Monday, July 30, 2018
Last week, House Ways and Means Committee Chairman Kevin Brady released the committee’s working outline for a tax legislative proposal that they are presently working on with hopes of passage later this summer or fall. It appears to be a framework at this time, with not much substantive Code structure attached to it. But, the framework is something to go on in anticipating what might be a forthcoming legislative proposal. In any event, it’s worth noting what has been released so that feedback from tax professionals can be provided to tax staffers as the drafting process proceeds.
A tax proposal following-up on the Tax Cuts and Jobs Act – that’s the topic of today’s post.
The framework puts the tax proposals into three separate categories: 1) individual and small business tax cuts; 2) promotion of individual savings; and 3) promotion of business innovation.
Individual and small business. The effort seems to be with respect to the first category to make most of the TCJA provisions that apply to individuals and small business permanent. Under the TCJA, many provisions are set to expire at the end of 2025. Remember, however, tax provisions are only “permanent” if they don’t contain a statutory sunset date and the Congress doesn’t otherwise change the law.
Savings. The second area of focus, promoting individual savings, contains several proposals designed not only to spur individual savings, but also incentivize the use of workplace retirement plans. One proposal that is outlined would establish a “Universal Savings Account.” The description of the account is that it would be a “fully flexible savings tool for families.” At this time, however, there are no details as to how the account would be established or function.
While the TCJA did expand the potential use and application of funds contained in a “529” education account, the proposal would attempt to expand further the use of such funds by allowing them (on a tax-favored basis) to be used to pay for apprenticeship fees to learn a trade, cover home schooling expenses and be applied to pay-off student debt.
This prong of the proposal would also allow money to be withdrawn without penalty from existing retirement accounts to pay for childbirth or adoption costs. In addition, amounts withdrawn for such purposes could be paid back at a later time.
Innovation. The third prong of the proposal focuses on spurring small business entrepreneurship and innovation. To accomplish this objective, the proposal would allow qualified small businesses to write off a greater amount of initial start-up costs than is permitted under present law. There is no specification as to the additional amount, nor is there any “meat” to the comment in the proposal that new tax provisions would be used to “remove barriers to growth.”
In recent years, tax legislation (or most legislation, for that matter) passes the House and then goes to the Senate to either die or not get acted upon – largely because of the 60-vote requirement to pass tax legislation in the Senate without the reconciliation process. That same process could also be true for this proposal. A likely scenario is that the House passes a tax bill, but the Senate fails to take action before the end of the year (or takes action at the last minute in December). For this reason, it looks as if (at least right now) the House will introduce its tax proposals in three separate bills – one for each of the prongs mentioned above. It is believed that such a strategy will assist in the process of getting the necessary 60 votes by tailoring each proposal to specific provisions. But, then there is always the politics of the situation. The Senate majority leader could call for a vote before the fall congressional election. Or, on the other hand, the vote could be put off until after the election on anticipation that the Republican majority in the Senate will widen.
While some in the Congress could balk at what is likely to be budget scoring that will say that additional tax cuts will widen the deficit, that may be counterbalanced by those wanting deeper cuts and pointing to the strength of the overall economy. In addition, I am already hearing talk from some tax staffers that there could be an attempt to tweak the TCJA by repealing the tax on private college endowments, modifying the new qualified business income deduction of I.R.C. §199A and indexing capital gains. The I.R.C. §199A issue is an interesting one. There are many unanswered question concerning it and the first set of regulations involving the new deduction have yet to be released. Also, politicians from high tax states may push for a full reinstatement of the state and local tax deduction.
Another possibility is that any new tax legislation will contain technical corrections to TCJA provisions. That is probably a slim possibility, however, until after the midterm election. That means that technical corrections, if any, won’t be until later in November or December. Of course, those are needed now (actually they were needed months ago) as are regulations and forms so that tax pros can give advice to clients and take appropriate planning steps.
As for health care, on July 25, the U.S. House passed two health care reform bills which would do numerous things but, in particular, expand access to tax-preferred health savings accounts (HSAs). As usual, it remains to be seen whether the Senate will even take up either or both of the bills.
The first of the two bills, H.R. 6311, would allow individuals to bypass the Obamacare restriction on using premium tax credits to buy catastrophic health care plans and would broaden eligibility for contributions to an HSA. Specifically, the bill would raise the contribution limit to $6,650 for individuals and $13,000 for families. That’s the combination of the annual limit for out-of-pocket and deductible expenses for 2018. The bill would also permit HSA funds to pay for qualified medical expenses at the start of coverage of the high deductible health policy (HDHP) if the HSA has been opened within 60 days of the HDHP start date. The bill would also suspend until 2022 Obamacare’s annual fee on health insurers.
The other bill concerning health care that was passed on July 25 is H.R. 6199. This legislation repeals the portions of Obamacare that limit payments for medications from HSAs, medical savings accounts, health FSAs, and health reimbursement arrangements to only prescription drugs or insulin. As a result, distributions from such accounts can be made without penalty for over-the-counter medications and products. The bill would also allow persons with health insurance that qualifies as HSA family coverage to contribute to an HSA if their spouse is enrolled in a medical FSA. It would also allow an HDHP to annually cover up to $250 (self) and $500 (family) of non-preventative services (e.g., chronic care) that may not be covered until after the deductible is reached.
Tax policy will remain a key topic over the weeks leading up to the midterm election. Whether any legislation is enacted remains to be seen. Certainly, technical corrections are needed to deal with certain aspects of the TCJA. From there, additional legislation is an add-on. In any event, certainty in tax policy will not likely be part of the future for some time. All of this makes providing tax advice to clients difficult.
Thursday, July 26, 2018
Financial distress in the farm sector continues to be a real problem. Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years. As an example, the level of working capital in the farm sector has fallen sharply since 2012. Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak. In the past year alone, working capital dropped by 18 percent. It has also declined precipitously as a percentage of gross revenue. This means that many farmers have a diminished ability to reinvest in their farming operations. It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate. When that happens, the sellers of the assets that repossess have tax consequences to worry about.
Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains. Other times, farmland might be repossessed.
Tax issues upon repossession of farmland – that’s the topic of today’s post.
Repossession of Farmland
Special exception. A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt. It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale. However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved. See I.R.C. §453B(f)(2). In addition, for the special rules to apply, the debt must be secured by the real property.
When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition.
Handling interest. Amounts of interest received, stated or unstated, are excluded from the computation of gain. Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt. However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income. I.R.C. §453B(f)(2). But, a question exists as to whether that provision applies in financial distress situations.
The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts.
Debt secured by the real property. The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property. Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules.
Character of gain. The character of the gain from reacquisition is determined by the character of the gain from the original sale. For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation. If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income. If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain.
Basis issues. Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property. The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs.
The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition. However, the holding period does not include the time between the original sale and the date of reacquisition.
Is the personal residence involved? The provisions on reacquisition of property generally apply to residences or the residence part of the transaction. However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale. An adjustment is made to the sales price of the old residence and the basis of the new residence. If not resold within one year, gain is recognized under the rules for repossession of real property. An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election. The exclusion can, therefore, be made after reacquisition. An election can be made at any time within three years after the due date of the return.
No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero. Losses are not deductible on sale or repossession of a personal residence. When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property. Adjustment is made to the income tax basis of the reacquired residence.
Special situations. In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69-83, 1969-1 C.B. 202. A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent. However, the Installment Sales Revision Act of 1980 changed that result. The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980. Presumably, that means acquisitions by the estate or beneficiary. Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been. The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable.
The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.
Tax planning is important for farmers that are in financial distress and for creditors of those farmers. As usual, having good tax counsel at the ready is critical. Tax issues can become complex quickly.
Tuesday, July 24, 2018
For many people, the most important estate planning document is the will (or trust) that disposes of property at the time of death. Assets that pass by will are subject to probate and are known as “probate assets.” But, a decedent’s estate may also have “non-probate assets.” Those are assets that are not subject to the probate court’s jurisdiction and pass by a contractual beneficiary designation. These contractual arrangements include life insurance, pensions, IRAs and annuities.
For married couples, one spouse typically names the other spouse as the beneficiary of these non-probate assets. But, what if one spouse names the other as the beneficiary of a non-probate contractual arrangement and divorce occurs and the beneficiary designation is not changed? Does the beneficiary-spouse remain the beneficiary, or is that designation automatically revoked? Can the law automatically remove the former spouse as beneficiary? How does the Constitution’s Contracts Clause factor into this?
That’s the topic of today’s post – beneficiary changes upon divorce.
The Contracts Clause
Article I, Section 10, Clause 1 of the U.S. Constitution specifies that a state cannot enact legislation that disrupts contractual arrangements. That provision says that, “[n]o state shall…pass any…Law impairing the Obligation of Contracts.” Thus, while citizens have the right to enter into contracts that don’t violate “public policy,” the government cannot impair otherwise permissible contracts. But, what does that mean? Does it mean that a state can enact a law that changes the contractual beneficiary designation on a life insurance policy, for example? The issue recently came up in a case that made it all of the to the U.S. Supreme Court.
In Sveen v. Melin, 138 S. Ct. 1815 (2018), a couple married in 1997. In 1998, the husband bought a life insurance policy that named his wife as the primary beneficiary and his two children from a prior marriage as the contingent beneficiaries. In 2002, a new Minnesota law took effect providing that “the dissolution or annulment of a marriage revokes any revocable…beneficiary designation…made by an individual to the individual’s former spouse.” Minn. Stat. §524.2-804, subd.1. Thus, divorce automatically revokes the designation of a spouse as the beneficiary. That would cause the insurance proceeds to go to the contingent beneficiary or the policyholder’s estate upon death of the policyholder. If the policyholder does not want this result, the former spouse can be named as beneficiary (again). In 2007, the couple divorced and the former husband died in 2011 without changing the beneficiary designation. The deceased ex-husband’s children claimed that they were the beneficiaries of the life insurance proceeds. But, the surviving ex-spouse claimed that she was the beneficiary because the law did not exist at the time the policy was purchased and she was named the primary beneficiary. Her core argument was that the retroactive application of the law violated the Contracts Clause.
The U.S. Court of Appeals for the Eighth Circuit agreed with the surviving ex-spouse (Metro Life Insurance Co. v. Melin, 853 F.3d 410 (8th Cir. 2017), but the U.S. Supreme Court reversed. The Supreme Court noted that the Contracts Clause did not establish a complete prohibition against states from enacting laws that impacted pre-existing contracts. The Court noted that a two-step test existed form determining the constitutionality of such a law. Step one involves the question of whether the law “operated as a substantial impairment of a contractual relationship” based on the extent to which the law undermined the parties’ bargain, interfered with the parties’ reasonable expectations, and barred the parties from safeguarding their rights. If a contractual impairment is determined under step one, then the second step examines the means and ends of the legislation to determine whether the state law advances a significant and legitimate public purpose.
In Sveen, the Court held that the law did not substantially impair pre-existing contractual arrangements. The Court reasoned that the law was designed to reflect a policyholder’s intent based on an assumption that an ex-spouse would not be the desired primary beneficiary. In addition, the Court stated that an insured cannot reasonably rely on a beneficiary designation staying in place after a divorce – noting that divorce courts have wide discretion to divide property, including the revocation of spousal beneficiary designations in life insurance policies (or mandating that they remain). Accordingly, the Court concluded that a policyholder had no reliance interest in the policy in the event of divorce, and could undo the impact of the law by again naming the (now) ex-spouse as the primary beneficiary. The decedent’s children were held to be the primary beneficiaries of the policy.
Kansas, like other states, has an automatic revocation provision for wills upon divorce. Kan. Stat. Ann. §59-610. For non-probate assets with a beneficiary designation, in divorce actions judges are to include changes in beneficiary status as part of the property division between the spouses and note any change in the divorce decree. Kan. Stat. Ann. §2-2602(d). The policyholder remains responsible for actually changing the beneficiary designation. Id.
The Court’s conclusion expands the reach of the government into private contractual arrangements. It also assumes that all divorces are acrimonious and that a divorced policyholder would never want to benefit a former spouse. That's simply not true. What's more is that the Court upheld the Minnesota law even though it retroactively applied in the case at bar. If a statute that changes (rewrites) the primary beneficiary designation of a contract on a retroactive basis doesn’t substantially impair that contract, I don’t know what does. Judge Gorsuch seems to agree with that last point in his dissent.
How does your state law treat the issue?
Friday, July 20, 2018
Many states criminalize the intentional killing, injuring, maiming, torturing or mutilating of any animal. In some states, simply abandoning or leaving an animal in any place without making provisions for its proper care or having physical custody of an animal and failing to provide food, potable water, protection from the elements, opportunity for exercise and other care, as is needed for the health or well-being of the animal is criminal.
But, what must the state prove to make a cruelty to animals charge stick? That issue came up in a recent case and is the topic of today’s post.
Typically, the state must prove that the defendant acted with depraved intent. Cruelty to animals is typically classified as a misdemeanor carrying a penalty of up to six months in jail and/or a fine of up to $2,000. Most states do not classify as cruelty to animals accepted veterinary practices and bona fide experiments carried on by commonly recognized research facilities. In many of the western states, rodeo practices accepted by the Rodeo Cowboy's Association are statutorily determined not to constitute cruelty to animals as well as the humane killing of an animal which is diseased or disabled beyond recovery for any useful purpose or for population control by the animal's owner. Normal or accepted practices of animal husbandry do not constitute cruelty to animals with respect to farm animals, and killing an animal that is found injuring or posing a threat to another person, farm animal or property is also permitted.
In Cadwell v. State, No. 06-17-00227-CR 2018 Tex. App. LEXIS 4545 (Tex. Ct. App. Jun. 21, 2018), the defendant and his estranged wife were involved in divorce proceedings and during that time various horses belonging to them that had been ordered into the defendant’s custody lost weight, reportedly due to inadequate nutrition. The defendant’s estranged wife as well as two other investigators and animal control officers all testified that the horses were in very bad condition with ribs showing and cracked and had split hooves due to malnutrition. The investigator testified that the horses were kept in an enclosure that had “virtually no grass,” and that grass that was present was too short for them to eat. All the bushes and shrubs had been picked clean. The water troughs within that enclosure were empty and had only leaves and debris in them or had been overturned. A stock tank or pond had water, but it was filled with debris and was stagnant. In addition, there was no evidence of hay found in the horses’ enclosure. The state’s expert witness was a veterinarian with 11 years’ experience. She explained that there is a body scoring scale from one (extremely emaciated) to nine or ten (being extremely obese). In addition, she explained that the acceptable range for a horse is four to six. A horse that is scored under four is in a condition that needs to be addressed. A horse scored at three on this scale is considered thin, while a score of two would indicated that a horse is badly emaciated but standing, while a one indicates extreme emaciation, not able to stand, and not considered savable. She testified that when she saw them the majority of the horses were scored at a three. She also testified that she was surprised with the relatively low parasite presence in most of them and concluded that the most likely reason for the horses’ thinness was that they were not being fed properly.
Ultimately, the defendant was convicted of cruelty to livestock animals and sentenced to 180 days in jail (which was changed to 24 months on the condition that the defendant serve 30 days in jail). The defendant appealed on the basis that there the state failed to prove that he had the criminal intent (mens rea) to harm the animals. The appellate court determined that evidence could lead a rational jury to find beyond a reasonable doubt that the defendant was intentional or knowing in not providing one or more of the horses in his care enough nutrition.
The defendant also claimed that by inserting “by neglect” in the information and the jury charge, the State and the trial court, improperly instructed the jury and improperly lowered the mens rea requirement from intentionally or knowingly to a lower level of mens rea. However, the appellate court determined that the phrase “by neglect” charges the defendant with cruelty to animals by the manner and means of failure to act or of behavior that was not attentive to the needs of the horses, not with negligently doing so, especially given that the mens rea was specified in both the information and in the jury charge as intentional or knowing. Thus, the appellate court held that because the use of the phrase “by neglect” set out the manner and means of committing the offense and because the information and the jury charge clearly set out the required mens rea of intentional or knowing behavior by the defendant, the use of the phrase did not improperly reduce the State’s burden to prove the defendant’s willful or knowing mens rea.
Generally accepted farming practices do not constitute animal cruelty. Generally, providing adequate food and shelter is required, but some states have little to no shelter requirements in certain situations and with respect to certain types of livestock. The statutory rules vary from state to state.
Wednesday, July 18, 2018
Next month, Washburn Law School and Kansas State University (KSU) will team up for its annual symposium on agricultural law and the business of agriculture. The event will be held in Manhattan at the Kansas Farm Bureau headquarters. The symposium will be the first day of three days of continuing education on matters involving agricultural law and economics. The other two days will be the annual Risk and Profit Conference conducted by the KSU Department of Agricultural Economics. That event will be on the KSU campus in Manhattan. The three days provide an excellent opportunity for lawyers, CPAs, farmers and ranchers, agribusiness professionals and rural landowners to obtain continuing education on matters regarding agricultural law and economics.
This year’s symposium on August 15 will feature discussion and analysis of the new tax law, the Tax Cuts and Jobs Act, and its impact on individuals and businesses engaged in agriculture; farm and ranch financial distress legal issues and the procedures involved in resolving debtor/creditor disputes, including the use of mediation and Chapter 12 bankruptcy; farm policy issues at the state and federal level (including a discussion of the status of the 2018 Farm Bill); the leasing of water rights; an update on significant legal (and tax) developments in agricultural law (both federal and state); and an hour of ethics that will test participant’s negotiation skills.
The symposium can also be attended online. For a complete description of the sessions and how to register for either in-person or online attendance, click here: http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/continuingeducation/businessofagriculture/index.html
Risk and Profit Conference
On August 16 and 17, the KSU Department of Agricultural Economics will conduct its annual Risk and Profit campus. The event will be held at the alumni center on the KSU campus, and will involve a day and a half of discussion of various topics related to the economics of the business of agriculture. One of the keynote speakers at the conference will be Ambassador Richard T. Crowder, an ag negotiator on a worldwide basis. The conference includes 22 breakout sessions on a wide range of topics, including two separate breakout sessions that I will be doing with Mark Dikeman of the KSU Farm Management Association on the new tax law. For a complete run down of the conference, click here: https://www.agmanager.info/risk-and-profit-conference
The two and one-half days of instruction is an opportunity is a great chance to gain insight into making your ag-related business more profitable from various aspects – legal, tax and economic. If you are a producer, agribusiness professional, or a professional in a service business (lawyer; tax professional; financial planner; or other related service business) you won’t want to miss these events in Manhattan. See you there, or online for Day 1.
July 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Monday, July 16, 2018
In recent years, the IRS has shown an increased focus on business activities that it believes are being engaged in without an intent to make a profit. If that is the case, the “hobby loss” rules apply and limit deductions to the amount of income from the activity. But, engaging in an activity with a profit intent may not be enough to fully deduct losses from the activity. That’s particularly the case if the taxpayer hires a paid manager to run the operation. In that situation, the IRS may claim that the taxpayer is not materially participating in the activity under the passive loss rules. If the IRS prevails on that argument, loss deductions are severely limited, if not eliminated.
A recent Tax Court case involved both the hobby loss rules and the passive loss rules. While the ranching activity was deemed not to be a hobby, the court believed that the taxpayer was not materially participating in the activity.
Paid managers and the passive loss rules – that’s the focus of today’s post.
Passive Loss Rules
The passive loss rules, enacted in 1986, reduce the possibility of offsetting passive losses against active income. I.R.C. §469(a)(1). The rules apply to activities that involve the conduct of a trade or business (generally, any activity that is a trade or business for purposes of I.R.C. §162) where the taxpayer does not materially participate (under at least one of seven tests) in the activity on a basis which is regular, continuous and substantial. I.R.C. § 469(h)(1). Property held for rental usually is a passive activity, however, regardless of the extent of the owner's involvement in the management or operation of the property.
If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains). Losses (and credits) that a taxpayer cannot use because of the passive loss limitation rules are suspended and carry over indefinitely to be offset against future passive activity income from any source. I.R.C. §469(b). For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, as noted, the losses from the venture cannot be used to offset the income from the farming operation.
Facts. In Robison v. Comr., T.C. Memo. 2018-88, the petitioners were a married couple who lived in the San Francisco Bay area. The husband worked in the technology sector, and during the years in issue (2010-2014) the husband’s salary ranged from $1.4 million to $10.5 million. In 1999, the petitioners bought a 410-acre tract in a remote area of southeastern Utah for $2,000,000. They later acquired additional land, bringing their total land holdings to over 500 acres. The wife sold her physical therapy practice to focus her time on the administrative side of their new ranching activity.
The property was in shambles and the petitioners spent large sums on infrastructure to refurbish it. The began a horse activity on the property which they continued until 2010. The activity never made money, with a large part of the losses (roughly $500,000 each year) attributable to depreciation, repairs due to vandalism, and infrastructure expense such as the building of a woodshop and cement factory as the property’s remote location made repair work and build-out necessary to conduct on-site. The petitioners did not live on the ranch. Instead, they traveled to the ranch anywhere from four to ten times annually, staying approximately 10 days each time. The petitioners drafted all employee contracts, and managed all aspects of the horse activity.
They deducted their losses from the activity annually, and presumably because of the continued claimed losses, they were audited by the IRS in 2004 and 2008. Each of those audits concluded with an IRS determination that the petitioners were conducting a trade or business with profit intent (e.g., the activity was not a hobby). The IRS also determined that the petitioners were materially participating for purposes of the passive loss rules. The petitioners did not maintain contemporaneous records of their time spent on ranch activities. However, for each of those audits, the petitioners prepared time logs based on their calendars and their historical knowledge of how long it took them to complete various tasks. The IRS deemed the petitioners’ approach to documenting and substantiating their time spent on various ranch activities as acceptable. That documentation showed that the petitioners were putting over 2,000 hours (combined) into the ranch activity annually. In one year alone, they devoted more than 200 hours dealing with the IRS audit.
In 2010, the petitioners shifted the ranch business activity from horses to cattle. The husband retired in 2012 and, upon retirement, the couple moved to Park City, Utah, with the husband devoting full-time to the ranching activity along with his wife. The cattle operation was strictly grass-fed, with the cattle grazing upper-elevation Bureau of Land Management (BLM) land during the summer months. The petitioners negotiated the lease contracts with the BLM. They also hired a full-time ranch manager to manage the cattle. However, the petitioners managed the overall business of the ranch. From 2013-2015, the losses from the ranch declined each year.
The IRS initiated a third audit (all three audits involved different auditors) of the petitioners’ ranching activity, this time examining tax years 2010-2014. The IRS examined whether the activity constituted a hobby, but raised no questions during the audit concerning the petitioners’ material participation. The IRS hired an expert who spent three days at the ranch looking at all aspects of the ranching activity and examining each head of cattle. The expert produced a report simply concluding that the petitioners had too many expenses for the activity to be profitable. This time the IRS issued a statutory notice of deficiency (SNOD) denying deductions for losses associated with the ranching activity. The IRS claimed that the ranching activity was a “hobby,” and also raised the alternative argument that the petitioners failed to satisfy the material participation test of the passive loss rules.
The petitioners disagreed with the IRS’ assessment and filed a petition with the U.S. Tax Court. The IRS did not disclose to the petitioners whether the petitioners’ alleged lack of material participation was an issue until two days before trial. At the seven-hour trial, the court expressed no concern about any lack of profit motive on the petitioners’ part. The IRS’ trial brief focused solely on the hobby loss issue and did not address the material participation issue. In addition, the IRS did not raise the material participation issue at trial, and it was made clear to the court that the paid ranch manager was hired to manage the cattle, but that the overall business of the ranch was conducted by the petitioners. At the conclusion of the trial, the court requested that the parties file additional briefs on the material participation issue.
Tax Court’s opinion – hobby loss rules. Judge Cohen determined that the ranching activity was not a hobby based on the nine factors set forth in Treas. Reg. §1.183-2. One of the key factors in the petitioners’ favor was that they had hired a ranch manager and ranch hand to work the ranch and a veterinarian to assist with managing the effects of high altitude on cattle. This indicated that the activity was being conducted as a business with a profit intent. They had many consecutive years of losses, didn’t have a written business plan and didn’t maintain records in a manner that aided in making business decisions. However, the court noted that they had made a significant effort to reduce expenses and make informed decisions to enhance the ranch’s profitability. Indeed, after ten years of horse activity, the petitioners changed the ranching activity to cattle grazing in an attempt to improve profitability. While the petitioners’ high income from non-ranching sources weighed against them, overall the court determined that the ranching activity was conducted with the requisite profit intent to not be a hobby.
Note: While the court’s opinion stated that the horse activity was changed to cattle in 2000, the record before the court indicated that the petitioners didn’t make that switch until 2010.
Tax Court’s opinion – passive loss rules. However, Judge Cohen determined that the petitioners had failed to satisfy the material participation test of the passive loss rule. The losses were, therefore, passive and only deductible in accordance with those rules. The court determined that only two of the seven tests for material participation were relevant – the 500-hour test (Treas. Reg. § 1.469-5T(a)(1)) and the facts and circumstances test (Treas. Reg. §1.469-5T(a)(7)). As for the 500-hour test, the court took issue with the manner in which the petitioners documented their time spent on the ranching activity. The court opined that the logs were merely estimates of time spent on ranch activities and were created in preparation for trial. The court made no mention of the fact that the IRS, on two prior audits, raised no issue with the manner in which the petitioners tracked their time spent on ranch activities and had not questioned the accuracy of the logs that were prepared based on the petitioners’ calendars during the third audit which led to the SNOD and eventual trial.
As for the facts and circumstances test, the court determined that the petitioners could not satisfy the test because of the presence of the paid ranch manager. The court made no distinction between the cattle grazing activity which the ranch manager was responsible for and the overall business operations for which the petitioners were responsible. Indeed, on the material participation issue, due to the presence of the ranch manager, all of the personal actions and involvement of the petitioners on which the court based its determination of their profit motive were dismissed as “investor” hours.
The regulations do not list the facts and circumstances considered relevant in the application of the test, but the legislative history behind the provision does provide some guidance. Essentially, the question is whether and how regularly the taxpayer participates in the activity. Staff of Joint Comm. on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 238 (Comm. Print 1987) [hereinafter 1986 Act Bluebook]. A taxpayer that doesn’t live at the site of the activity can still satisfy the test. Id. While management activities can qualify as material participation, they are likely to be viewed skeptically because of the difficulty in verifying them. See, e.g., HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986); 1986 Act Bluebook, supra note 35, at 240. Merely “formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment is not material participation.” HR Rep. No. 841, 99th Cong., 2d Sess. II-148 (Conf. Rep. 1986); S. Rep. No. 313, 99th Cong., 2d Sess. 734 n.20 (1986). Thus, the decisions the taxpayer makes must be important to the business (and they must be continuous and substantial).
It is true that a taxpayer’s management activities are ignored if any person receives compensation for management services performed for the activity during the taxable year. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Clearly, this exclusion applies where the “taxpayer has little or no knowledge or experience” in the business and “merely approves management decisions recommended by a paid advisor.” See Treas. Reg. §1.469-5T(k), Ex. 8. However, the regulation applies well beyond those situations. In addition, a taxpayer's management work is ignored if some other unpaid manager spends more time than the taxpayer on managing the activity. Treas. Reg. § 1.469-5T(b)(ii)(B). Thus, there is no attributions of the activities of employees and agents to the taxpayer for purposes of the passive loss rules, but hiring a paid manager does not destroy the taxpayer’s own record of involvement for the material participation purposes except for the facts and circumstances test. See, e.g., S. Rep. No. 313, 99th Cong., 2d Sess. 735 (1986)( “if the taxpayer’s own activities are sufficient, the fact that employees or contract services are utilized to perform daily functions in running the business does not prevent the taxpayer from qualifying as materially participating”).
Clearly, the petitioners’ type of involvement in the ranching activity was not that of an investor. However, equally clearly was that the petitioners’ method of recordkeeping was a big issue to the court (even though IRS was not concerned). The preparation of non-contemporaneous logs and those prepared from calendar entries has been a problem in other cases. See, e.g., Lee v. Comr., T.C. Memo. 2006-193; Fowler v. Comr., T.C. Memo. 2002-223; Shaw v. Comr., T.C. Memo. 2002-35. Without those logs being available to substantiate the petitioners’ hours, the petitioners were left with satisfying the material participation requirement under the facts and circumstances test. That’s where the presence of the paid manager proved fatal. Thus, the ranching activity was not a hobby, but it was passive.
Combining the passive loss rules with a hobby loss argument is not a new tactic for the IRS (it was recently utilized with respect to a Kansas ranch), but the Robison decision certainly indicates that it can be expected to be used more frequently. But, remember, the IRS, at no point in the audit or litigation in Robison pressed the material participation issue – it was simply stated as an alternative issue in the SNOD. It was Judge Cohen that sought additional briefing on the issue.
The result in Robison is that the losses will only be deductible to the extent of passive income from the activity. Otherwise, the losses remain suspended until the petitioners dispose of their entire interest in the activity in a fully taxable transaction to an unrelated party. I.R.C. §469(g). That’s exactly what is going to happen. The petitioners are tired of the constant battle with the IRS and will not appeal the Tax Court’s decision. The ranch is for sale.
Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.
Tuesday, July 10, 2018
The Tax Cuts and Jobs Act made significant changes in the tax law. That’s an obvious conclusion. It also changed some of the rules associated with charitable giving, and other rules that have an impact are likely to impact a taxpayer’s decision to donate to charity. Because of these changes, some charities have expressed concerns about a potential decline in charitable giving overall.
Is a drop in overall charitable giving likely? If so, are there planning options that can be utilized to preserve charitable deductions for charitable gifts?
Post-2017 charitable giving. That’s the topic of today’s post.
For tax years beginning before 2018, taxpayers that itemized deductions (Schedule A) could deduct charitable donations of cash or property to qualifying organizations. That remains true for tax years beginning after 2017. However, the TCJA has made a couple of important changes. Pre-TCJA, most cash contributions were generally limited to 50 percent of the taxpayer’s “contribution base.” “Contribution base” is defined as the taxpayer’s adjusted gross income (AGI). For this purpose, AGI is computed without including any net operating loss carryback to the tax year. I.R.C. §170(b)(1)(H).
The 50 percent limit applies to donations of ordinary income property and cash to charitable organizations described in I.R.C. §170(b)(1)(A). Those charities include public charities, private foundations other than nonoperating private foundations, and certain governmental units. Donations of capital gain property to these entities are limited to 30 percent of the taxpayer’s contribution base. Donated capital gain property to these organizations that are for the purpose of allowing the charity to use the property is capped at 20 percent of the donor’s contribution base. Gifts to non-operating foundations are capped at 30 percent of the donor’s contribution base for gifts of ordinary income property and case. The cap is 20 percent for capital gain property gifted to a non-operating foundation.
Under the TCJA, effective for tax years beginning after 2017 and before 2026, the 50 percent limitation is increased to 60 percent. Thus, an individual taxpayer can deduct cash contributions up to 60% of contribution base for donations to I.R.C. §170(b)(1)(A) organizations. I.R.C. §170(b)(1)(G)(i). Any amount that is disallowed due to the limitation can be carried forward for five years. In addition, for taxpayers that have contributions of both cash and capital gain property in the same tax year, the cash contribution will reduce the amount of deduction for the donated capital gain property.
Example: Tammy has a contribution base of $75,000 for 2018. She donates $10,000 of cash to various I.R.C. §170(b)(1)(A) organizations. The 60 percent limitation would limit her cash contributions for 2018 to $45,000. Tammy also donated her 1969 John Deere 4020 tractor to an I.R.C. §170(b)(1)(A) organization in 2018. The tractor was valued at $32,500. Her limitation on donated capital gain property for 2018 is $22,500 (30 percent of $75,000). However, the $22,500 is reduced by her $10,000 cash contribution. Thus, her limit in 2018 for capital gain donations (30 percent property) is $12,500. Tammy will be able to deduct $12.500 of the tractor’s value in 2018 and carry forward the balance of the donated value ($20,000).
The increase from 50 percent to 60 percent on the AGI maximum deduction amount is certainly good news for taxpayers with charitable inclinations. In addition, the TCJA eliminates the “Pease limitation” (I.R.C. §68) through 2025. That rule phased-out itemized deductions at particular income levels. These two TCJA changes could, by themselves, trigger a significant increase in charitable giving – particularly by higher income taxpayers. However, the TCJA made other changes that could have an offsetting effect.
Other TCJA Changes That Could Impact Giving
The TCJA significantly increases the standard deduction – to $12,000 for single filers and $24,000 for married filing jointly taxpayers. Also, many expenses that were deductible for tax years beginning before 2018 are either non-deductible or are limited. For example, the deduction for state and local taxes associated with non-business property is limited to $10,000. The increase in the standard deduction coupled with the elimination/limitation of various deductions will have an impact on giving, particularly by taxpayers that make relatively smaller gifts. That’s because the TCJA has made it more difficult for Schedule A deductions to exceed the standard deduction. More taxpayers are likely to simply claim the standard deduction rather than file Schedule A. Without filing Schedule A to itemize deductions, there is no deduction for charitable gifts.
Normally, a tax deduction cannot be taken for a donation to a qualified charity when there is a quid pro quo. However, for tax years beginning before 2018, a taxpayer could deduct 80 percent of charitable contributions made to an institution of higher learning for the right to buy tickets or seating at an athletic event. However, the TCJA changed this rule. For tax years beginning after 2017, the 80 percent rule is eliminated.
The TCJA also increased the federal unified credit for estate and gift tax purposes such that, beginning in 2018, federal estate tax doesn’t apply until a decedent’s taxable estate value exceeds $11.18 million. That’s practically twice the amount that it was for 2017. It’s likely that this significant increase will dampen charitable bequests. Presently, about 8 percent of charitable giving derives from bequests.
Will these changes be enough to cause taxpayers to curb charitable giving? To the extent a taxpayer donates to charity based on getting a tax break, that could be the case to the extent the TCJA changes reduce the deduction associated with charitable gifts. Many charities are concerned. Historically, taxpayers that itemize deductions are more likely to give to charity than are non-itemizers. Similarly, non-itemizers make up a relatively small percentage of total charitable giving. One estimate is that, for tax years beginning after 2017, less than five percent of taxpayers will itemize by filing Schedule A. The Indiana University School of Philanthropy and Independent Sector has estimated that the TCJA changes will reduce overall charitable giving by 1.7 percent to 4.6 percent. Those percentages convert to an annual reduction in giving between $4.9 billion and $13.1 billion.
Are there options to plan around the TCJA impacts on charitable giving? There might be, at least for some taxpayers. One approach is for a taxpayer to aggregate charitable gifts – make them in one year but not the following year, etc., so that there is a larger amount gifted in any particular year. This technique is designed to get the level of itemized deductions to an amount that is greater than the standard deduction for the years of the gifts.
If “gift stacking” won’t work for a taxpayer, other techniques may include gifting to private foundations, using charitable trusts or a donor advised fund. A donor advised fund allows a donor to make a charitable contribution, get an immediate tax deduction and then recommend grants from the fund to qualified charities. Of course, these various donation vehicles come with their own limitations on deductions and how they can operate. Likewise, there is no “one size fits all” when it comes to putting together a charitable giving plan. Some techniques just simply won’t work unless large gifts are made.
The TCJA made significant changes to the rules surrounding charitable giving. For many taxpayers, planning steps need to be taken to alter existing approaches to account for the new rules. Make sure to get good tax advice for your own situation. Also, when it comes to charitable giving, make sure to keep good records to substantiate your gifts. The IRS looks at the substantiation issue very closely.
Friday, July 6, 2018
Owner-lessors and operator-lessees of oil and gas interests can claim depletion associated with the production of oil and gas. Although conceptually similar to depreciation, the depletion deduction differs in significant ways from depreciation. The depletion deduction is based on the depletion of the mineral resource, whereas depreciation is based on the exhaustion of an asset that is used in the taxpayer’s trade or business.
The depletion deduction associated with oil and gas interests – that’s the topic of today’s post.
Requirements for the Deduction
To claim a depletion deduction, the taxpayer must have an economic interest in the mineral property, and the legal right to the income from the oil and gas extraction. Treas Reg. §1.611-1(b). If these two requirements are met, the deduction is allowed upon the sale of the oil and gas when income is reported. For the owner-lessor, the deduction can offset royalty payments but not bonus lease payments (because the deduction is allowed only when oil or gas is actually sold and income is reportable). For the operator-lessee, the depletable cost is the total amount paid to the lessor (the lease bonus) and other costs that are not currently deducted such as exploration and development costs as well as intangible drilling costs.
Conceptually, the taxpayer is entitled to a deduction against the revenue received as the income tax basis in the mineral property is depleted. For the owner-lessor, a cost basis in the minerals must have been established at the time basis in the taxpayer’s property (surface and mineral estate) was established. This may have occurred as part of an estate tax valuation in which the minerals and surface were separately valued or upon allocation of the purchase price at the time of acquisition. For the operator- lessee, the operator’s historical investment cost is the key.
When a lease of minerals is involved, the depletion deduction must be equitably apportioned between the lessor and the lessee. IRC §611(b). If a life estate is involved (the property is held by one person for life with the remainder to another person), the deduction is allowed to the life tenant but not the remainderman. For property held in a trust, the deduction is apportioned between the income beneficiaries and the trustee in accordance with the terms of the trust. If the trust instrument does not contain such provisions, the deduction is apportioned on the basis of the trust income allocable to each. For a decedent’s estate, the deduction is apportioned between the estate and the heirs on the basis of the estate income allocable to each.
There are two methods available for computing the depletion deduction: the cost depletion method and the percentage depletion method. A comparison should be made of the two methods and the one that provides the greater deduction should be used.
Cost depletion. For the owner-lessor, the cost depletion method is a units-of-production approach that is associated with the owner’s basis in the property. Cost depletion, like depreciation, cannot exceed the taxpayer’s basis in the property. The basis includes the value of the land and any associated capital assets (e.g., timber, equipment, buildings, and oil and gas reserves). See I.R.C. §612. Basis also includes any other expenses that were incurred in acquiring the land (e.g., attorney fees, surveys, etc.). Basis is tied to the manner in which a property is acquired. For example, mineral property can be acquired via purchase (purchase price basis), inheritance (basis equals the property’s FMV at the time of the decedent’s death) or gift (carryover basis from the donor). Basis is allocated among the various capital assets and is determined after accounting for the following items:
- Amounts recovered through depreciation deductions, deferred expenses, and deductions other than depletions;
- The residual value of land and improvements at the end of operations; and
- The cost or value of land acquired for purposes other than mineral production
Under the cost depletion approach, the taxpayer must know the total recoverable mineral units in the property’s natural deposit and the number of mineral units sold during the tax year. The total recoverable units is the sum of the number of mineral units remaining at the end of the year plus the number of mineral units sold during the tax year. The landowner must estimate or determine the recoverable units of mineral product using the current industry method and the most accurate and reliable information available. A safe harbor can be elected to determine the recoverable units. Rev. Proc. 2004-19, 2004-10 IRB 563. The mechanics of the computation are contained in Treas. Reg. §1.611-2.
The number of mineral units sold during the tax year depends on the accounting method that the taxpayer uses (i.e., cash or accrual). Many taxpayers, particularly landowners, are likely to be on the cash method. Thus, for these taxpayers, the units sold during the year are the units for which payment was received. Under the cost depletion approach, an estimated cost per unit of the mineral resource is computed annually by dividing the unrecoverable depletable cost at the end of the year by the estimated remaining recoverable units at the beginning of the year. The cost per unit is then multiplied by the number of units sold during the year.
Let’s look at an example:
Billie Jo’s father died in 2014. His will devised a 640-acre tract of land to Billie Jo. The value of the tract as reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, for estate tax purposes was $6.4 million. Of that amount, $1 million was allocated to the mineral rights in the tract.
In 2018, a well drilled on the property produced 300,000 barrels of oil. Geological and engineering studies determined that the deposit contained 2 million barrels of usable crude oil. In 2018, the 300,000 barrels produced were sold. Billie Jo’s cost depletion deduction for 2018 is $150,000 and is calculated as follows.
Unrecoverable depletable cost at the end of the year × Number of units Estimated remaining recoverable units at the beginning of the year sold during the year
$1,000,000 /$2,000,000 × 300,000 = $150,000
Billie Jo deducts the $150,000 on her 2018 Schedule E. Billie Jo’s adjusted basis in the mineral deposit for 2019 that is eligible for cost depletion is $850,000 ($1 million − $150,000).
Also, consider this example:
Acme Drilling Corporation paid Bubba $300,000 to acquire all of the oil rights associated with Bubba’s land. The $300,000 was Acme’s only depletable cost. Geological and engineering studies estimated that the deposit contains 800,000 barrels of usable crude oil.
In 2018, 200,000 barrels of oil were produced and 180,000 were sold. Acme’s cost depletion deduction for 2015 is $67,500 and is calculated as follows.
Unrecoverable depletable cost at the end of the year x Number of units
Estimated remaining recoverable units at the beginning of the year sold during the year
$300,000 /$800,000 × 180,000 = $67,500
Percentage depletion. As noted previously, the amount allowed as a depletion deduction is the
greater of cost or percentage depletion computed for each property (as defined in I.R.C. §614(a) for the tax year. See IRC §§613 and 613A and Treas. Reg. §1.611-1(a).
Landowners without an established cost basis may be able to claim percentage depletion (discussed later). It is common for a landowner to not allocate any part of the property’s basis to the oil and gas reserves. Thus, percentage depletion may be the only depletion method available.
Under the percentage depletion method, the taxpayer (owner-lessor or a producer that is not a retailer or refiner) uses a percentage of gross income from the property, which is limited to the lesser of the following:
- 15% of the gross income from the oil/gas property (for an operator-lessee, this is defined as gross income from the property less expenses attributable to the property other than depletion and the production deduction, but including an allocation of general )
- 65% of the taxable income from all I.R.C. §613A(d).
For percentage depletion purposes, total taxable income is a function of gross income. Gross income from the property includes, among other things, the amount received from the sale of the oil or gas in the immediate vicinity of the well. Treas. Reg. §1.613-3. Gross income does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property. I.R.C. §613A(d)(5).
Any amount not deductible due to the 65% limitation can be carried over to the following year, subject to the same limitation. Any amount carried over is added to the depletion allowance before any limits are applied for the carryover year. I.R.C. §613A and the underlying regulations set forth a detailed multi-step process that is utilized to compute percentage depletion allowed to independent producers and royalty owners.
A production limit also applies. For partnerships, all depletion is computed at the partner level and not by the partnership. Prop. Treas. Reg. §1.613A-3(e). The partnership must allocate the adjusted basis of its oil and gas properties to its partners in accordance with each partner’s interest in capital or income.
Consider the following example:
In 2018, Rusty received $50,000 of royalty income from a well on his farm. His taxable income from all sources in 2018 is $432,000. Of that amount, $300,000 is income from crops and livestock. He has $82,000 of income from other sources.
Rusty computes his percentage depletion deduction by multiplying his $50,000 gross income from the oil/gas property by 15%, which is $7,500. His taxable income from all sources is $432,000, and 65% of that amount is $280,800. Thus, Rusty’s depletion deduction is the lesser of $7,500 or $280,800. Rusty can claim the $7,500 deduction on line 18 (depreciation expense or depletion) of his 2018 Schedule E.
Oil and gas taxation is complex. But, the Code does provide some beneficial rules to offset the cost of production. That’s true for other lines of businesses also. The cost of production associated with business property typically generates a tax write-off. When it comes to oil and gas, the rules may be more difficult. If you have these issues, it will pay to hire tax counsel that is well versed in the tax rules associated with oil and gas.
Monday, July 2, 2018
Over two thousand years ago, the Roman philosopher Cicero coined a phrase for opinions not supported by facts. “Ipse dixit” is Latin for “he said it himself.” It’s an assertion without proof, with the person (or entity) making the assertion claiming that a matter is because the party making the assertion said it is.
In a recent case involving wetlands, the court determined that the U.S. Army Corps of Engineers (Corps) claimed jurisdiction over “wetlands” without any supporting evidence. It was a wetland because the Corps said it was a wetland – an “ipse dixit” determination. The court set the Corps’ determination aside.
This isn’t the first time this has happened. In 1998, the USDA/NRCS did the same thing in a Nebraska case involving ditch maintenance of a hay meadow caught up in the Swampbuster regulations.
“Ipse dixit” determinations involving wetlands – that’s today’s blog post topic.
Farmed Wetlands and Swampbuster
The conservation-compliance provisions of the 1985 Farm Bill introduced the concept of “Swampbuster.” In 1986, the interim rules for Swampbuster were published in the Federal Register and evidenced general compliance with congressional intent and made no mention of “farmed wetland.” However, the final rules published in 1987 introduced the concept of “farmed wetland,” defining a farmed wetland as playa, potholes, and other seasonally flooded wetlands that were manipulated before December 23, 1985, but still exhibited wetland characteristics. Drains affecting these areas can be maintained, but the scope and effect of the original drainage system cannot be exceeded. 7 C.F.R. § 12.33(b). The USDA/NRCS has interpreted this as meaning that farmed wetland can be used as it was before December 23, 1985 (National Food Security Act Manual (NFSAM) § 514.23), and a hydrologic manipulation can be maintained to the same “scope and effect” as before December 23, 1985. Id. § 515.10(a). In particular, the government has interpreted the “scope and effect” regulation such that the depth or scope of drainage ditches, culverts or other drainage devices be preserved at their December 23, 1985, level regardless of the effect any post-December 23, 1985, drainage work actually had on the land involved.
Nebraska case. However, in 1999, the Eighth Circuit Court of Appeals invalidated the government’s interpretation of the “scope and effect” regulation. The court held that a proper interpretation should focus on the status quo of the manipulated wetlands rather than the drainage device utilized in post-December 23, 1985, drainage activities. Barthel v. United States Department of Agriculture, 181 F.3d 934 (8th Cir. 1999).
In Barthel, to determine the original scope and effect of the manipulation, the USDA focused solely on the depth of the ditch that drained the hay meadow at issue. In essence, the USDA interpreted the manipulation to be the ditch. The USDA pointed out that the level of the culvert (that drained the ditch beneath a road) on or before December 23, 1985, was eighteen inches higher than at the time of the litigation. The USDA took the position that the culvert could only be placed at that higher level. At that level, the meadow would not drain and the plaintiff’s land was flooded.
The USDA/NRCS claimed it had the authority to “determine the scope and effect of [the] original manipulation” by selecting “any pre-December 23, 1985, manipulation ‘which can be determined by reliable evidence.’” Thus, if the agency had reliable evidence about the ditch level in 1965, then the Barthels would be stuck with those findings, even if in 1983 (still before the effective date of the Act), more far reaching modifications were made. The appellate court disagreed, noting that it was presented with a factual setting that was cyclical. The court noted that the record showed that the ditch was continually silted-in by natural conditions and animal traffic and must be periodically cleaned out. The court then stated that if it accepted “the government’s argument, the USDA could select a level for the original manipulation, either intentionally or unintentionally, which is at the end of the natural cycle - just before the periodic clean-up. This would essentially redefine the cycle. Thus, in the government’s view, if partial flooding occurred just before the clean-up, the flood level would be the best the Barthels could expect for use of their land. An ipse dixit determination like this would drastically reduce the use of the land and even leave it underwater - reviving a wetland [citation omitted]. This interpretation conflicts with the Act considered as a whole.”
Wetland and the Clean Water Act
In 1993, the COE and EPA adopted new regulations clarifying the application of the permit requirement of §404 of the CWA to land designated as wetland. Section 404 of the CWA makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” (WOTUS) without obtaining a permit from the Secretary of the Army acting through the Corps. The regulations specifically exempt prior converted wetlands from the definition of “navigable waters” for CWA purposes. 58 Fed. Reg. 45,008-48,083 (1993); 33 C.F.R. §328.3(a)(8). Thus, prior converted cropland is not subject to the permit requirements of § 404 of the CWA. Indeed, the Corps stated clearly that the only method for prior converted cropland to return to the Corps’ jurisdiction under the regulation was for the cropland to be “abandoned” – cropland production ceases with the land reverting to a wetland.
In early 2009, the Corps prepared an Issue Paper announcing for the first time that prior converted cropland that is shifted to non-agricultural use becomes subject to regulation by the Corps. See Issue Paper Regarding "Normal Circumstances" (ECF No. 18-22). The paper was the Corps’ response to five pending applications for jurisdictional determinations involving the transformation of prior converted cropland to limestone quarries. The paper concluded that the transformation would be considered an "atypical situation" within the meaning of the Corps’ Wetlands Manual and, thus, subject to regulation. The paper further found that active management, such as continuous pumping to keep out wetland conditions, was not a "normal condition" within the meaning of 33 C.F.R. § 328.3(b). However, no APA notice-and-comment period occurred (as required by the Administrative Procedure Act (APA) – Pub. L. 79-404, 69 Stat. 237, enacted Jun. 11, 1946)) before the Corps issued the memorandum. Even so, the Corps implemented and enforced the rules nationwide. The rules were challenged and in New Hope Power Company, et al. v. United States Army Corps of Engineers, 746 F. Supp.2d 1272 (S.D. Fla. Sept. 2010), the court held that the Corps had improperly extended its jurisdiction over the prior converted croplands that were converted to non-agricultural use and where dry lands were maintained using continuous pumping. Under the Corp’s new rule, wetland determinations were being made based on what a property’s characteristic would be if pumping ceased. The court noted that the rules effectively changed the regulatory definition of prior converted cropland without the new definition being subjected to notice and comment requirements. Accordingly, the court invalidated the Corp’s new rule.
Illinois case. In Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 15-cv-06344, 2017 U.S. Dist. LEXIS 151673 (N.D. Ill. Sept. 19, 2017), the plaintiff was a developer that obtained title to a 100-acre tract on the southeast side of Chicago metro area in 1995. The local town then passed a zoning ordinance allowing development of the property. The tract was divided into three sections - 25 acres were to be developed into 168 townhomes; 61 acres to be developed into 169 single-family homes; and 14 acres in between the other acreages to function as a stormwater detention area. The townhomes and water detention area was to be developed first and then the single-family housing. Construction of the townhomes began in 1996, and the single-family housing development was about to begin when the defendant designated about 13 acres of the undeveloped property as “wetlands” and asserted regulatory jurisdiction under the CWA.
The defendant claimed jurisdiction on the basis that the “wetland” drained via a storm sewer pipe to a creek that was a tributary to a river that was a navigable water of the U.S. The plaintiff administratively appealed the defendant’s jurisdictional determination to the Division Engineer who agreed that the District Engineer failed to properly interpret and apply applicable the U.S. Supreme Court decision in Rapanos v. United States, 547 U.S. 715 (2006), which created a significant nexus test. On reconsideration, the District Engineer issued a second approved jurisdictional determination in 2010 concluding that the tract had a significant nexus to the navigable river. The plaintiff appealed, but the Division Engineer dismissed the appeal as being without merit. In 2011, the plaintiff sought reconsideration of the defendant’s appeal decision because of a 1993 prior converted cropland designation that excluded a part of the 100-acres from CWA jurisdiction. Upon reconsideration, the District Engineer issued a third jurisdictional determination in 2012 affirming its prior determination noting that farming activities had ceased by the fall of 1996 and wetland conditions had returned. The plaintiff appealed on the basis that the “significant nexus” determination was not supported by evidence. The Division Engineer agreed and remanded the matter to the District Engineer for supportive documentation and to follow the defendant’s 2008 administrative guidance. The District Engineer issued a new jurisdictional determination with supportive evidence, including an 11-page document that had previously not been in the administrative record. This determination, issued in 2013, constituted a final agency determination, from which the plaintiff sought judicial review.
In court, the plaintiff claimed that the defendant didn’t follow its own regulations, disregarded the instructions of the Division Engineer, and violated the Administrative Procedures Act (APA) by supplementing the record with the 11-page document. However, the trial court judge (an Obama appointee) noted that existing regulations allowed the Division Engineer, on remand, to instruct the District Engineer to supplement the administrative record on remand and that the limitation on supplementing the administrative record only applied to the Division Engineer. The trial court also determined that the supplemental information did not violate the Division Engineer’s remand order, and that the supplemental information had been properly included in the administrative record and was part of the basis for the 2013 reviewable final agency determination. The trial court also upheld the defendant’s nexus determination because it sufficiently documented a physical, chemical and biological impact of the navigable river. In addition, the trial court determined that the prior converted cropland exemption did not apply because farming activities had been abandoned for at least five years and wetland characteristics returned.
On appeal, in Orchard Hill Building Co. v. United States Army Corps of Engineers, No. 17-3403, 2018 U.S. App. LEXIS 17608 (7th Cir. Jun. 27, 2018), the appellate court three-judge panel in a unanimous opinion (the author of the opinion is a Trump appointee and another judge is also a Trump appointee; the third panel member is a Ford appointee) first noted that the Corps concluded that the tract was a WOTUS based on the 11-page document both “alone and in combination with other wetlands in the area.” However, the appellate court held that this conclusion lacked substantial evidence. Simply stating that wetlands filter out pollutants and that the tract has a “discrete and confined intermittent flow” to a creek that flowed to a WOTUS which gave the tract the ability to pass pollutants along was mere speculation that didn’t support a significant nexus with a navigable water. The appellate court also that the Corps also determined that the development of the tract would result in a floodwater rise of a fraction of one percent. On this point, the court stated, “If the Corps thinks that trivial number significant, it needs to give some explanation as to why.” The appellate court found similarly with respect to the potential increase on downstream nitrogen. The Corps provided no reasoning for its conclusion.
The appellate court also noted that the Corps referenced the National Wetland Inventory for a listing of all of the wetlands in the area that were in proximity to the creek that flowed into a navigable waterway. But, again, the appellate court scolded the Corps for making a bald assertion that the wetlands in the watershed were adjacent to the same tributary without any supporting evidence. The Corps claimed it didn’t have to show or explain how each wetland was adjacent to the creek, but the appellate court stated that constituted jurisdictional overreach. Importantly, the court stated that, “the significant nexus test has limits: the Corps can consider the effects of in-question wetlands only with the effects of lands that are similarly situated. To do as the Corps did on this record – to consider the estimated effects of a wide swath of land that dwarfs the in-question wetlands, without first showing or explaining how the land is in fact similarly situated – is to disregard the test’s limits…. By contrast, the Corps’ similarly-situated finding here, lacking as it does record support or explanation, is little more than administrative ipse dixit.”
Consequently, the appellate court vacated the trial court’s grant of summary judgment to the Corps and remanded with instructions to remand to the Corps for reconsideration of its jurisdiction over the tract.
Two ipse dixit determinations by federal agencies against landowners. In each situation, the appellate court found that the government had abused its discretion. The cases point out that maybe there is some hope that the courts will hold government agencies to the requirement that they must support their determinations with solid proof. They can’t just say that it is so because they say it is.