment as an expense, rather than the amount of the entire lease payment (which can be done with an operating lease).
So, what distinguishes a capital lease from an operating lease and why is the distinction important? There are at least a couple of reasons for properly characterizing capital and operating leases. One reason involves the fact that leases can be kept off a lessee’s financial statements, which could provide a misleading picture of the lessee’s finances. Another reason involves the proper tax characterization of the transaction. With an operating lease, the lessee deducts the lease payment as an operating expense and there is no impact on the lessee’s balance sheet. With a capital lease, however, the lessee recognizes the lease as an asset and the lease payment as a liability on the balance sheet. Also, with a capital lease, the lessee claims an annual amount of depreciation and deducts the interest expense associated with the lease. Based on these distinctions, many businesses prefer to treat lease transactions as operating leases, sometimes when the structure of the transaction indicates that they should not.
For a capital lease, the present value of all lease payments is considered to be the asset’s cost which, as noted above, the lessee records as a fixed asset, with an offsetting credit to a capital lease liability account. For accounting purposes, as each lease payment is made, the lessee records a combined reduction in the capital lease liability account and a charge to interest expense. The lessee records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset in its accounting records. The lessor has revenue equal to the present value of the future cash flows from the lease, and records the expenses associated with the lease. For the lessor, a lease receivable is recorded on the lessor’s balance sheet and recognizes the interest income as it is paid.
A transaction that is a capital lease has any one of the following features (according to the Financial Accounting Standards Board (FASB)):
- Ownership of the asset shifted from the lessee by the end of the lease period; or
- The lessee can buy the asset from the lessor at the end of the lease term for a below-market price; or
- The lease term is at least 75 percent of the estimated economic life of the asset (and the lease cannot be cancelled during that time); or
- The value of the minimum lease payments (discounted to present value) required under the lease equals or exceeds 90 percent of the fair value of the asset at the time the lease is entered into.
If none of the above factors can be satisfied, the transaction is an operating lease. In that event, the lessee is able to deduct the lease payment as a business expense and the leased asset is not treated as an asset of the lessee.
In the typical example, a farmer “trades in” equipment in return for not having to pay any of the operating lease payments or make a large down payment on the lease. If the trade is for a capital lease, with the IRS treating the transaction as a financing arrangement (i.e., a loan), then no gain is triggered on the trade if no cash is received. But there also is no deduction for the lease payments (although interest may be deductible). If the trade constitutes an operating lease, the farmer has gain equal to the amount of “trade-in” value that is credited to the operating lease minus the farmer’s tax cost in the equipment. The gain can be offset (partially or fully) with the lease expense (lease cost amortized for the year of sale).
On June 1, 2016, a farmer trades in a used, fully depreciated, tractor worth $120,000 for a new tractor under an operating lease over four years. The farmer will have ordinary income of $120,000 in 2016 and can deduct the lease payments made in 2016 and later years as a business expense. Had the trade occurred late in 2016, it is possible that no lease expense could be claimed in 2016, but that $30,000 could be claimed as a lease expense deduction in each year of 2017- 2020.
TCJA Modification to Like-Kind Exchanges
While the above discussion focuses on a trade-in of equipment in return for a lease, it is useful to remember that the recently enacted tax bill modifies the like-kind exchange rules. Under a provision include the “Tax Cut and Jobs Act,” for exchanges completed after December 31, 2017, I.R.C. §1031 is inapplicable to personal property exchanges. Thus, for example, on the trade of an item of farm equipment, the transaction will be treated as a sale with gain recognition on the sale of the item “traded.” The trade-in value is reported as the sales price (Form 4797), with no tax deferral for any I.R.C. §1231 gain or I.R.C. §1245 recapture. The typical result will be that gain will result because most farm equipment has been fully depreciated via expense method or bonus depreciation. The taxpayer’s income tax basis in the new item of farm equipment acquired in the “trade” will be the new item’s purchase price. That amount will then be eligible for a 100 percent deduction (“bonus” depreciation) through 2022. The “bonus” percentage is reduced 20 percentage points annually through 2026. In 2027, a taxpayer would have to report 100 percent of the gain realized on a “trade” of personal property, but could deduct the cost of the item acquired in the “trade” under the expense method depreciation provision of I.R.C. §179 (presently capped at $1 million). The gain on the “trade” is not subject to self-employment tax, and the depreciation deduction on the item acquired in the trade reduces self-employment tax. A further complication, beginning in 2018, is that net operating losses can only offset 80 percent of taxable income. Thus, a taxpayer may want to elect out of bonus depreciation on the newly acquired asset and use just enough expense method depreciation to get taxable income to the desired level.
Understanding the difference between a capital lease and an operating lease, is helpful to avoiding bad tax and legal results in agricultural transactions. The proper classification is very important. It’s a big deal particularly when the agricultural economy turns south.
Monday, April 9, 2018
In late March, 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 several ag-related provisions. I looked at one of those a couple of weeks ago – the modification to 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 modification, 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 was modified by a provision that provides greater equity between sales to agricultural cooperatives and non-cooperatives.
The modification to I.R.C. §199A received a lot of attention. However, there were a couple of other provisions in the Omnibus bill that are also ag-related. Today’s blog post examines those other two provisions.
Animal Waste Air Reporting Exemption For Farms
Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and the Emergency Planning and Community Right-to-Know Act (EPCRA), the federal government is to be notified when large quantities of hazardous materials are released into the environment. Once notified, the Environmental Protection Agency (EPA) has discretion to take remedial actions or order further monitoring or investigation of the situation. In 2008, the EPA issued a final regulation exempting farms from the reporting/notification requirement for air releases from animal waste on the basis that a federal response would most often be impractical and unlikely. However, the EPA retained the reporting/notification requirement for Confined Animal Feeding Operations (CAFOs) under EPCRAs public disclosure rule. Various environmental groups challenged the exemption on the basis that the EPA acted outside of its delegated authority to create the exemption. Agricultural groups claimed that the retained reporting requirement for CAFOs was also impermissible. The environmental groups claimed that emissions of ammonia and hydrogen sulfide (both hazardous substances under CERCLA) should be reported as part of furthering the overall regulatory objective. The court noted that there was no clear way to best measure the release of ammonia and hydrogen sulfide, but did determine that continuous releases are subject to annual notice requirements. The court held that the EPA’s final regulation should be vacated as an unreasonable interpretation of the de minimis exception in the statute. As such, the challenge brought by the agriculture groups to the CAFO carve out was mooted and dismissed. Waterkeeper Alliance, et al. v. Environmental Protection Agency, No. 09-1017, 2017 U.S. App. LEXIS 6174 (D.C. Cir. Apr. 11, 2017).
The court’s order potentially subjected almost 50,000 farms to the additional reporting requirement. As such, the court delayed enforcement of its ruling by issuing multiple stays, giving the EPA additional time to write a new rule. The EPA issued interim guidance on October 25, 2017. The court issued its most recent stay in the matter on February 1, 2018, with the expiration scheduled for May 1. However, Division S, Title XI, Section 1102 of the Omnibus bill, entitled the Fair Agricultural Reporting Method Act (FARM Act), modifies 42 U.S.C. §9603 to include the EPA exemption for farms that have animal waste air releases. Specifically, 42 U.S.C. §9603(e) is modified to specify that “air emissions from animal waste (including decomposing animal waste) at a farm” are exempt from the CERCLA Sec. 103 notice and reporting requirements. “Animal waste” is defined to mean “feces, urine, or other excrement, digestive emission, urea, or similar substances emitted by animals (including any form of livestock, poultry, or fish). The term animal waste “includes animal waste that is mixed or commingled with bedding, compost, feed, soil or any other material typically found with such waste.” A “farm” is defined as a site or area (including associated structures) that is used for “the production of a crop; or the raising or selling of animals (including any form of livestock, poultry or fish); and under normal conditions, produces during a farm year any agricultural products with a total value equal to not less than $1,000.”
ELD Rule Involving Agricultural Commodities Defunded
The Omnibus bill also addresses an Obama-era regulation involving truckers that is of particular importance to the livestock industry. On December 18, 2017, the U.S. Department of Transportation (USDOT) Final Rule on Electronic Logging Devices (ELD) and Hours of Service (HOS) was set to go into effect. 80 Fed. Reg. 78292 (Dec.16, 2015). The final rule was issued in late 2015. The new rule would require truck drivers to use electronic logging devices instead of paper logs to track their driving hours starting December 18, 2017. The devices connect to the vehicle's engine and automatically record driving hours. There are numerous exceptions to the ELD final rule.
While the mandate was set to go into effect December 18, 2017, the Federal Motor Carrier Safety Administration (FMCSA) granted a 90-day waiver for all vehicles carrying agricultural commodities. That 90-day delay was later extended. Other general exceptions to the final rule exist for vehicles built before 2000; vehicles that operate under the farm exemption (a “MAP 21” covered farm vehicle; 49 C.F.R. §395.1(s)); drivers coming within the 100/150 air-mile radius short haul log exemption (49 CFR §395.1(k)); and drivers who maintain HOS logs for no more than eight days during any 30-day period.
Under the Omnibus legislation, the ELD rule was defunded through the end of the government's current fiscal year - September 30, 2018. Under Division L, Title I, Section 132, specifies that, “None of the funds appropriated or otherwise made available to the Department of Transportation by this Act or any other Act may be obligated or expended to implement, administer, or enforce the requirements of 5 section 31137 of title 49, United States Code, or any regulation issued by the Secretary pursuant to such section, with respect to the use of electronic logging devices by operators of commercial motor vehicles, as defined in section 31132(1) of such title, transporting livestock as defined in section 602 of the Emergency Livestock Feed Assistance Act of 1988 (7 U.S.C. 1471) or insects.”
The Omnibus bill is a conglomeration of many provisions, most of which don’t have a direct impact on agricultural producers or agribusinesses. However, there were a few provisions included of importance to agriculture. While very few people, if any, have read and understand all of the provisions in the 2,232-page bill, it is important for those in the agricultural industry to have an understanding of the provisions that apply to them.
Thursday, April 5, 2018
When the Congress eventually gets around to debating the next Farm Bill, I suspect that crop insurance will comprise a significant part of the discussion. In certain parts of the country in recent years, crop insurance comprised the largest portion of farm income. Given that one of those areas, Kansas, is represented in the Senate by the chair of the Senate Ag Committee, that practically guarantees that crop insurance will get plenty of attention by the politicians during the Farm Bill debate.
The Federal Crop Insurance Corporation (FCIC) was created in 1938 to carry out the fledgling crop insurance program. That program was basically an experimental one until the Congress passed the Federal Crop Insurance Act (FCIA) of 1980. Changes were made to the crop insurance program on multiple occasions and, in 1994, the program underwent a major overhaul with the Federal Crop Insurance Reform Act of 1994 which made it mandatory for farmers to participate in the program to qualify for various federal farm program benefits.
With the 1996 Farm bill, the mandatory participation in crop insurance was repealed, so to speak. However, if a farmer received other farm program benefits the farmer had to buy crop insurance for the crop year or waive eligibility for disaster benefits for that year. In addition, the Risk Management Agency (RMA) was also created in 1996 as a part of the United States Department of Agriculture (USDA). The RMA administers the FCIC programs and other risk management programs in conjunction with private sector entities to develop insurance products for farmers.
In recent months, the courts have decided numerous cases involving crop insurance. In today’s post, I take a look at three of them. Each of them involves unique issues.
RMA and Freedom of Information Act (FOIA) Requests
In Bush v. United States Department of Agriculture, No. 16-CV-4128-CJW, 2017 U.S. Dist. LEXIS 131381 (N.D. Iowa Aug. 17, 2017), the RMA pursuant to the FOIA. The plaintiff was seeking the disclosure of soybean and corn yield within four townships in Cherokee County, Iowa. The RMA provided a no records in response to the plaintiff’s request explaining that it did not have the information available by section for townships within a county. The court determined that the purpose of the FOIA is to give the public greater access to governmental records. However, there are exceptions to this rule. The court determined that summary judgment for an agency is appropriate when the agency shows that it made a good faith effort to conduct a search for the requested records, using methods which can reasonably be expected to produce the information requested. However, the agency does not have to search every record system. In addition, the court pointed out that the FOIA neither requires an agency to answer questions disguised as FOIA requests or to create documents or opinions in response to an individual’s request for information.
The court concluded that the evidence illustrated that RMA did not maintain records matching the description of the plaintiff’s requests. Although it did collect some information from the records of insurance companies which would contain some of the information the plaintiff sought, it did not maintain records containing the precise information requested. As a result, the RMA was not required to provide information that it did not have to the plaintiff, and the court granted RMA’s motion for summary judgment.
Actual Production History
In Ausmus v. Perdue, No. 16-cv-01984-RBJ, 2017 U.S. Dist. LEXIS 169305 (D. Colo. Oct. 13, 2017), the plaintiffs, farmers who produce winter what in Baca County, Colorado, sought judicial review of an adverse decision of the RMA which was subsequently affirmed by the National Appeals Division (NAD). Section 11009 of the 2014 Farm Bill amended subparagraph 1508(g)(4)(C) of the FCIA to add an APH Yield Exclusion to give crop producers the opportunity to exclude uncharacteristically bad crop years from the RMA’s calculation of how much crop insurance coverage they are entitled to. The plaintiffs wished to insure their 2015 winter wheat crop. Believing that they were eligible to invoke the APH Yield Exclusion, they gave their crop insurance agents letters electing to exclude all eligible crop years for purposes of calculating their coverage. After receiving the letters from the plaintiff and other crop producers, crop insurance providers contacted the RMA requesting guidance on how to handle the APH Yield Exclusion elections concerning the 2015 winter wheat crop. The RMA informed insurance providers that it had authorized the APH Yield exclusion for most crops for 2015, but it did not authorize the APH Yield Exclusion for winter wheat. As a result, the Agency directed insurance providers to deny winter wheat producers’ requests for the APH Yield Exclusion.
The plaintiffs challenged the directive as an adverse decision appealable to NAD. A NAD Hearing Officer conducted a hearing and issued a determination that NAD did not have jurisdiction over the matter and did not reach the merits. The plaintiffs then requested NAD Director Review of the Hearing Officer’s Determination pursuant to 7 C.F.R. § 11.9. The NAD Director reversed the Hearing Officer’s determination as to jurisdiction, but also held that the RMA has discretion to determine the appropriate time to implement the APH Yield Exclusion with regard to 2015 winter wheat. This decision effectively affirmed the RMA’s decision not to authorize the APH Yield exclusion. The plaintiffs appealed, and the trial court determined that, absent clear direction by Congress to the contrary, a law takes effect on the date of its enactment. The court noted that there was no statutory indication that it would take effect other than on the date of its enactment. The court viewed Congress’ silence as an expression that it meant the APH Yield Exclusion to be immediately available to producers on the date the Farm Bill was signed into law. Consequently, the court reversed the NAD Director’s decision and remanded this case for the proper application of the APH Yield Exclusion.
In POCO, L.L.C. v. Farmers Crop Ins. All., Inc., No. 16-35310, 2017 U.S. App. LEXIS 20853 (9th Cir. Oct. 23, 2017), the defendant was a federal crop insurer and the plaintiff was a farming operation that raised potatoes and onions. The plaintiff claimed that it purchased a federal crop insurance policy from the defendant and tendered an insurance claim to the defendant in 2004. The defendant denied the claim and the plaintiff demanded arbitration. The arbitrator found for the plaintiff, requiring the defendant to pay $1,454,450 plus interest on the claim. The defendant appealed the arbitrator’s award, but the trial court affirmed the award for the plaintiff. While the claim was in dispute the USDA was, unbeknownst to the plaintiff, conducting a criminal investigation of the plaintiff for an alleged scheme to profit from the filing of false federal crop insurance claims. Ultimately, the plaintiff and its principal were indicted based on their acceptance of the arbitration award which the government claimed constituted a criminal act. At the subsequent trial, the court dismissed all of the counts with prejudice.
The plaintiff had also sued the defendant for breach of contract, negligent misrepresentation, and violation of the Washington Consumer Protection Act (WCPA). The plaintiff claimed that the defendant had acted as the USDA’s agent and, as a result, the arbitration award was simply a ruse to entrap the plaintiff. The plaintiff claimed that if it had known about the criminal investigation that it could have required the USDA’s direct involvement in the arbitration process and be assured that no criminal charges were pending. The plaintiff also claimed that USDA's direct involvement would have allowed it to get a court order that the plaintiff had a right to recover on its claims. The trial court granted summary judgment for the defendant holding that a private insurance company has no authority to bind the federal government from pursuing a criminal prosecution, absent involvement from a party with the requisite authority. The trial court ruled that it was unreasonable as a matter of law for a settlement agreement between private parties which clearly defines the subject matter of the agreement, to preclude criminal prosecution by the government. The plaintiff appealed.
The Mutual Release in the parties’ contract provided that the defendant, “for itself and for its insurance companies, and related companies” releases the plaintiff from liability for claims arising out of the plaintiff’s claim for indemnity under the 2003 crop insurance policies issued by the defendant. The plaintiff argued that “its insurance companies” included the Federal Crop Insurance Company and, therefore, the federal government. However, the appellate court held that the phrase could not reasonably be interpreted to bind the federal government and prevent the Department of Justice from pursing a criminal prosecution against the plaintiff for events related to the 2003 policies. Furthermore, the limited scope of the release could not be reasonably read to encompass the criminal charges filed against the plaintiff, which dealt with inflating crop baseline prices to increase eventual payouts on numerous insurance policies. Thus, the appellate court affirmed the trial court’s grant of summary judgment on the breach of contract claim. The plaintiff also alleged misrepresentation of a material fact. The appellate court determined, however, that the plaintiff failed to demonstrate a genuine factual dispute as to whether the defendant knew that the plaintiff was under a criminal investigation. The plaintiff’s evidence in support of that proposition stemmed from a 2004 insurance policy, rather than the 2003 insurance policy at issue in this case.
Consequently, the appellate court agreed with the trial court that, as a matter of law, the plaintiff could not have reasonably relied on the purported misrepresentation. Therefore, the trial court’s grant of summary judgment on the plaintiff’s misrepresentation claim was granted. Finally, the plaintiff’s WCPA claim failed because there was no misrepresentation, deception or unfairness. The terms of the contract were not deceptive and the plaintiff did not make a showing that there was a genuine dispute over whether the defendant knew about the criminal investigation.
These cases are just three of those that have been recently decided by the federal courts involving crop insurance. Crop insurance is important, but it is imperative to follow the rules. Because those rules are often complex and difficult to understand, it is important for a farmer to have competent legal counsel to provide guidance through the issues.
Tuesday, April 3, 2018
The Congress, through numerous tax and other legislative bills that have been enacted since the 1970s, has provided numerous subsidies designed to stimulate the production, sale and use of alternative fuels. In addition to the production-related subsidies, alternative fuel infrastructure subsidies also exist. In addition to the tax subsidies, Title IX of the 2014 Farm Bill included $694 million of mandatory funding and $765 million of discretionary funding for biofuels. In addition to tax subsidies and other funding mechanisms, the Renewable Fuel Standard provides preferential treatment for corn and soybean production. Many farmers, particularly in the Midwest, view the credits as important to their businesses (by removing supply and creating demand) and as an investment opportunity (“fueled” as it is, by government mandates).
The Internal Revenue Code (Code) provisions concerning the tax credits for alternative fuels are complex and must be precisely followed. The fact that many of these credits are refundable (can reduce the tax liability below zero and allow a tax refund to be obtained) increases the likelihood of fraud with respect to their usage. As a consequence, the IRS can levy huge penalties for the misuse of the credits. A recent federal case from Iowa illustrates how the alternative fuel credit can be misused, and the penalties that can apply for such misuse.
The alternative fuel credit – that’s the topic of today’s post.
The Alternative Fuel Credit
Section 6426 of the Code provides for several alternative fuel credits. Subsection (d) specifies the details for the alternative fuel credit. The initial version of the credit was enacted in 2004 as part of the American Jobs Creation Act of 2004. That initial version provided credits for alcohol and biodiesel fuel mixtures. In 2005, the Congress added credits to the Code for alternative fuels and alternative fuel mixtures. The credits proved popular with taxpayers. During the first six months of 2009, more than $2.5 million in cash payments were claimed for “liquid fuel derived from biomass.” That’s just one of the credits that were available, and the bulk of the $2.5 million went to paper mills for the production of “black liquor” as a fuel source for their operations (which they had already been using for decades without a taxpayer subsidy). The IRS later decided that “black liquor” production was indeed entitled to the credit because the process resulted in a net production of energy. C.C.M. AM2010-001 (Mar. 12, 2010). However, later that year new tax legislation retooled the statute and removed the production of “black liquor” from eligibility for the credit.
As modified, I.R.C. §6426(d) (as of 2011) allowed for a $.50 credit for each gallon of alternative fuel that a taxpayer sold for use as a fuel in a motor vehicle or motorboat or sold by the taxpayer for use in aviation, or for use in vehicles, motorboats or airplanes that the taxpayer used. In addition, an alternative fuel mixture credit of $.50 per gallon is also allowed for alternative fuel that the taxpayer used in producing any alternative fuel mixture for sale or use in the taxpayer’s trade or business.
For purposes of I.R.C. §6426, “alternative fuel” is defined as “liquid fuel derived from biomass” as that phrase is defined in I.R.C. 45K(c)(3). I.R.C. §6426(d)(2)(G). “Liquid fuel” is not defined, but the U.S. Energy Information Administration defines the term as “combustible or energy-generating molecules that can be harnessed to create mechanical energy, usually producing kinetic energy [, and that] must take the shape of their container.” An “alternative fuel mixture” requires at least 0.1 percent (by volume) (i.e., one part per thousand) of taxable fuel to be mixed with an alternative fuel. See Notice 2006-92, 2006-2, C.B. 774, 2006-43 I.R.B. §2(b). An alternative fuel mixture is “sold for use as a fuel” when the seller “has reason to believe that the mixture [would] be used as a fuel either by the buyer or by any later buyer. Id. In other words, a taxpayer could qualify for the alternative mixture fuel credit by blending liquid fuel derived from biomass and at least 0.1 percent diesel fuel into a mixture that was used or sold for use as a fuel, once the taxpayer properly registered with the IRS. I.R.C. 6426(a)(2).
In Alternative Carbon Resources, LLC v. United States, No. 1:15-cv-00155-MMS, 2018 U.S. Claims LEXIS 189 (Fed. Cl. Mar. 22, 2018), the plaintiff was a Pella, IA firm that produced alternative fuel mixtures consisting of liquid fuel derived from biomass and diesel fuel. The plaintiff registered with the IRS via Form 637 and was designated as an alternative fueler that produces an alternative fuel mixture that is sold in the plaintiff’s trade or business. Clearly, the plaintiff’s business model was structured around qualifying for and taking advantage of the taxpayer subsidy provided by the I.R.C. §6426 refundable credit for alternative fuel production.
To produce alternative fuel mixtures, the plaintiff bought feedstock from a supplier, with a trucking company picking up the feedstock and adding the required amount of diesel fuel to create the alternative fuel mixture. The mixture would then be delivered to a contracting party that would use the fuel in its business. The plaintiff entered into contracts with various parties that could use the alternative fuel mixture in their anaerobic digester systems to make biogas. One contract in particular, with the Des Moines Wastewater Reclamation Authority (WRA), provided that the plaintiff would pay WRA to take the alternative fuel mixtures from the plaintiff. The plaintiff’s consulting attorney (a supposed expert on energy tax credits from Atlanta, GA) advised the plaintiff that it would “look better” if the plaintiff charged “anything” for the fuel mixtures. Accordingly, the plaintiff charged the WRA $950 for the year for all deliveries. In return, the plaintiff was charged a $950 administrative fee for the same year. The WRA also charged the plaintiff a disposal fee for accepting the alternative fuel mixtures in the amount of $.02634/gal. for up to 50,000 gallons per day.
The plaintiff treated the transfers of its alternative fuel mixtures as sales for “use as a fuel.” That was in spite of the fact that the plaintiff paid the fee for the transaction. The plaintiff never requested a formal tax opinion from its Atlanta “expert,” however, the “expert” advised the plaintiff that the transaction qualified as a sale, based upon an IRS private letter ruling to a different taxpayer involving a different set of facts and construing a different section of the Code. The expert did advise the plaintiff that an IRS inquiry could be expected, but that the transaction with the WRA amounted to a sale “regardless of who [paid] whom.” A few months later, the IRS issued a Chief Counsel Advice indicating that if the alternative fuel was not consumed in the production of energy or did not produce energy, it would not qualify for the alternative fuel credit. C.C.A. 201133010 (Jul. 12, 2011). The “expert” contacted the IRS after the CCA was issued and then informed the plaintiff that the IRS might challenge any claiming of the credit, but continued to maintain that the “plaintiff’s qualification for tax credits…was straightforward.”
The plaintiff claimed a refundable alternative fuel mixture credit in accordance with I.R.C. §6426(e) of $19,773,393 via Form 8849. The IRS initially allowed the credit amount of $19,773,393 for 2011, but upon audit the following year disallowed the credit and assessed a tax of $19,773,393 in 2014. The IRS also assessed an excessive claim penalty of $39,546,786 for claiming excessive fuel credits without reasonable cause (I.R.C. §6675); civil fraud penalty (I.R.C. §6663) and failure-to-file and failure-to-pay penalties (I.R.C. 6651).
The court agreed with the IRS. While the court noted that the plaintiff was registered with the IRS and produced a qualified fuel mixture, the court determined that the plaintiff did not sell an alternative fuel mixture for use as a fuel. While the court noted that the term “use as a fuel” is undefined by the Code, the court rejected the IRS claim that the alternative fuel mixtures were not used as a fuel because the mixtures did not directly produce energy. Instead, they produced biogas that then produced energy, and the court noted that the IRS had previously issued Notice 2006-92 stating that an alternative fuel mixture is “used as a fuel” when it is consumed in the energy production process. However, the “production of energy” requirement contained in the “use of a fuel” definition meant, the court reasoned, that the alternative fuel mixture that is sold must result in a net production of energy. As applied to the facts of the case, the WRA could not provide any data that showed which of the feedstock sources from its numerous suppliers was producing energy, and which was simply burned off and disposed of. As such, the plaintiff could not prove that its fuel mixtures resulted in any net energy production, and the “use as a fuel” requirement was not satisfied.
In addition, even if the “use as a fuel” requirement was deemed satisfied, the court held that the plaintiff did not “sell” the alternative fuel mixture to customers. The nominal flat fee lacked economic substance. The fee, the court noted was “charged” only for the purpose of receiving the associated tax credit. In addition, no sales taxes were charged on the “sales.” Thus, the plaintiff was not entitled to any alternative mixture fuel credits.
The court upheld the 200 percent penalty insomuch as the professional advice the plaintiff received was not reasonably relied upon. The court noted that the plaintiff’s “expert” told the plaintiff that he was not fully informed of the plaintiff’s production process and informed the plaintiff that he did not understand the anaerobic digestion process. In addition, while the plaintiff was informed that there had to be a net production of energy from its production process to be able to claim the credit, the plaintiff ignored that advice. In addition, the court noted that the IRS private letter ruling the “expert” based his opinion on involved a different statute, a distinguishable set of facts, and did not support the plaintiff’s position and, in any event, was ultimately not relied upon. Likewise, a newly admitted local CPA that was hired to track feedstock received from suppliers and alternative fuel mixtures deliveries for the plaintiff provided no substantive tax advice that the plaintiff could have relied upon.
The end result was that that plaintiff had to repay the $19,773,393 of the claimed credits and pay an additional penalty of $39,546,786. A large part of the other penalties had already been abated. The court noted that any portion of those penalties that had not been abated may remain a liability of the plaintiff.
Initially, the refundable credits were presented to Congress as incubators. As the business and demand grew, there would be less need for the subsidy. The initial tax subsidies are critical for these business models to succeed. Unknown is whether any of the business models wean themselves off of the credit to be successful without taxpayer subsidy.
Each year, the IRS releases a list of the “Dirty Dozen” tax scams. On the current list are “excessive claims for business credits.” That includes alternative fuel tax credits. The fact that the alternative fuel credit is refundable makes it even more enticing to those that are seeking to scam the system. While alternative fuel credits may have their place, extreme care must be taken to ensure that appropriate business models and transactions are utilized to properly claim them. In the recent case, a local municipality (the WRA) was brought in to help make the scam look legitimate.