Wednesday, May 9, 2018
Purchase and Sale Allocations to CRP Contracts
Under the typical Conservation Reserve Program (CRP) contract, farmland is placed in the CRP for a ten-year period. Contract extensions are available, and the landowner must maintain a grass cover on the ground which may involve planting appropriate wild grasses and other vegetation and to perform mid-contract maintenance of the enrolled land in accordance with USDA/FSA specifications.
But, what happens if the CRP land is sold even though several years remain on the contract? This is particularly the case when crop prices are relatively high and there is an economic incentive to put the CRP-enrolled land back into production.
The possible penalties and tax consequences of not keeping land in the CRP for the duration of the contract – that the topic of today’s post.
Consequences of Early Termination
When a landowner doesn’t keep land in the CRP for the full length of the contract, the landowner of the former CRP-enrolled land must pay back to the USDA all CRP rents already received, plus interest, and liquidated damages (which might be waived). That’s synonymous with a lessee’s termination of a lease when the obligations under the lease exceed the benefits. When that happens, and the lessee pays a cancellation fee to get out from underneath the lease, the lessee is generally allowed a deduction. The rationale for allowing a deduction is that the lessee does not receive a future benefit, as long as the lease cancellation payment is not integrated in some manner with the acquisition of another property right. If, however, the termination payment is part of a single overall plan involving the acquisition of an affirmative benefit, the taxpayer must capitalize the payment. See Priv. Ltr. Rul. 9607016 (Nov. 20, 1995). That would be the case, for instance, when a lessee terminates a lease by buying the leased property. I.R.C. §167(c)(2) bars an allocation of a portion of the cost to the leasehold interest. Thus, allocations to lease contracts by real estate purchasers of real estate are not effective. The taxpayer must allocate the entire adjusted basis to the underlying capital asset.
Sale Price Allocation To CRP Contract
The IRS has ruled that a taxpayer who sold the right to 90 percent of the revenue from three CRP contracts that had approximately 11 years remaining was required to report the lump sum payment as ordinary gross income in the year of receipt. C.C.A. 200519048 (Jan. 27, 2005). The taxpayer agreed to comply will all of the provisions of the CRP contract, with damage provisions applying if he failed to comply. The taxpayer’s return for the year of sale reported the entire amount received for the sale on Form 4835. On the following year’s return, the taxpayer included the annual CRP payment from the remaining 10 percent on Form 4835 and claimed a deduction for the part which sold the prior year. On the next year’s return, the taxpayer included the total CRP payment and did not offset it with the amount he received from the buyer. The taxpayer later filed amended returns to remove the amount reported as income on Form 4835 in the year of sale, and to remove the expense deduction that was claimed on the following year’s return. The taxpayer claimed that the lump-sum was not income in the year of sale because he did not have the unrestricted right to the funds (due to the damage clause applying in the event of noncompliance), and only held them as a conduit. The IRS disagreed, noting that the taxpayer had received the proceeds from the sale of the CRP contracts, with the risk of nonpayment by the USDA shifted to the purchaser. The IRS also stated that amounts received under a claim of right are includable in income, even though the taxpayer may have to repay some portion at a later date. In addition, the IRS noted that a lump sum payment for the right to future ordinary income generally results in ordinary income in the year of receipt. See, e.g., Cotlow v. Comr., 22 T.C. 1019 (1954), aff’d., 228 F.2d 186 (2nd Cir. 1955).
The acquiring farmer may pay the early termination costs. In such case, the payment should be considered part of the land, as an additional cost incurred to acquire full rights in the property (i.e., a payment made to eliminate an impediment to full use of the property).
Early Termination Payments
Generally. A lessor’s payment to the lessee to obtain cancelation of a lease that is not considered an amount paid to renew or renegotiate a lease is considered a capital expenditure subject to amortization by the lessor. Treas. Reg. §1.263(a)-4(d)(7). The amortization period depends on the intended use of the property subject to the canceled lease.
If the lessor pays a tenant for early termination to regain possession of the land, the termination costs should be capitalized and amortized over the lease’s remaining term. Rev. Rul. 71-283. However, if early termination costs are incurred solely to allow the sale of the farm, the costs should be added to the basis of the farmland and deducted as part of the sale.
As applied to CRP contracts. A landlord paying early CRP termination costs to enter into a new lease of farmland with another farmer will capitalize and amortize the costs over the remaining term of the CRP contract that is being terminated. That’s the case where a lease cancelation is not tied to substantial improvements that are to be made to the property. However, the IRS might claim that such costs should be amortized over the term of the new lease if the new lease is for a longer period that the remaining term of the CRP contract. However, the U.S. Court of Appeals for the Ninth Circuit has questioned this position, noting that the Tax Court decision seeming to bolster the IRS position relied on court cases that seemed to alternate between using the unexpired lease term versus the new lease term. Handlery Hotels, Inc. v. United States, 663 F.2d 892 (9th Cir. 1981). Thus, the general rule that lease cancelation costs should typically be written off over the unexpired term of the canceled lease.
The early disposition of a CRP contract carries with it some substantial consequences, both financial and tax. It’s important to understand what might happen if early termination is a possibility.