Friday, August 31, 2018
Economic and financial conditions remain tough in much of agriculture. Bankruptcy filings have seen an increase, and that includes the number of Chapter 12 filings. In a Chapter 12 the debtor must file a reorganization plan under which the debtor proposes a plan for paying off creditors. Plan payments generally must pass through the hands of the bankruptcy trustee. The trustee is compensated out of a portion of the plan payments.
But, what if a debtor proposes to make payments directly to the creditors? Doing so would bypass the trustee, and would also bypass the trustee’s fee. It would also mean that all of the payments made under the bankruptcy plan would go to the creditors instead of some of it syphoned off to pay the trustee.
That’s the focus of today’s post – whether a debtor in reorganization bankruptcy can make direct payments to creditors under the debtor’s reorganization plan.
The Reorganization Plan
A Chapter 12 debtor has an exclusive 90-day period after filing for Chapter 12 bankruptcy to file a plan for reorganization unless the court grants an extension. A court may grant additional time only if circumstances are present for which the debtor should not fairly be held accountable. 11 U.S.C. §1221. See e.g., In re Davis, No. CC-16-1390-KuLTa, 2017 Bankr. LEXIS 2169 (B.A.P. 9th Cir. Aug. 2, 2017). If the court determines that the debtor will be unable to make all payments as required by the plan, the court may require the debtor to modify the plan, convert the case to a Chapter 7, or request the court to dismiss the case. In other words, the plan must be feasible. It must also be proposed in good faith. Good faith can be viewed as practically synonymous the requirement that the plan be feasible. See, e.g., In re Lockard, 234 B.R. 484 (Bankr. W.D. Mo. 1999).
The Bankruptcy Trustee
Duties. A trustee is appointed in every Chapter 12 case. A Chapter 12 trustee’s duties are similar to those under Chapter 13. Specifically, a trustee under Chapter 12, is directed to:
* be accountable for all property received;
* ensure that the debtor performs in accordance with intention;
* object to the allowance of claims which would be improper;
* if advisable, oppose the discharge of the debtor;
* furnish requested information to a party in interest unless the court orders otherwise;
* make a final report;
* for cause and upon request, investigate the financial affairs of the debtor, the
operation of the debtor’s business and the desirability of the continuance of the business;
* participate in hearings concerning the value of property of the bankruptcy estate; and
* ensure that the debtor commences making timely payments required by confirmed plan.
In specifying the duties of trustees, Chapter 12 modifies the duty applicable to trustees under other chapters of the Bankruptcy Code to “investigate the financial affairs of the debtor.” Chapter 12 authorizes an investigative role for trustees, as noted above, “for cause and on request of a party in interest....” Thus, it would appear, in a routine case where there is no fraud, dishonesty, incompetence or gross mismanagement, the debtor should be allowed to reorganize without significant interference from the trustee.
Compensation. The compensation of trustees is not to exceed 10 percent of payments made under the debtor’s plan for the first $450,000 of payments. The fee is then not to exceed three percent of aggregate plan payments above that amount. 28 U.S.C. §586(e)(1). The trustee collects the fee from payments received under the plan. 28 U.S.C. § 586(e)(2). That’s an important point - the fee is based on all payments the debtor makes under the plan to the trustee rather than on amounts the trustee disperses to creditors. See, e.g., Pelofsky v. Wallace, 102 F.3d 350 (8th Cir. 1996).
Except as provided in the plan or in order confirming the plan, it is the trustee that is to make payments to creditors under the plan. Courts have generally recognized that payments on fully secured claims that the bankruptcy plan does not modify can be paid directly to the creditor, as can claims not impaired by the plan. However, for claims that are impaired, courts are divided as to whether a court may approve direct payments to creditors.
The issue of who actually disburses the debtor’s payments is important to the trustee because, as noted above, the trustee is entitled to a statutory commission only on funds actually received from the debtor pursuant to the reorganization plan. But, the bankruptcy code does not prevent a debtor from making payments directly to creditors.
So, how does a court decide whether a debtor can make payments directly to creditors and bypass the trustee (and the trustee fee)? Historically, the courts have utilized three approaches for deciding whether a debtor can make direct payment under a Chapter 12 reorganization plan (and thereby bypass the trustee fee). One approach utilizes a blanket rule barring the direct payment of impaired secured creditors. See, e.g., In re Fulkrod, 973 F.2d 801 (9th Cir. 1992). Another approach is, essentially, the direct opposite. Under this approach, debtors can pay secured creditors directly, regardless of their impaired status. See, e.g., In re Wagner, 36 F.3d 723 (8th Cir. 1994). But, the majority approach is to weigh a number of factors in the balance on a case-by-case basis to determine whether direct payments can be made. See, e.g., In re Beard, 45 F.3d 113 (6th Cir. 1995)
The issue came up again in a recent case.
In In re Speir, No. 16-11947-JDW, 2018 Bankr. LEXIS 2359 (Bankr. N.D. Miss. Aug. 8, 2018), the debtor filed Chapter 12 in mid-2016 and a reorganization plan later that year. The plan called for direct payments to the secured creditors but payments to the unsecured creditors would be made to the trustee for distribution. The trustee objected, but the court upheld the direct payments except as applied to one secured creditor based on the application of a 13-factor test. Those factors are:
- The debtor’s past history;
- The debtor’s business acumen;
- Whether the debtor has complied post-filing statutory and court-imposed duties;
- Whether the debtor is acting in good-faith;
- The debtor’s ability to achieve meaningful reorganization absent direct payments;
- How the reorganization plan treats each creditor to which a direct payment is proposed to be made;
- The consent, or non-consent, of the affected creditor to the proposed plan treatment;
- How sophisticated a creditor is, and whether the creditor has the ability and incentive, to monitor compliance;
- The ability of the trustee and the court to monitor future direct payments;
- The potential burden on the trustee;
- The possible effect on the trustee’s salary or funding of the U.S. Trustee system;
- The potential for abuse of the bankruptcy system; and
- The existence of other unique or special circumstances
In balancing the factors, the In re Speir court noted that each factor may be considered, but it is not necessary that equal weight be given to each factor or even to different claims in the same case. Ultimately, what the analysis came down to in In re Speir was a weighing of the necessary compensation for the Trustee against a feasible plan for the debtor. The court noted that the debtor had used the bankruptcy process to substantially modify one secured creditor’s claim and, as a result, had to pay that creditor’s claim through the Trustee. The other secured creditors, the court noted, remained mostly unaffected by the debtor’s bankruptcy and could be paid directly.
While times remain tough in agriculture for some ag producers, Chapter 12 bankruptcy was created specifically to assist farm debtors in distress. The ability to pay creditors directly and bypass the Trustee (and the Trustee’s fee) might be possible. For those in Chapter 12, the issue should be evaluated.
Wednesday, August 29, 2018
In late 2016, I blogged on the issue of what ag employers need to do to verify employment and provided a survey of the primary employment laws and their application to agricultural employers. The issue has increased in importance recently, so it’s a good time to brush the dust off that blog post and update it.
Verifying the legal status of ag employees – that’s the topic of today’s post.
Ag Employment Data
Most estimates peg the total number of persons working on farms and ranches in the United States at approximately 3 million. Hired farm workers make up approximately one-third of that total. Of that number, about half are full-time workers, and about twenty-five percent are ag service workers that are contract hires. A slight majority of the hires work in crop agriculture with the balance working in the livestock industry. Two states – California and Texas account for more than a third of all farmworkers. According to the USDA data, 59 percent of farm laborers and supervisors are U.S. citizens (compared to 91 percent for all U.S. workers). The data also show that about 70 percent of hired crop farmworkers were born in Mexico.
According to the National Agricultural Worker Survey (NAWS), approximately 48 percent of farmworkers lack work authorization. However, this estimate may be low due to a variety of factors. But, this number is likely low because a worker not in the country legally may not complete the survey or may complete it untruthfully. Due to this, estimates assert that at least 70 percent of the ag workforce is not working in the United States legally. Over 90 percent of the ag immigrant labor comes from Mexico.
This presents a very real problem for ag employers.
In late 2016, the U.S. Citizenship and Immigration Service (USCIS) updated Form I-9 and the related instructions. Beginning on January 22, 2017, the update Form I-9 became mandatory for employers to use when hiring persons.
The Form is used for verifying the identity and employment authorization of individuals hired for employment in the U.S. All U.S. employers must ensure proper completion of Form I-9 for each individual they hire for employment in the U.S., whether the employment involves citizens or noncitizens. While agriculture is often exempt from or treated differently in many situations, that is not the case with respect to Form I-9. There is no exception based on the size of the farming operation or for farming businesses where a majority of the interests are held by related persons.
Form I-9 applies to employment situations. It doesn’t apply to situations where a farmer hires custom work or other work to be done on an independent contractor basis. Whether a situation involves the hiring of an employee or an independent contractor basically comes down to the issue of control over the work. If the farmer controls the means and method of the work, then it’s likely to be an employment situation that will trigger the use of Form I-9.
Completing the form. Both employees and employers (or an employer’s authorized representative) must complete the form within three days of the hire. On the form, an employee must attest to their employment authorization. The employee must also present his or her employer with acceptable documents evidencing identity and employment authorization. The employer must examine the employment eligibility and all identity documents an employee presents to determine whether the documents reasonably appear to be genuine and relate to the employee. The employer must also record the document information on the Form I-9. The list of acceptable documents can be found on page three of Form I-9. Employers must retain Form I-9 for a designated period and make it available for inspection by authorized government officers.
The form itself is comprised of three sections.
- Section 1 is for the reporting of employee information and attesting to that information. The employee has to attest that they are a citizen, a noncitizen national of the U.S., a lawful permanent resident or an alien that is authorized to work until the time specified in the document. If the employee is an alien that is authorized to work, they must provide their alien registration number/USCIS number or their Form I-94 admission number, or their foreign passport number and list the country of issuance. The employee must sign the form and date it. Likewise, the employer must also sign and date the form and provide their address. The employee selects the appropriate Citizenship/Immigration status in this section. Also, the new Form I-9 contains a box where the employee indicates if they did not use a translator or preparer in completing Section 1.
- Section 2 is a certification of the employer’s review and verification of the documents of the new hire. On the new form, there is a “Citizenship/Immigration Status” field where the employer is to select (or write) the number that corresponds with the Citizenship/Immigration status that the employee selected in Section 1.
- Section 3 pertains to reverifications and rehires. This section lists the acceptable documents that employees can select from to establish their identity and their employment authorization.
The form is to be completed in English, unless it involves and employer and employees that are in Puerto Rico.
Filing the form. The I-9 doesn’t get filed with any government agency. It doesn’t get filed with the USCIS or the U.S. Immigration and Customs Enforcement (ICE). Instead the employer simply keeps the completed Form I-9 on file for each person on their payroll who is required to complete the form. An employer has to retain Form I-9 for three years after the date of hire or for one year after employment is terminated, whichever is later. It must also be made available for inspection by authorized U.S. Government officials from the Department of Homeland Security, Department of Labor, or Department of Justice.
The form can be completed via computer, but it is not an electronic Form I-9 that is subject to the electronic Form I-9 storage regulations. Instead, Form I-9 is to be printed, signed and stored as a hard copy. If it is completed on a computer, the new form has new drop-down screens, field checks and instructions that are easily accessible.
Penalties. In 2016, the U.S. Department of Justice increased the penalties that can be imposed on employers that hire illegal immigrants. The minimum penalty for a first offense is now $539 (up from $375) and the maximum penalty is $4,313 (up from $3,200). These new amounts are effective August 1, 2016. The minimum penalty for failing to comply with the Form I-9 employment verification requirements is $216 for each form (first offense) and the maximum penalty is $2,156 per form. There are also other penalties that can apply, and the failure to complete the Form I-9 paperwork properly and completely can lead to multiple fines getting stacked together. For example, in 2015, an employer was ordered to pay a fine of over $600,000 for more than 800 Form I-9 violations. The fines were primarily the result of the failure of the employer to sign Section 2 of Form I-9. That’s the section, as noted above, where the employer certifies within three days of a hire that the employer has reviewed the verification and employment authorization documents of a new hire. The penalties arose from the hire of union employees who worked for the employer on a project-by-project basis during the term of a collective bargaining agreement. The workers were not terminated when they completed a project and remained “on-call.” The employer didn’t complete a separate Form I-9 apart from what the union provided and didn’t sign Section 2 of the union form.
Mistakes. So, with the possibility for penalties for improper completion of Form I-9, what are the biggest potential areas of pitfalls? Some basic ones come to mind – incorrect dates, missing signatures, transposed numbers and not checking boxes properly. Also, the correct document codes have to be recorded for each identification method. An employer should also make sure to ask for only those documents that are necessary to identify the employee. Not too many or too few. Requesting too many can lead to a charge of discrimination; too few can trigger a violation for an incomplete form.
Other mistakes can include failure to comply with the three-day rule, failure to re-verify and get updated documents from employees. Also, it is a good idea to get rid of outdated forms. Any outdated forms that exist can lead to penalties if discovered in an audit.
E-Verify is a web-based system operated by the Department of Homeland Security (DHS). The system allows an employer to confirm the eligibility of an employee to work in the United States. E-Verify involves an electronic match of identity and employment eligibility of new hires. The system matches the Form I-9 information against the records of the Social Security Administration and the Department of Homeland Security.
The E-Verify system is not mandatory (except for federal contractors, vendors and agencies). However, employers use it to make sure that a new hire is in compliance with federal law. It is a no-charge system. More than 600,000 employers used the E-Verify system in 2016.
States can mandate the use of E-Verify. While federal law generally pre-empts most state authority on immigration, it does not do so with respect to licensing and similar laws. Indeed, a challenge to the Arizona law requiring a business to use E-Verify or lose its state business license upon hiring a worker not in the United States legally failed when the U.S. Supreme Court held that federal law did not pre-empt the Arizona law. United States Chamber of Commerce v. Whiting, 563 U.S. 582 (U.S. 2011). Iowa, for example, has made numerous attempts to pass legislation requiring employers to utilize the E-Verify system with no success. The Iowa legislation, most recently S.F. 412 introduced during the 2018 legislative session, was modeled after the Arizona legislation.
The proper documentation of employees is critically important. There are indications that the federal government is now looking more closely at employer hiring practices. That makes compliance with Form I-9 requirements even more important. In addition, it makes sense for an ag employer to utilize the E-Verify system. Failure to do so could result in really bad consequences for the business.
Monday, August 27, 2018
The Tax Cuts and Jobs Act (TCJA) created a new deduction for tax years 2018-2025 of up to 20 percent of domestic qualified business income (QBI) from a pass-through entity (e.g., partnership, S corporation or sole proprietorship). Similarly, the deduction is allowed for specified agricultural or horticultural cooperatives. In earlier posts, beginning back in December of 2017, I started detailing various aspects of the new QBI deduction (QBID).
The QBID incorporates a limitation based on wages paid, or on wages plus a capital element. The limitation is phased-in for taxpayers with taxable income above a threshold amount - $157,500 for single filers; $315,000 for all other filing statuses.
For those taxpayers above the applicable income threshold, the definition of “wages” is important. Does it include commodity wages? What about wages parents pay to their children that are under age 18? Do those count for purposes of the limitation?
The definition of “wages” for purposes of the QBID. That’s the focus of today’s post.
The Pertinent Formula
For taxpayers with taxable income exceeding $157,500 (single) or $315,000 (joint), the QBID for a business is (in general) the lesser of 20 percent of the taxpayer’s qualified business income amount (QBIA) from the trade or business, or a “W-2 wages/qualified property limit” (W-2/QP limit). The W-2/QP limit is the greater of 50 percent of the W-2 wages of the trade or business; or the sum of 25% of the W-2 wages of the trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property of the trade or business. I.R.C. §199A(b)(2). So, by the way the formula works, having W-2 wages and/or qualified property can enhance the ultimate QBID that the taxpayer can claim. That is, for those taxpayers over the applicable threshold. For these taxpayers, the QBID is further reduced through a “phase-in” range of the formula. Taxpayers with taxable income beneath the applicable threshold are not subject to the formula. I.R.C. §§199A(b)(3)(A) and (e)(2)(A).
Under the statute, W-2 wages are wages that the taxpayer’s qualified trade or business paid to its employees during the calendar year that ends in the business’s tax year. I.R.C. §199A(b)(4)(A). This Code section references I.R.C. §6051(a)(3) and I.R.C. §6051(a)(8) for the definition of W-2 wages. It is the I.R.C. §6051(a)(3) definition that is pertinent to our discussion, as I.R.C. §6051(a)(8) concerns elective deferrals and other types of deferred compensation.
In particular, I.R.C. §6051(a)(3) specifies that total wages are defined in I.R.C. §3401(a). That definition generally excludes wages paid for agricultural labor, unless it is wages (as defined in I.R.C. §3121(a)) paid for agricultural labor (as that term is defined in I.R.C. §3121(g)). Under the I.R.C. §3121(a) definition of “wages,” agricultural wages paid in-kind are disqualified (I.R.C. §3121(a)(8)(A)), as are cash wages paid to an employee for agricultural labor unless the employee pays at least $150 in cash wages to the employee for the year and the employer’s expenditures for agricultural labor for the year equal or exceed $2,500. I.R.C. §3121(a)(8)(B)(i)-(ii). Wages paid to children under age 18 by their parents are not specified as an exception in I.R.C. §3401(a). However, under IRC §3401(a)(2), commodity (“in-kind”) wages are not included because they are not “wages” under I.R.C. §3121(a)(8)(A). They are specifically excluded from the definition of “wages.”
The bottom line is that wages paid to children under age 18 by their parents count as wages for QBI purposes, but agricultural wages paid in-kind do not. In addition, the wages must be paid for amounts that are properly allocable to producing QBI.
Additionally, under I.R.C. §199A(b)(4)(C) the term “W-2 wages” does not include any amount that is not properly included in a return filed with Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for such return. Thus, wages, whether they are “required” in a technical sense to be reported, must be reported to count as “W-2 wages” for purposes of I.R.C. §199A. Wages paid to children under age 18 in the employ of their parents are subject to withholding, but are often exempt because the amount is less than the standard deduction. Reporting such wages to SSA on a timely filed return will cause them to count as “W-2 wages” for QBID purposes.
The QBID is a complex provision, for sole proprietors and other business owners that operate in a business form that is something other than a C corporation. That’s especially true for taxpayers with income over the applicable threshold. While ag wages paid in-kind don’t count as “W-2 wages” for purposes of the QBID formula for higher income taxpayers, wages paid to children under age 18 by their parents do count. That can generate a larger QBID for those taxpayers that are subject to the wages/qualified property limitation.
Thursday, August 23, 2018
If you are looking for additional training on the new tax law (Tax Cuts and Jobs Act (TCJA)) and, in addition, how the TCJA applies to your farming or ranching operation, there are several opportunities for you that I am participating in that are open to the public. In addition, I continue to do in-house CPA/law firm training on the new law. If your firm has an interest in some in-house training, please contact me.
Today’s post contains a listing of those seminars coming up over the next couple of months.
For those of you in the western South Dakota area, eastern Wyoming, northwest Nebraska and Montana, I have the following events coming up. Tomorrow afternoon (Aug. 24), I will be making an hour-long presentation on how the new tax law applies to agricultural producers in Rapid City, SD. That event is open to the public. If you are in the area, stop in for a brief discussion of the new law. You can learn more about the event here: https://www.r-calfusa.com/event/annual-convention/.
On September 17-19, I will be conducting tax seminars for the North Dakota Society of CPAs in Grand Forks and Bismarck. The September 17 and 18 events will be in Grand Forks, and the second day there will be a day devoted to farm and ranch estate and business planning. For more information on the North Dakota events, you can find it here: https://www.ndcpas.org/courses.
Later in September I will be presenting a two-day seminar in Great Falls, Montana for the Montana Society of CPAs with my co-speaker, Paul Neiffer. The first day on September 26 will be devoted to farm income tax issues and day 2 on September 27 will focus on Farm Estate and Business Planning. For more information, click here: https://www.mscpa.org/professional_development/course/2518/farm_ranch_income_tax_estate_business_planning.
Illinois, Iowa and Indiana
If you are in eastern Iowa or western Illinois, on September 21, I will be presenting a farm tax seminar in Rock Island, Illinois, with Bob Rhea of the Illinois Farm Business Management Association. Details about that seminar can be found here: https://taxschool.illinois.edu/merch/2018farm.html. We will repeat that seminar on September 24 in Champaign, Illinois. So, if you are in central, southern or eastern Illinois or western Indiana, this seminar is in your area. Again, details on the Champaign event can be found here: https://taxschool.illinois.edu/merch/2018farm.html.
On October 12, I will be making a presentation on estate planning issues that are unique to farmers and ranchers at the 44th Annual Notre Dame Tax and Estate Planning Institute in South Bend, Indiana. Information about the Institute can be found here: https://law.nd.edu/for-alumni/alumni-resources/tax-and-estate-planning-institute/.
Fall Tax Schools – South Dakota/Northwest Iowa Event
In the near future, I will do a post on the fall tax schools that I conduct in various states. One new one this year will be in Sioux Falls, South Dakota on November 8 and 9. That event is sponsored by the American Society of Tax Professionals and will be held at the Ramada Inn & Suites. For information on that event call 1-877-674-1996. The seminar will be a two-day school taught by myself and Paul Neiffer. We will be teaching from the tax workbook produced by the University of Illinois that many of you may be familiar with. For those of you in northwest Iowa, northeast Nebraska, eastern SD and southwestern MN, these two days are for you.
The events mentioned above are the major events coming up over the next couple of months. I haven’t listed the in-house private seminars that I have scheduled in September and October. I have room for a couple more of those if your firm is interested. Also, most of my speaking events are listed on my website, www.washburnlaw.edu/waltr.
I hope to see you at one or more of the events this fall.
Tuesday, August 21, 2018
The Migratory Bird Treaty Act (MBTA) protects migratory birds that are not necessarily endangered and, thereby, protected under the ESA. 16 U.S.C. § 703 et seq. The MBTA makes it unlawful at any time, by any means or in any manner, to pursue, hunt, take, capture or kill any migratory bird. The Act is not limited to covering only hunting, trapping and poaching activities, but extends to commercial activities that kill migratory birds.
But, can a farmer get caught in the web that the MBTA weaves? Potential application of the MBTA to farming activities – that’s the topic of today’s post.
The Act prohibits taking or killing of migratory birds at any time, by any means or in any manner. See, e.g., Unitied States v. Citgo Petroleum Corp., et al., No. C-06-563, 2012 U.S. Dist. LEXIS 125996 (S.D. Tex. Sept. 5, 2012). Violation of the Act is a misdemeanor punishable by fine up to $500 and imprisonment up to six months. Anyone who knowingly takes a migratory bird and intends to, offers to, or actually sells or barters a migratory bird is guilty of a felony, with fines up to $2,000, jail up to two years, or both.
The MBTA is a strict liability statute, and has been applied to impose liability on farmers who inadvertently poison migratory birds by use of pesticides. While the MBTA is a strict liability statute, constitutional due process requirements must still be satisfied before liability can be imposed. For instance, in United States v. Apollo Energies, Inc., et al., 611 F.3d 679 (10th Cir. 2010), the court held that oil drilling operators were not liable for deaths of migratory birds under the MBTA to the extent that the operators did not have adequate notice or a reasonable belief that their conduct violated the MBTA. Similarly, in United States v. Rollins, 706 F. Supp. 742 (D.C. Idaho 1989), a farmer was prosecuted for violating the MBTA when he used a mixture of granular pesticides on an alfalfa field. The chemicals poisoned a flock of geese and killed several of them. The trial court held that even though the farmer had not applied the pesticide in a negligent manner and could not control the fact that the geese would land and eat the granules, liability under the Act was based on whether the farmer knew that the land was a known feeding area for geese. The trial court concluded that “a reasonable person would have been placed on notice that alfalfa grown on Westlake Island in the Snake River would attract and be consumed by migratory birds.” The trial court was reversed on appeal on the grounds that the MBTA was too vague to give the farmer adequate notice that his conduct would likely lead to the killing of the protected birds since the farmer's past experience with the pesticide and the geese was that it did not kill them
Again, in United States v. Van Fossan 899 F.2d 636 (7th Cir. 1990), the court confirmed the notion that the MBTA is a strict liability statute and approved its application to a defendant who used pesticides to poison birds, even though the defendant did not know that his use of the pesticide would kill migratory birds protected under the Act.
The MBTA also prohibits the taking of migratory game birds by the aid of “baiting”. However, it is permissible to take migratory game birds, including waterfowl, on or over standing crops, flooded harvested croplands, grain crops that have been properly shocked on the field where grown, or grains found scattered solely as the result of normal agricultural planting or harvesting. See 50 C.F.R. §§ 20.11(g), 20.21(i). The U.S. Fish and Wildlife Service (FWS) has promulgated regulations defining “normal agricultural planting” and “harvesting.” In one case, the court held that FWS determinations that harvesting corn after December 1 and aerial seeding of winter wheat in standing corn were not “normal planting” and that the landowners were barred from hunting next to neighbors’ baited fields were reasonable interpretation of MBTA because the determinations were based on substantial evidence. Falk v. United States Fish and Wildlife Service, 452 F.3d 951 (8th Cir. 2006).
Some states also have statutes that prohibit the baiting of wildlife for hunting purposes unless the alleged baiting was the result of commonly accepted agricultural practices. For example, in State v. Hansen, 805 N.W.2d 915 (Minn. Ct. App. 2011), the defendant’s conviction for using bait to hunt deer was reversed. The state statute at issue was deemed to violate the defendant’s due process as it was vague as applied to defendant’s pumpkin patch operation because it did not distinguish between normally accepted agricultural practices and the unlawful baiting of deer.
Also, with respect to the baiting issue, the MBTA permits the taking of all migratory game birds, except waterfowl, on or over any lands where shelled, shucked, or unshucked corn, wheat or other grain, salt, or other feed has been distributed or scattered as the result of bona fide agricultural operations or procedures. In United States v. Adams 174 F.3d 571(5th Cir. 1999), a farmer was convicted of violating the MBTA for hunting doves on a field that he had recently planted to wheat. For purposes of the “baiting” provision of the Act, the trial court judge determined that intent was not an element of the offense for which the farmer was convicted and did not allow the farmer to introduce evidence concerning the procedures commonly used to plant winter wheat in northeast Louisiana. On appeal, the Fifth Circuit Court of Appeals reversed the trial court, holding instead that the government was required to prove that the farmer’s intentions were not in good faith and that the farmer’s acts were merely a sham to attract migratory birds to hunt. Accordingly, the court reversed the farmer’s conviction and rendered acquittal based on the court’s determination that the farmer was entitled to have the lower court consider the evidence of his good faith in growing the wheat, and because there was no evidence from which a jury could find that the farmer’s planting was not the result of a “bona fide agricultural operation or procedure.”
Another MBTA “baiting” case was recently decided. In United States v. Obendorf, No. 16-30188, 2018 U.S. App. LEXIS 18561 (9th Cir. Jul. 9, 2018), the defendant was charged with illegally baiting and conspiracy to bait ducks, under the MBTA. FWS agents patrolled the area near the defendant’s farm by plane, and aerially spotted large piles of corn near hunting blinds. They also noticed irregular harvesting in one field on the farm. Along with an Idaho Department of Fish and Game Agent, the FWS “snuck” on to the farm that night. The agents observed six piles of corn and a strip combined field (partly cut field, leaving strips of standing corn) as well as a lot of corn wasted on the ground around the strip. The agents left trail/game cameras hidden on the property. Two years after the initial investigation, the defendant was charged. At trial, the defendant argued that the “agricultural practice” exception of the MBTA applied. That exception states that taking birds over specified areas, including “standing crops or flooded crops,” is not baiting. The trial court jury was instructed that the government had the duty to prove that the exception did not apply in the case at hand as well as proving the defendant’s guilt. The plaintiff presented witnesses that testified that strip cropping and other farming activities by the defendant were not recommended farming practices. The jury was persuaded that the exception did not apply and, the defendant was convicted of baiting under the MBTA. On appeal the defendant claimed that the court misinterpreted the exception. The plaintiff, however, claimed that the exception only applied to “taking” and not baiting. The appellate court agreed and upheld the defendant’s conviction.
The MBTA is another federal law that can entangle farmers in its provisions. While some conduct is clearly beyond the pale and should be within the MBTA’s reach, other conduct that is otherwise innocent may also be caught. In any event, it is important for farmers to understand the potential reach of the law and how the courts have decided the key cases.
Friday, August 17, 2018
An important concern for many farm and ranch families is how to keep the business in the family and operating as a viable economic enterprise into subsequent generations. Of course, economics and family relationships are very important to accomplishing this objective. So are various types of planning vehicles.
One of those vehicles that can work for some families is an intentionally defective grantor trust (IDGT). It allows the creator of the trust (grantor) to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period. The “freeze” is achieved by capitalizing on the mismatch between interest rates used to value transfers and the actual anticipated performance of the transferred asset.
The use of an IDGT as part of a plan to transfer business assets from one generation to the next – that’s the topic of today’s post.
IDGT - Defined
An IDGT is a specially type of irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death. For federal income tax purposes, the trust is designed as a grantor trust (as far as the grantor is concerned) under I.R.C. §671 for income tax purposes because of the powers the grantor retains. However, those retained powers do not cause the trust assets to be included in the grantor’s estate. The trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.
The trust is “defective” because the seller (grantor) and the trust are treated as the same taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected (e.g., they are effective) for federal estate and gift tax purposes. The “defective” nature of the trust meant that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments (discussed below) are paid to the grantor in-kind and makes the trust an eligible S corporation shareholder. Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A)(i).
The IDGT Transaction
The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note. The grantor makes an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor. Typically, the IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences. That also means, however, that the transfer is a completed gift and the trust will receive a carryover basis in the gifted assets.
The trust language is carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate. This is what makes the IDGT a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death.
Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term. The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments. Given the current low interest rates (but they have been rising), it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).
The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 (Priv. Ltr. Rul. 9535026 (May 31, 29915)) that took the position that I.R.C. §2701 would not apply because a debt instrument is not an “applicable retained interest.” I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an “applicable retained interest” is not a creditor interest in bona fide debt. The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.
If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments.
How It Works
If for example, a multi-dimensional farming operation is valued at $15 million and is transferred to a family limited partnership (FLP), a valuation discount for lack of marketability and/or minority interest might approximate 30 percent.
Note: A few months ago, the Treasury announced that it was not finalizing regulations that would tighten the ability to valuation discounts in such situations. So, a discount of 30-40 percent would be reasonable for such a transfer.
A 30 percent discount on a $15 million transfer would be $4.5 million. So, the transfer to the FLP would be valued at $11.5 million. Then an IDGT could be created and the $11.5 million FLP interest would be sold to the IDGT in exchange for a note with the installment payments to the grantor under the note being established based on the $11.5 million value rather than the $15 million value. This means that, in effect, $4.5 million has been transferred tax-free the transferors’ heirs.
The installment note can be structured in various ways, with the approach chosen generally tied to the cash flow that the assets generate that have been transferred to the IDGT. In addition, the income from the property contained in the IDGT is the grantor’s tax responsibility (with those taxes paid annually from a portion of the installment sale payments from the note), but it’s not a gift for estate and gift tax purposes. That means, then, that additional assets can be shifted to the IDGT which will further reduce the grantor’s taxable estate at death. The heirs benefit and the grantor gets a reduced taxable estate value. That could be a big issue if the current level of the federal estate tax exemption goes back down starting in 2026 (or sooner on account of a political change in philosophy).
When the grantor of the IDGT dies, the only item included in the grantor’s gross estate is the installment note. It is included at its fair market value. That means that the IDGT “froze” the value of the assets as of the sale date with any future appreciation in asset value occurring outside of the decedent’s estate.
Pros and Cons of IDGTs
As noted above, an IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the interest rate on the installment note payable. Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes.
On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death. Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income. In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.
Proper Structuring of the Sale to the IDGT
Thee installment note must constitute bona fide debt. That is the key to the IDGT transaction from an income tax and estate planning or business succession standpoint. If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate. I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it. In the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.
All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note represents bona fide debt.
Administrative Issues with IDGT’s
An IDGT is treated as a separate legal entity. Thus, a separate bank account is opened for the IDGT in order to receive the “seed” gift and annual cash inflows and outflows. An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.
Farmers and ranchers that intend to keep the farming or ranching business in the family for subsequent generations are searching for ways to accomplish that goal. The IDGT is one tool in the planner’s arsenal to accomplish that goal.
Wednesday, August 15, 2018
Earlier this year I did a blog post on some recent developments in crop insurance. Since that time, there have been more very significant developments involving crop insurance. As a result, another post on crop insurance is necessary.
More crop insurance recent developments – that’s the topic of today’s post.
Relying on Agent Representations
Bush v. AgSouth Farm Credit, No. A18A0339 2018, Ga. App. LEXIS 437 (Ga. Ct. App. Jun 27, 2018), the plaintiff owned a 280-acre soybean and wheat farm. The farm had been in his family for many years and operated as a dairy farm. In 2011, the plaintiff began planting wheat and soybean as commodity crops. At this point he took out several loans from the defendant in order to purchase farm machinery and equipment. After he obtained these loans, the defendant recommended that he get crop insurance in case of a weather-related crop loss. The plaintiff had heard about crop insurance and agreed that he needed it, but told the defendant that he knew nothing about crop insurance or anybody who “writes it.”
The defendant put the plaintiff in touch with an insurance agent who had been a licensed crop insurance agent with the defendant since 2000. The insurance agent told the plaintiff she sold crop insurance for “Diversified” (a company contracted with USDA to deliver the federal crop insurance program). At that time, the plaintiff told her where he obtained his grain and that he had never sold crops commercially before 2011, using it only as feed or seed to replant. The insurance agent handled all of the production history calculations, presumably from weight tickets he had provided to her. As a result of their meetings, the insurance agent procured crop insurance from Diversified for the plaintiff’s 2011 soybean crop and his 2012 wheat crop. The plaintiff had a continuous policy for wheat with an actual production history (APH) of 75 bushels per acre, which the insurance agent calculated based upon what the plaintiff told her that he produced for the four years prior to 2012.
The agent did not ask the plaintiff for documents supporting these amounts and explained that he was not required to submit such documentation with his insurance application, but she warned him that if he was ever audited he would have to document what was reported in the insurance application. The application requested 60 percent coverage, and the plaintiff testified that he left it up to the agent to decide the amount, but did not object to it when he signed the application. The plaintiff did not read the insurance application or the production and yield report on which the insurance agent calculated the APH, and he did not ask any questions about either document. For crop year 2012, the plaintiff planted over 600 acres of wheat and conducted his farming operations based on the agent’s representation that the wheat was insured at the coverage level stated in his policy. In July of 2013, he suffered a complete loss of his wheat crop due to excessive moisture.
The plaintiff called the insurance agent to report the loss, and Diversified sent an adjuster to examine the crop and calculate the loss. The plaintiff received approximately $102,986 from Diversified, which he then assigned to the defendant to pay down an existing loan. In July 2014 Diversified performed an audit of the plaintiff’s claim. Shortly thereafter, Diversified notified the plaintiff that a reduction in production and yields for specific units was applied resulting in an overpayment of $102,986 and demanded repayment. The plaintiff filed a complaint against the defendant and the insurance agent on May 9, 2016, alleging that the agent held herself out as a crop insurance expert and that he relied on that expertise and her representations to establish his farming plan. The plaintiff also claimed that the defendant, as the agent’s employer, was vicariously liable for her actions. The defendant moved for summary judgment, arguing that the plaintiff was obligated to read the policy and, if he had, he would have known that documentation was required to support the claimed APH.
The trial court granted the defendant’s motion for summary judgment and the plaintiff appealed. The appellate court determined that a jury could find that the plaintiff, a layperson, could not be expected to read the policy and determine what constituted a written verifiable record. The policy at issue referred to supporting “written verifiable records” and relied upon a reference to a federal regulation to define that term. Thus, the court held that it would not have been readily apparent to the plaintiff, on the face of the policy, that the weight tickets or other information he provided to the agent were not adequate to meet the definition of “written verifiable record.” Thus, the court held that even if the plaintiff had the read the policy from beginning to end, he would not have known that the calculation was not properly done in accordance with federal regulations because calculating the APH was up to the expert agent and governed by the rules set out in the Crop Insurance Handbook. As such, the appellate court held that the trial court erred in granting summary judgment to the defendant.
In Bottoms Farm Partnership v. Perdue, No. 17-2164, 2018 U.S. App. LEXIS 19609 (8th Cir. Jul. 17, 2018), the plaintiffs were entities engaged in rice farming. Their rice crops were insured under federally-reinsured multi-peril crop insurance policies purchased from Rural Crop Insurance Services (RCIS). The insurance policy was provided under the Federal Crop Insurance Act (FCIA), which is administered by the Federal Crop Insurance Corporation (FCIC) and the Risk Management Agency (RMA). After they purchased the insurance and planted the 2012 crop, their rice crops were damaged by excessive rainfall. They filed claims for indemnity with RCIS. RCIS denied the claims on the basis that the crops were not insurable under the policy because levees were not surveyed and constructed immediately after seeding the rice, and levee gates were not immediately installed and butted as required by a special provision in the policy. When their claims were denied, the plaintiffs sought arbitration with RCIS as required by the policy, which stated that: “In addition to the definition of Planted Acreage specified in section 1 of the Crop Provisions, the following must have occurred immediately following seeding. If these activities have not occurred, the acreage will be considered ‘acreage seeded in any other manner’ and will not be insurable: (1) levees are surveyed and constructed; (2) levee gates are installed and butted; and (3) the irrigation pump is operable, ready to be started in the event sufficient rainfall has not been received, and turned on to provide sufficient water for the purposes of germination or elimination of soil crusting.”
The FCIC agreed with RCIS that the Merriam-Webster dictionary defines "immediately" as "without any delay,” which means that the listed activities must occur right after planting has ended, weather permitting, without any delay. The plaintiffs requested a review of the FCIC's interpretation by the RMA, and the RMA affirmed. The National Appeals Division (NAD) concluded that RMA's written interpretation was not appealable and that the plaintiffs had exhausted their administrative remedies.
The trial court upheld the administrative determinations, as did the appellate court. The appellate court noted that the clear language of the FCIA indicated that the Congress intended the FCIC to have extensive and broad authority. Under the FCIA, judicial review is available but limited. Given the FCIA’s broad grant of authority to the FCIC, and the specific authority over the provisions of insurance and insurance contracts, the appellate court concluded that it must give substantial deference to the FCIC's interpretation of the special provision. In addition, the court determined that the FCIC's interpretation of the special provision was consistent with the plain reading of the policy, which indicated that the activities listed must "have occurred immediately following seeding" or the acreage would be considered to be uninsurable. The appellate court also determined that the FCIC's decision that the language provided a condition for insurability and was not subject to an analysis of good farming practices was not plainly erroneous. The appellate court, like the trial court found that the interpretation was not "'arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.
APH Yield Exclusion
Adkins v. Vilsack, No. 1:15-CV-169-C 2017 U.S. Dist. LEXIS 72790 (N. D. Tex. May 12, 2017), aff’d. sub. nom., Adkins v. Silverman, No. 17-10759, 2018 U.S. App. LEXIS 21961 (5th Cir. Aug. 7, 2018) involved a provision in the 2014 Farm Bill - Actual Production History (APH) Yield Exclusion. The APH Yield Exclusion allows eligible producers impacted by severe weather to receive a higher approved yield on their insurance policies through the federal crop insurance program. APH works by allowing a farmer to exclude yields in particularly bad years (e.g., those having a natural disaster or other extreme weather event) from their production history when calculating yields that are used to establish their crop insurance coverage. The level of crop insurance available to a farmer is based on the farmer’s average recent yields. Particularly low yields in a prior year would reduce the level of insurance coverage in future years but for the APH provision. Farmers are eligible for the APH exclusion when the county yield is at least 50 percent below the average of the immediately previous 10 consecutive crop years.
The APH provision was to become effective in the spring of 2015 for spring crops with a November 30, 2014 change date. Eligible crops include corn, soybeans, wheat, cotton, grain sorghum, rice, barley, canola, sunflowers, peanuts and popcorn. However, the USDA later decided to delay the APH Yield Exclusion for wheat for the 2015 crop year for winter wheat. The plaintiff challenged that decision as arbitrary, but the USDA’s National Appeals Division (NAD) upheld the decision. However, in late 2016 a U.S. Magistrate Judge recommended that the court reverse the USDA’s decision to delay implementation of the APH Yield Exclusion (i.e., “yield plug”) for winter wheat. The USDA appealed, but the trial court found that the NAD’s decision was erroneous because it failed to recognize the Farm Bill’s (7 U.S.C. §1508 (g)(4)(A)) effect on implementation for the 2015 winter wheat crop year. The court determined that Congress chose to leave the applicability provision in place thereby making it self-executing and immediate for the APH Yield Exclusion. In addition, the fact that Congress chose to include specific application/implementation language for other crops and yet stay silent as to winter wheat indicates a direct intention to allow the governing and existing statutory law to be applicable as to the implementation of the APH Yield Exclusion for the 2015 winter wheat crop. As a result, the court adopts the findings and conclusions of the Magistrate Judge. The USDA appealed, and the issue on appeal was “whether farmers were permitted to exclude the historical data for the 2015 crop year, even though the FCIC had not completed its data compilation.” The appellate court considered the “plain meaning” of the statute at issue in accordance with the standard set forth in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) and affirmed the trial court's decision.
Crop insurance is an important part of many farmer’s financial “toolbox.” It will likely also play a significant part of the next Farm Bill. But, as illustrated in today’s post (and the one earlier this year), numerous legal issues can arise.
Monday, August 13, 2018
As a result of the Tax Cuts and Jobs Act (TCJA), for tax years beginning after 2017 and before 2026, a non C corporate business owner as well as an owner of an interest in a pass-through entity is entitled to a deduction of 20% of the taxpayer’s share of qualified business income (QBI) associated with the conduct of a trade or business in the United States. I.R.C. 199A. The QBID replaces the DPAD, which applied for tax years beginning after 2004. The TCJA repealed the DPAD for tax years beginning after 2017.
The basic idea behind the provision was to provide a benefit to pass-through businesses and sole proprietorships that can’t take advantage of the lower 21 percent corporate tax rate under the TCJA that took effect for tax years beginning after 2017 (on a permanent basis). The QBID also applies to agricultural/horticultural cooperatives and their patrons.
Last week, the Treasury issued proposed regulations on the QBID except as applied to agricultural/horticultural cooperatives. That guidance is to come later this fall. The proposed regulations did not address how the QBID applies to cooper
The proposed regulations for the QBID – that the topic of today’s post.
The QBI deduction (QBID) is subject to various limitations based on whether the entity is engaged manufacturing, producing, growing or extracting qualified property, or engaged in certain specified services (known as a specified service trade or business (SSSB)), or based on the amount of wages paid or “qualified property” (QP) that the business holds. These limitations apply once the taxpayer’s taxable income exceeds a threshold based on filing status. Once the applicable threshold is exceeded the business must clear a wages threshold or a wages and qualified property threshold.
Note: If the wages or wages/QP threshold isn’t satisfied for such higher-income businesses, the QBID could be diminished or eliminated.
What is the wage or wage/QP hurdle? For farmers and ranchers (and other taxpayers) with taxable income over $315,000 (MFJ) or $157,500 (other filing statuses), the QBID is capped at 50 percent of W-2 wages or 25 percent of W-2 wages associated with the business plus 2.5 percent of the “unadjusted basis immediately after acquisition” (UBIA) of all QP. But those limitations don’t apply if the applicable taxable income threshold is not met. In addition, the QBID is phased out once taxable income reaches $415,000 (MFJ) or $207,500 (all others).
On August 8, the Treasury issued proposed regulations on the QBID. Guidance was needed in many areas. For example, questions existed with respect to the treatment of rents; aggregation of multiple business activities; the impact on trusts; and the definition of a trade or business, among other issues. The proposed regulations answered some questions, left some unanswered and raised other questions.
Rental activities. One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations do confirm that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s the case if the rental is between “commonly controlled” entities – defined as common ownership of 50 percent or more in each entity (e.g., between related parties). This part of the proposed regulations is generous to taxpayers, and will be useful for many rental activities. It’s also aided by the use of I.R.C. §162 for the definition of a “trade or business” as opposed to, for example, the passive loss rules of I.R.C. §469.
But, the proposed regulations may also mean that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation is correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID.
The proposed regulations use an example or a rental of bare land that doesn’t require any cost on the landlord’s part. This seems to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. There is another example in the proposed regulations that also seems to support this conclusion. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. That means it may be crucial to be able to aggregate (group) those activities together.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations creates confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also states that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, does that mean that those separate rental activities can’t be aggregated (discussed below) unless each rental activity is a trade or business? If the Treasury is going to be making the trade or business determination on an entity-by-entity basis, triple net leases might be problematic.
Perhaps the final regulations will clarify whether rentals, regardless of the lease terms, will be treated as a trade or business (and can be aggregated).
Aggregation of activities. Farmers and ranchers often utilize more than a single entity for tax as well as estate and business planning reasons. The common technique is to place land into some form of non C corporate entity (or own it individually) and lease that land to the operating entity. For example, many large farming and ranching operations have been structured to have multiple limited liability companies (LLCs) with each LLC owning different tracts of land. These operations typically have an S corporation or some other type of business entity that owns the operating assets that are used in the farming operation. It appears that these entities can be grouped under the aggregation rule. For QBID purposes (specifically, for purposes of the wages and qualified property limitations) the proposed regulations allow an election to be made to aggregate (group) those separate entities. Thus, the rental income can be combined with the income from the farming/ranching operation for purposes of the QBID computation. Grouping allows wages and QP to also be aggregated and a single computation used for purposes of the QBID (eligibility and amount). In addition, taxpayers can allocate W2 wages to the appropriate entity that employs the employee under common law.
Note: The wages and QP from any trade or business that produces net negative QBI is not taken into account and is not carried over to a later year. The taxpayer has to offset the QBI attributable to each trade or business that produced net positive QBI.
Without aggregation, the taxpayer must compute W-2 wages for each trade or business, even if there is more than one within a single corporation or partnership. That means a taxpayer must find a way to allocate a single payroll across different lines.
To be able to aggregate businesses, they must meet several requirements, but the primary one is that the same person or group of persons must either directly or indirectly own 50 percent or more of each trade or business. For purposes of the 50 percent test, a family attribution rule applies that includes a spouse, children, grandchildren and parents of the taxpayer. However, siblings, uncles, and aunts, etc., are not within the family attribution rule. To illustrate the rule, for example, the parents and a child could own a majority interest in three separate businesses and all three of those businesses could be aggregated. But, the bar on siblings, etc., counting as "family" is a harsh rule for agricultural operations in particular. Perhaps the final regulations will modify the definition of "family."
Note: A ”group of persons” can consist of unrelated persons. It is important that the “group” meet the 50 percent test. It is immaterial that no person in the group meets the 50 percent test individually.
Common ownership is not all that is necessary to be able to group separate trade or business activities. The businesses to be grouped must provide goods or services that are the same or are customarily offered together; there must be significant centralized business elements; and the businesses must operate in coordination with or reliance upon one another. Meeting this three-part test should not be problematic for most farming/ranching operations, but there is enough "wiggle room" in those definitions for the IRS to create potential issues.
Once a taxpayer chooses to aggregate multiple businesses, the businesses must be aggregated for all subsequent tax years and must be consistently reported. The only exception is if there is a change in the facts and circumstances such that the aggregation no longer qualifies under the rules. So, disaggregation is generally not allowed, unless the facts and circumstances changes such that the aggregation rules no longer apply.
Losses. If a taxpayer’s business shows a loss for the tax year, the taxpayer cannot claim a QBID and the loss carries forward to the next tax year where it becomes a separate item of QBI. If the taxpayer has multiple businesses (such as a multiple entity farming operation, for example), the proposed regulations require a loss from one entity (or multiple entities) to be netted against the income from the other entity (or entities). If the taxpayer’s income is over the applicable threshold, the netting works in an interesting way. For example, if a farmer shows positive income on Schedule F and a Schedule C loss, the Schedule C loss will reduce the Schedule F income. The farmer’s QBID will be 20 percent of the resulting Schedule F income limited by the qualified wages, or qualified wages and the QP limitation. Of course, the farmer may be able to aggregate the Schedule F and Schedule C businesses and would want to do so if it would result in a greater QBID.
Note: A QBI loss must be taken and allocated against the other QBI income even if the loss entity is not aggregated. However, wages and QP are not aggregated.
If the taxpayer had a carryover loss from a pre-2018 tax year, that loss is not taken into account when computing income that qualifies for the QBID. This can be a big issue if a taxpayer had a passive loss in a prior year that is suspended. That's another taxpayer unfriendly aspect of the proposed regulations.
Trusts. For trusts and their beneficiaries, the QBID can apply if the $157,500 threshold is not exceeded irrespective of whether the trust pays qualified wages or has QP. But, that threshold appears to apply cumulatively to all trust income, including the trust income that is distributed to trust beneficiaries. In other words, the proposed regulations limit the effectiveness of utilizing trusts by including trust distributions in the trust’s taxable income for the year for purposes of the $157,500 limitation. Prop. Treas. Reg. §1.199A-6(d)(3)(iii). This is another taxpayer unfriendly aspect of the proposed regulations.
Based on the Treasury's position, it will likely be more beneficial for parents, for example, for estate planning purposes, to create multiple trusts for their children rather than a single trust that names each of them as beneficiaries. The separate trusts will be separately taxed. The use of trusts can be of particular use when the parents can't utilize the QBID due to the income limitation (in other words, their income exceeds $415,000). The trusts can be structured to qualify for the QBID, even though the parents would not be eligible for the QBID because of their high income. However, the proposed regulations state that, “Trusts formed or funded with a significant purpose of receiving a deduction under I.R.C. §199A will not be respected for purposes of I.R.C. §199A.” Again, that's a harsh, anti-taxpayer position that the proposed regulations take.
Under I.R.C. §643(f) the IRS can treat two or more trusts as a single trust if they are formed by substantially the same grantor and have substantially the same primary beneficiaries, and are formed for the principle purpose of avoiding income taxes. Does the statement in the proposed regulations referenced above mean that the Treasury is ignoring the three-part test of the statute? By itself, that would seem to be the case. However, near the end of the proposed regulations, there is a statement reciting the three-part test of I.R.C. §643(f). Prop. Treas. Reg. §1.643(f)-1). Hopefully, that means that any trust that has a reasonable estate/business planning purpose will be respected for QBID purposes, and that multiple trusts will not be aggregated that satisfy I.R.C. §643(f). Time will tell what the IRS position on this will be.
Unfortunately, the proposed regulations do not address how the QBID is to apply (or not apply) to charitable remainder trusts.
Here are a few other observations from the proposed regulations:
- Guaranteed payments in a partnership and reasonable compensation in an S corporation are not qualified wages for QBID purposes.
- Inherited property that the heir immediately places in service gets a fair market value as of date of death basis, but the proposed regulations don’t mention whether this resets the property’s depreciation period for QP purposes (as part of the 2.5 percent computation).
- For purposes of the QP computation, the 2.5 percent is multiplied by the depreciated basis of the asset on the day it is transferred to an S corporation, for example, but it’s holding period starts on the day it was first used for the business before it is transferred.
- A partnership’s I.R.C. §743(b) adjustment does not count for QP purposes. In other words, the adjustment does not add to UBIA. Thus, the inheritance of a fully depreciated building does not result in having any QP against which the 2.5 percent computation can be applied. That's a harsh rule from a taxpayer's standpoint.
- R.C. §1231 gains are not QBI. But, any portion of an I.R.C. §1231 gain that is taxed as ordinary income will qualify as QBI.
- Preferred allocations of partnership income will not qualify as QBI to the extent the allocation is for services. This forecloses a planning opportunity that could have been achieved by modifying a partnership agreement to provide for such allocations.
The proposed regulations are now subject to a 45-day comment period with a public hearing to occur in mid-October. The proposed rules do not have the force of law, but they can be relied on as guidance until final regulations are issued. From a practice standpoint, rely on the statutory language when it is more favorable to a client than the position the Treasury has taken in the proposed regulations.
Numerous questions remain and will need to be clarified in the final regulations. The Treasury will be hearing from the tax section of the American Bar Association, the American Institute of CPAs, other tax professionals and other interested parties. Hopefully, some of the taxpayer unfavorable positions taken in the proposed regulations can be softened a bit in the final regulations. In addition, it would be nice to get some guidance on how the rules will apply to cooperatives and their patrons.
Also, this post did not exhaust all of the issues addressed in the proposed regulations, just the one that are most likely to apply to farming and ranching businesses. For example, a separate dimension of the proposed regulations deals with “specialized service businesses.” That was not addressed.
Thursday, August 9, 2018
A tort is a civil (as opposed to a criminal) wrong or injury, other than breach of contract, for which a court will provide a remedy in the form of an action for damages. Tort law is based heavily upon state case law. That means that different legal rules apply in different jurisdictions. In addition, in all jurisdictions, tort law changes as new cases are decided.
Tort law is concerned with substandard behavior, and its objective is to establish the nature and extent of responsibility for the consequences of tortious (wrongful) conduct. Cases involving torts,
in an agricultural context, may involve such situations as employer/employee relationships, fence and boundary disputes, crop dusting and many other similar situations.
In today’s post, I take a look at several recent ag tort cases that provide a sampling of the tort situations that can happen on a farm or ranch.
In Halderson v. N. States Power Co., No. 2017AP2176, 2018 Wisc. App. LEXIS 645 (Wisc. Ct. App. July 24, 2018), the plaintiff’s dairy cows were experiencing health problems and the plaintiff contacted a veterinarian. In turn, the veterinarian suggested that the plaintiff contact an electrician that investigates stray voltage. The electrician found that the farm had stray voltage exceeding the defendant power company’s standards of one amp. The electrician suggested that the plaintiff request a neutral isolation from the defendant to separate the primary and secondary naturals, preventing any off-farm stray voltage from affecting the livestock. The defendant did so, and the cows’ health improved substantially. The plaintiff’s sued to recover economic losses to their dairy operation and, after a 12-day jury trial, the jury awarded the plaintiff $4.5 million dollars on the plaintiff’s negligence and nuisance claims. The jury also found that the defendant acted in a “… willful, wanton, or reckless manner…” thus activating treble damages under Wisconsin Code §196.64.
The plaintiff moved for judgment on the verdict. The defendant made numerous post-trial motions - renewing their motions to dismiss and for directed verdict. In addition, the defendant moved for a new trial based on a jury instruction and the plaintiff’s attorney failing to disclose that one of the juror’s uncles had been hired by the attorney as an expert witness on another stray voltage case. The trial court granted the defendant’s motion for directed verdict on the damages issue, stating that the evidence was insufficient to conclude that the defendant had acted in the manner that the jury found. However, the trial court affirmed the jury’s negligence findings and denied the motion for a new trial. The plaintiff appealed the directed verdict on the damages issue and the defendant cross-appealed the jury verdict on the negligence findings. The appellate court affirmed, and also noted that the defendant had failed to move for a mistrial on the conflict issue.
In Reasner v. Goldsmith, No. A17-1989, 2018 Minn. App. Unpub. LEXIS 578 (Minn. Ct. App. Jul. 9, 2018). The defendant’s cattle escaped their enclosure and were involved in an automobile accident. The defendant claimed that the cattle broke through a closed pasture gate. The defendant testified that the fences were checked weekly and that the cattle had been in that particular pasture for at least a week. In addition, the defendant testified that he had been working the field between the pasture and the road that day, and the cattle were in the pasture the whole time. After returning the cattle to the pasture the defendant fixed a few wires on the gate. The defendant also noted that the cattle were uneasy, like they had been “spooked.” No photos were taken of the broken gate before the fix. There was no dispute that the cattle came though the field from the pasture. The plaintiff claimed that the defendant came to him in the hospital and apologized for leaving the gate between the pasture and the field open. There was also a statement by a passenger in the plaintiff’s vehicle claiming that he saw the cattle in the field and not in the pasture the morning before the accident.
The trial court relied heavily on the defendant’s testimony, and granted summary judgment for the defendant. The court determined that the defendant neither allow the cattle to be on the road nor knew that they were on the road. Also, the court reasoned that it was unforeseeable to the defendant that the cattle would escape because of the weekly fence checks. Thus, the cattle were not running at-large and the defendant was not negligent in keeping the cattle fenced in. On appeal, the appellate court determined that there was an issue of genuine fact remaining with respect to where the cattle were before the accident and what was the cause of their escape. Thus, the trial court’s grant of summary judgment was reversed and the case remanded.
Statutory Protection for Horse-Related Injury
In James v. Young, No. 10-17-00346-CV, 2018 Tex. App. LEXIS 2406 (Tex. Ct. App. Apr. 4, 2018), the plaintiff, along with some others, offered to help at the defendant’s farm. An injury occurred to a child as a result of the defendant’s horses and the plaintiff sued, claiming negligent handling of horses. The defendant (in both the corporate capacity and individual capacity) moved for summary judgment based on no evidence, and the trial court granted the motion. The trial court granted the motions for summary judgment. The plaintiff did not appeal the grant of summary judgment for the defendant corporation, but did appeal the granting of summary judgment for the defendant individuals. The appellate court affirmed.
The plaintiff conceded that the Texas Equine Activity Limitation of Liability Act applied to the action. That Act protects owners of livestock and horses from liability from incidents stemming from the inherent risk of livestock and horses. However, the plaintiff claimed that the owner failed to make a reasonable effort to gauge the skill level of a participant to ensure safety – an exception to coverage under the Act. Since the no-evidence summary judgment motion is like a directed verdict, the burden is on the non-moving party to show genuine issue of material fact. The plaintiff never produced any evidence that the defendant failed to ask of the child’s riding ability or to prove that the lack of questioning lead to the accident directly. Thus, the appellate court affirmed the grants of summary judgment.
In Bryant v. Reams, Civil Action No. 16-cv-01638-NYW, 2018 U.S. Dist. LEXIS 99929 (D. Colo. Jun. 14, 2018), the plaintiff lost her arm when the car she was riding in collided with a dead cow on a public roadway in southwestern Colorado. She sued the defendant cow owner for negligence and the state (CO) Department of Transportation (CDOT) for failing to maintain fences along the state highway, seeking compensatory and punitive damages. The cow had been grazing with a herd of the defendant’s cattle on Bureau of Land Management (BLM) land, and the defendant alleged that the defendant did not have a license to graze cattle on BLM land but was doing so by virtue of a sublease from another rancher that did have a lease to graze cattle on the BLM land. The plaintiff claimed that the CDOT failed to maintain fences along the highway in a manner that was sufficient to bar cattle from wandering onto the road, and that the fence at issue had deteriorated and cattle had previously caused multiple accidents on the roadway. Both the CDOT and the defendant cow owner filed motions for summary judgment.
The trial court partially granted the cow owner’s motion by dismissing the claim for exemplary damages on the basis that the evidence clearly showed that the cow owner did not act in a willful and wanton manner toward the plaintiff because they never intentionally grazed cattle alongside the highway, but denied the motion with respect to negligence claim against the cow owner finding sufficient evidence regarding proximate causation to submit the issue to the jury. The trial court also denied the CDOT’s summary judgment motion on the plaintiff’s premises liability claim against the CDOT citing evidence showing that CDOT had been notified that the fence needed to be fixed.
Before the case went to trial, the CDOT and the plaintiff settled, but the other defendants moved to designate CDOT as a non-party at fault which would reduce the cow owner’s percentage of fault. At trial, the plaintiff claimed that the jury should be instructed that the CDOT could only be apportioned negligence if the CDOT had actual notice of a deficient fence. If that is true, the cow owner would have a greater percentage of fault leading to a larger damage award. The trial court held that the CDOT had an affirmative duty to maintain fences adjacent to state roads for the safety of motor vehicles irrespective of any actual notice that a fence is in need of repair. Bryant v. Reams, Civil Action No. 16-cv-01638-NYW, 2018 U.S. Dist. LEXIS 99929 (D. Colo. Jun. 14, 2018).
Wind Energy Company Creates Nuisance and Must Pay
In re Wisconsin Power and Light, Co., No. ET-6657/WS-08-573, Minn. Pub. Util. Commission (June 5, 2018) illustrates the problems that a commercial wind energy operation can present for nearby landowners. On October 20, 2009, the Minnesota Public Utilities Commission issued a large wind energy conversion system site permit to Wisconsin Power and Light Company (WPL) for the approximately 200-megawatt first phase of the Bent Tree Wind Project, located in Freeborn County, Minnesota. The project commenced commercial operation in February 2011. On August 24, 2016, the Commission issued an order requiring noise monitoring and a noise study at the project site. During the period of September 2016 through February 2018 several landowners in the vicinity filed over 20 letters regarding the health effects that they claim were caused by the project.
On September 28, 2017, the Department of Commerce Energy Environmental Review Analysis Unit (EERA) filed a post-construction noise assessment report for the project, identifying 10 hours of non-compliance with Minnesota Pollution Control Agency (MPCA) ambient noise standards during the two-week monitoring period. On February 7, 2018, EERA filed a phase-two post construction noise assessment report concluding that certain project turbines are a significant contributor to the exceedances of MPCA ambient noise standards at certain wind speeds. On February 8, 2018, WPL filed a letter informing the Commission that it would respond to the Phase 2 report at a later date and would immediately curtail three turbines that are part of the project, two of which were identified in the phase 2 report. On February 20, 2018, the landowners filed a Motion for Order to Show Cause and for Hearing, requesting that the Commission issue and Order to Show Cause why the site permit for the project should not be revoked, and requested a contested-case hearing on the matter. On April 19, 2018 WPL filed with the Commission a Notice of Confidential Settlement Agreement and Joint Recommendation and Request, under which WPL entered into a confidential settlement with each landowner, by which the parties agree to the terms of sale of their properties to WPL, execution of easements on the property, and release of all the landowners’ claims against WPL. The agreement also outlined the terms by which the agreement would be executed.
The finality of the agreement was conditioned upon the Commission making specific findings on which the parties and the Department agreed. These findings include, among others: dismissal of the landowners’ February 2018 motion and all other noise-related complaints filed in this matter; termination of the required curtailment of turbines; transfer of possession of each property to WPL; and a requirement that compliance filing be filed with commission. The Commission determined that resolving the dispute and the terms of the agreement were in the public interest and would result in a reasonable and prudent resolution of the issues raised in the landowner’s complaints. Therefore, the Commission approved the agreement with the additional requirement that upon the sale of either of the landowners’ property, WPL shall file with the Commission notification of the sale and indicate whether the property will be used as a residence. If the property is intended to be used as a residence after sale or upon lease, the permittee shall file with the Commission: notification of sale or lease; documentation of present compliance with noise standards of turbines; documentation of any written notice to the potential residence of past noise studies alleging noise standards exceedances, and if applicable, allegations of present noise standards exceedances related to the property; and any mitigation plans or other relevant information.
Tort situations can arise in a myriad of ways for farmers, ranchers and rural landowners. Think you might need an attorney sometime in the future that is well trained in these unique tort scenarios? That’s what we’re doing at Washburn Law School.
Tuesday, August 7, 2018
The “Water of the United States” (WOTUS) rule has caused a considerable amount of controversy in agriculture for many years. In 2006, the U.S. Supreme Court had a chance to add clarity to the matter, but managed to “muddy the waters” instead – rendering a split 4-1-4 decision. In subsequent years, the Environmental Protection Agency (EPA) attempted to exploit that lack of clarity by expanding the regulatory definition of a WOTUS.
The WOTUS issue is a very important issue for agricultural and rural landowners, and the U.S. Supreme Court is being asked to hear another case involving the issue at the present time.
So, what is the present status of the WOTUS matter? There have been many twists and turns in recent years Today’s post sorts out the significant recent developments
The WOTUS rule recent developments – that’s the topic of today’s post.
The Clean Water Act makes illegal the discharging of dredge or fill material into the “navigable waters of the United States” without first obtaining a permit from the Secretary of the Army acting through the Corps of Engineers (COE). In March of 2014, the EPA and the COE released a proposed rule defining “waters of the United States” (WOTUS) in a manner that would significantly expand the agencies’ regulatory jurisdiction under the CWA. Under the proposed rule, the CWA would apply to all waters which have been or ever could be used in interstate commerce as well as all interstate waters and wetlands. In addition, the proposed WOTUS rule specifies that the agencies’ jurisdiction would apply to all “tributaries” of interstate waters and all waters and wetlands “adjacent” to such interstate waters. The agencies also asserted in the proposed rule that their jurisdiction applies to all waters or wetlands with a “significant nexus” to interstate waters.
Under the proposed rule, “tributaries” is broadly defined to include natural or man-made waters, wetlands, lakes, ponds, canals, streams and ditches if they contribute flow directly or indirectly to interstate waters irrespective of whether these waterways continuously exist or have any nexus to traditional “waters of the United States.” The proposed rule defines “adjacent” expansively to include “bordering, contiguous or neighboring waters.” Thus, all waters and wetlands within the same riparian area of flood plain of interstate waters would be “adjacent” waters subject to CWA regulation. “Similarly situated” waters are evaluated as a “single landscape unit” allowing the agencies to regulate an entire watershed if one body of water within it has a “significant nexus” to interstate waters. The proposed rule became effective as a final rule on August 28, 2015 in 37 states.
In a recent case, Georgia v. Pruitt, No. 2:15-cv-79, 2018 U.S. Dist. LEXIS 97223 (S.D. Ga. Jun. 8, 2018), the plaintiffs claimed that the WOTUS rule, implemented in 2015, violates the Clean Water Act, the Administrative Procedure Act, the Commerce Clause of the Constitution, and the Tenth Amendment. The plaintiffs sought an injunction preventing the rule from being implemented in 11 states pending a full hearing on the merits. To receive the injunction, the plaintiffs had to prove that they would (1) likely succeed on the merits; (2) be irreparably harmed; (3) sustain more potential injury than the defendant would be harmed; and (4) establish that the injunction is not contrary to the public interest. The court determined that the plaintiffs had met the standards for all four requirements. As for success on the merits, the court determined that the WOTUS rule would not likely be upheld under the U.S. Supreme Court standard set forth in Rapanos v. United States, 547 U.S. 715 (2006), and was random and impulsive. The court also determined that the irreparable harm standard had been satisfied given the increase in federal jurisdiction of “wetlands” under the rule which overstepped states’ rights and had the potential to impose substantial monetary harm on affected landowners. As for the balancing of the equities, the court determined that the loss of state rights and the increased potential for monetary damages outweighed the harm to the government in complying with an injunction. The court also reasoned that entering an injunction would not violate public policy because the WOTUS rule may be an be an unenforceable rule as inconsistent with prior court rulings concerning the scope of the government’s jurisdiction over wetlands. Accordingly, the court entered a preliminary injunction.
The court’s order of preliminary injunction prevented the WOTUS rule from being implemented in 11 states – Alabama, Florida, Georgia, Indiana, Kansas, Kentucky, North Carolina, South Carolina, Utah, West Virginia and Wisconsin. A prior decision by the North Dakota federal district court had blocked the rule from taking effect in 13 states – AK, AZ, AR, CO, ID, MO, MT, NE, NV, NM, ND, SD and WY. North Dakota v. United States Environmental Protection Agency, No. 3:15-cv-59 (D. N.D. May 24, 2016).
The Sixth Circuit Litigation and the Jurisdiction Issue
On October 9, 2015, the U.S. Court of Appeals for the Sixth Circuit issued a nationwide injunction barring the rule from being enforced anywhere in the U.S. Ohio, et al. v. United States Army Corps of Engineers, et al., 803 F.3d 804 (6th Cir. 2015). Over 20 lawsuits had been filed at the federal district court level. On February 22, 2016, the U.S. Court of Appeals for the Sixth Circuit ruled that it had jurisdiction to hear the challenges to the final rule, siding with the EPA and the U.S. Army Corps of Engineers that the CWA gives the circuit courts exclusive jurisdiction on the matter. The court determined that the final rule is a limitation on the manner in which the EPA regulates pollutant discharges under CWA Sec. 509(b)(1)(E), the provision addressing the issuance of denial of CWA permits (codified at 33 U.S.C. §1369(b)(1)(E)). That statute, the court reasoned, has been expansively interpreted by numerous courts and the practical application of the final rule, the court noted, is that it impacts permitting requirements. As such, the court had jurisdiction to hear the dispute. The court also cited the Sixth Circuit’s own precedent on the matter in National Cotton Council of America v. United States Environmental Protection Agency, 553 F.3d 927 (6th Cir. 2009) for supporting its holding that it had jurisdiction to decide the dispute. Murray Energy Corp. v. United States, Department of Defense, No. 15-3751, 2016 U.S. App. LEXIS 3031 (6th Cir Feb. 22, 2016).
In January of 2017, the U.S. Supreme Court agreed to review the Sixth Circuit’s decision. National Association of Manufacturers v. Department of Defense, et al., 137 S. Ct. 811 (2017). About a month later, President Trump issued an Executive Order directing the EPA and the COE to revisit the Clean Water Rule and change their interpretation of waters subject to federal jurisdiction such that it only applied to waters that were truly navigable – the approach taken by Justice Scalia in Rapanos v. United States, 547 U.S. 715 (2006). The EPA and Corps later indicated they would follow the President’s suggested approach, and would push the effective date of the revised Clean Water Rule to two years after its finalization and publication in the Federal Register. In November of 2017, the EPA issued a proposed rule delaying the effective date of the WOTUS rule until 2020.
In January of 2018, the U.S. Supreme Court ruled unanimously that jurisdiction over challenges to the WOTUS rule was in the federal district courts, reversing the Sixth Circuit’s opinion. National Association of Manufacturer’s v. Department of Defense, No. 16-299, 2018 U.S. LEXIS 761 (U.S. Sup. Ct. Jan. 22, 2018). The Court determined that the plain language of the Clean Water Act (CWA) gives authority over CWA challenges to the federal district courts, with seven exceptions none of which applied to the WOTUS rule. In particular, the WOTUS rule neither established an “effluent limitation” nor resulted in the issuance of a permit denial. While the Court noted that it would be more efficient to have the appellate courts hear challenges to the rule, the court held that the statute would have to be rewritten to achieve that result. Consequently, the Supreme Court remanded the case to the Sixth Circuit, with instructions to dismiss all of the WOTUS petitioners currently before the court. Once the case was dismissed, the nationwide stay of the WOTUS rule that the court entered in 2015 was removed, and the injunction against the implementation of the WOTUS rule entered by the North Dakota court was reinstated in those 13 states. Thus, given the June 2018 by the Georgia court, an injunction is presently in place in 24 states against the implementation of the rule. Another case against the WOTUS rule is currently pending in a Texas federal court.
2018 Notice of Proposed Rulemaking
Most recently, as directed by President Trump, the (COE) and the EPA issued a supplemental notice of proposed rulemaking. The proposed rule seeks to “clarify, supplement and seek additional comment on” the 2017 congressional attempt to repeal the 2015 WOTUS rule. If the rule is repealed, the prior regulations defining a WOTUS will become the law again. The agencies are seeking additional comments on the proposed rulemaking via the supplemental notice. The comment period is open through August 13, 2018. Comments can be submitted by accessing the page at the following link: https://www.regulations.gov/docket?D=EPA-HQ-OW-2017-0203. COE/EPA, “Waters of the United States"– Reinstatement of Preexisting Rules, No. EPA-HQ-OW-2017-0203 (Jul. 12, 2018).
For those interested in the WOTUS issue, it may certainly be worthwhile to submit a comment to the EPA by the August 13 deadline. We will have to wait and see what happens to the definition of a WOTUS over the coming months. It’s a big issue for agriculture.
Friday, August 3, 2018
The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under IRC §179 to $1 million. The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017. The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018.
Is property held in trust eligible to be expensed under I.R.C. §179? That’s a big issue for farm and ranch families (and others). Trusts are a popular part of many estate and business plans, and if property contained in them is not eligible for I.R.C. §179 their use could be costly from an income tax standpoint.
Trusts and eligibility for I.R.C. §179 - that’s the topic of today’s post.
Does the Type of Trust Matter?
I.R.C. §179(d)(4) states that an estate or trust is not eligible for I.R.C. §179. That broad language seems to be all inclusive – all types of trusts and in addition to estates are included. If that is true, that has serious implications for estate planning for farmers and ranchers (and others). Revocable living trusts are a popular estate planning tool in many estate planning situations, regardless of whether there is potential for federal estate tax. If property contained in a revocable trust (e.g., a “grantor” trust) is not eligible for I.R.C. §179, that can be a significant enough income tax difference that would mean that the estate plan should be changed to not utilize a revocable trust.
Grantor trusts. A grantor trust is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust. Because of this retained power, the trust's income is taxable to the grantor. From a tax standpoint, the grantor is treated as the owner of the trust with the result that all items of income, loss, deduction and credit flowing through to the grantor during the period for which the grantor is treated as the owner of the trust. I.R.C. §671; Treas. Reg. § 1.671-3(a)(1); Rev. Rul. 57-390, 1957-2 C.B. 326. Another way of stating the matter is that a grantor trust is a disregarded entity for federal income tax purposes. C.C.A. 201343021 (Jun. 17, 2013). Effectively, the grantor simply treats the trust property as their own.
This is the longstanding position of the IRS. In Rev. Rul 85-13, 1985-1 C.B. 184, the IRS ruled that a grantor of a trust where the grantor retains dominion and control resulted in the grantor being treated as the trust owner. In other words, a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under I.R.C. §§671-677. In the ruling, the IRS determined that a transfer of trust assets to the grantor in exchange for the grantor's unsecured promissory note did not constitute a sale for federal income tax purposes. The facts of the ruling are essentially the same as those at issue in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984). In Rothstein, while the court found the trust at issue to be a grantor trust, the court concluded that the trust was separate from the taxpayer. But, in the 1985 ruling based on the same facts, the IRS stated that it would not follow Rothstein and reasserted its position that a taxpayer is deemed to own the assets contained in a grantor trust for federal tax purposes.
Thus, there is substantial authority for the position that property contained in a grantor trust, such as a revocable living trust, is eligible for expense method depreciation under I.R.C. §179. The grantor is the same thing for tax purposes as the grantor trust.
Irrevocable trusts. An irrevocable trust can't be modified or terminated without the beneficiary's permission. The grantor, having transferred assets into the trust, effectively removes all rights of ownership to the assets and control over the trust assets. This is the opposite of a revocable trust, which allows the grantor to modify the trust. That means that an irrevocable trust is a different entity from the taxpayer and the property contained in the trust is not eligible for expense method depreciation under I.R.C. §179 pursuant to I.R.C. §179(d)(4), unless the grantor retains some degree of power over trust income or assets. For instance, a common situation when an irrevocable trust will be treated by the IRS as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property. The same result occurs when the grantor retains any significant level of administrative control over the trust such as discretionary authority to distribute trust property to the grantor or the power to borrow money from the trust without paying a market rate of interest.
Pass-Through Entities and Irrevocable Trusts
The 20 percent deduction for qualified business income under I.R.C. §199A in effect for tax years beginning after 2017 and before 2026 for taxpayers with business income that are not C corporations, may spark increased interest in pass-through entities. With respect to a pass-through entity, though, questions concerning the use of I.R.C. §179 arise when an irrevocable trust has an ownership interest in the entity. Under Treas. Reg. § 1.179-1(f)(3), a trust that is a partner or S corporation shareholder is barred from deducting its allocable share of the I.R.C. §179 depreciation that is elected at the entity level. The pass-through entity’s basis in the I.R.C. §179 property is not reduced to reflect any portion of the I.R.C. §179 expense that is allocable to the trust or estate. Consequently, the entity claims a regular depreciation deduction under I.R.C. §168 with respect to any depreciable basis that results from the inability of a non-grantor irrevocable trust or the estate to claim its allocable portion of the I.R.C. §179 depreciation. Id. The irrevocable trust or estate does not benefit from the entity’s I.R.C. §179 election.
A revocable living trust, as a grantor trust, can claim I.R.C. §179 depreciation. Thus, that common estate planning vehicle won’t present an income tax planning disadvantage by taking I.R.C. §179 depreciation off of the table. However, when an irrevocable trust is involved, the result is different, unless the trust contains language that gives the grantor sufficient control over trust income or assets. Business property that is contained in an irrevocable trust is generally not eligible for I.R.C. §179 depreciation. But, trust language may change that general result. In addition, if a pass-through entity claims I.R.C. §179 depreciation, none of that depreciation flows to the irrevocable trust (or estate). That means that the entity will need to make special basis adjustments so that the deduction (or a portion thereof) is not wasted. Likewise, the depreciation should be “separately stated items” on the K-1 whenever an irrevocable trust or an estate owns an interest in the entity. Likewise, existing partnership agreements may need to be modified so that I.R.C. §179 deductions are allocated to non-trust partners and other expenses to owners of interests that are irrevocable trusts and estates.
This potential difference in tax treatment between revocable grantor trusts and irrevocable trusts should be considered as part of the overall tax planning and estate/business planning process.
Wednesday, August 1, 2018
Naming one person to receive the income and/or use of property until death and naming another person to receive ultimate ownership of the property is done for various reasons. One primary reason is to allow one person (or persons) to have the use of property during life and then have someone else own the property after the life estate expires. Life estate/remainder arrangements are also used for estate tax planning purposes. In that instance, the intent of the person creating the life estate/remainder arrangement is to effectively use the estate tax exemptions of both the husband and wife.
The life estate/remainder arrangement also raises some tax issues. One of those issues concerns the income tax basis of the property that is the subject of the arrangement. The cost basis of inherited property is almost always the fair market value of the property as of the testator's date of death. However, what is the income tax basis of property when the various rights to the property are not owned by the same people?
Income tax basis issues associated with property subject to a life estate/remainder arrangement. That’s the subject of today’s post.
The general rule is that property is valued in a decedent’s gross estate at its fair market value as of the date of the decedent’s death. I.R.C. §1014. It is that fair market value that determines the basis of the property in the hands of the recipient of the property. That’s fairly simple to understand when the decedent owns the entire property interest at death. However, that’s not the case with property that is held under a life estate/remainder arrangement. In that situation, the remainder holder does not benefit from the property until the life tenant dies. That complicates the income tax basis computation.
Uniform basis. The general idea of uniform basis is that the cost basis of inherited property should equal the value used for estate tax purposes. The new cost basis after death is usually referred to as the “stepped-up” basis, although the new basis can be lower than the original cost. As noted above, it’s tied to the property’s fair market value as of the date of death for purposes of inclusion in the decedent’s estate. The regulations state that the basis of property acquired from a decedent is uniform in the hands of every person having an interest in the property. Treas. Reg. §1.1014-4. As explained in the regulations, under the laws governing transfers from decedents, all ownership interests relate to the death of the decedent, whether the interests are vested or contingent. That means that there is a common acquisition date and a common basis for life tenants and remainder holders.
The uniform basis rule is easy to implement after the death of the life tenant, as shown in the following example.
Example. Boris leaves his entire estate to his son, Rocky, as a remainder holder. However, all income from the estate is payable to his wife, Natasha, until her death. The value of the property is $200,000 at the time of his death.
Natasha collects the income from the inherited property for 20 years. When she dies, the appreciated value of the property is $500,000.
When Natasha dies, Rocky becomes the sole owner of both the property and the future income. However, because Rocky's ownership of the property is based initially on his father's death, Rocky's basis is $200,000 - the value at the time his father died.
The result of the example makes sense when you consider that the value of the life estate interest is excluded from Natasha’s estate. Because it was excluded from her estate, there is not basis step-up in Rocky’s hands – the person who receives the right to the income after Natasha dies.
If the inherited property is subject to depreciation, the holder of the life interest is allowed to claim the depreciation expense attributable to the entire inherited basis of the depreciable property.
Sale of the Life Estate Interest
The basis rules change dramatically for the holder of a life estate interest if the rights to the income are sold without the remainder interest being sold as part of the same transaction. If the life interest is sold separately, the seller's basis for tax purposes is $0. I.R.C. 1001(e). The buyer of the life interest can amortize the cost of the purchase over the life expectancy of the seller.
Example. Bill leaves a life interest in stock to his neighbor, Dale, and a remainder interest to another neighbor, Bobbi. The value of the stock for estate tax purposes is $5,000 at the time Bill dies. Dale immediately sells his life interest to LuAnn for $100.
Dale's cost basis in his life interest is $0. Dale reports the gain of $100 on Schedule D, Capital Gains and Losses, as a long-term capital gain. I.R.C. §1223(10). This transaction has no effect on the uniform basis. The cost basis allocable to Bobbi's remainder interest will continue to increase each year as the life interest's value decreases. Treas Reg. §1-1014. LuAnn is entitled to subtract a portion of the $100 she paid Dale each year against her dividend income. The subtraction is based upon Dale's life expectancy at the time of the sale. Treas. Reg. 1.1014-5(c).
Technically, there is no authority directing LuAnn where.to include this subtraction on her return. The conservative approach is to include it in investment expense on Schedule A, Itemized Deductions. An aggressive approach is to treat it in the same way as premiums paid for bonds, which is as a subtraction on Schedule B, Interest and Ordinary Dividends.
Death of the Remainder Holder
If the holder of the remainder interest dies before the holder of the life interest, the uniform basis is not adjusted and the life tenant's basis is still calculated as explained previously.
However, the value of the remainder interest is included in the estate of the remainder holder. The regulations, therefore, allow the beneficiary of the remainder holder's estate to adjust the basis for a portion of the value that is included in the estate.
This basis adjustment is calculated by subtracting the portion of the uniform basis allocable to the decedent immediately prior to death from the value of the remainder interest included in the estate.
Example. Marge died in 2006. In her will, she left Bart, her son, a life estate interest in their family home. She left Lisa, her daughter, the remainder interest. In 2010, Lisa died. In Lisa's will, Maggie, her sister, is the sole heir. Bart is still alive.
The fair market value of the house in 2006 when Marge died was $100,000. At the time of Lisa's death, her share in the uniform basis was $15,000, based on Bart's life expectancy and the fair market value. The value of the home in 2010 when Lisa died was $200,000. The value of the remainder interest included in Lisa's estate was $30,000.
Maggie's basis adjustment in the inherited house is shown below:
Value of the house included in Lisa's estate
Less: Lisa's portion of the uniform basis at her death
Maggie's basis adjustment in the house
When the beneficiary to the remainder interest sells the property, the basis is calculated using the beneficiary's current portion of the uniform basis at the time of the sale plus the adjustment.
Most people have a pretty good understanding that the income tax basis of property received from a decedent that was included in that decedent’s estate is the fair market value of the property as of the date of the decedent’s death. But, the basis issue becomes more complex when the property at issue is part of a life estate/remainder arrangement. It’s a common estate planning technique, so the issue often arises. Hopefully, today’s post helped sort it out.