Tuesday, October 30, 2018
Many farming and ranching operations are structured in the partnership form, and many of them operate simply on an oral basis. The lack of a written partnership agreement can cause numerous problems. One of those problems can be uncertainty that results when a partner dies. What happens to the deceased partner’s partnership interest? Is it allocated among the surviving partner(s)? Does it pass to the deceased partner’s spouse or other heirs? Does something else happen to it?
The passage of a deceased partner’s partnership interest into the “wrong” hands can create various problems – not the least of which is possible discontinuation of the partnership business and farm business assets, including land, falling into hands of persons that have no interest in continuing the farming or ranching business. Even if a written partnership agreement exists, lack of clear language can also create uncertainty as to what happens when a partner dies.
Partnerships and the death of a partner – That’s the focus of today’s post.
What Is A Partnership?
First things first – when does a partnership exist? A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. As an estate planning device, the partnership is generally conceded to be less complex and less costly to organize and maintain than a corporation. A general partnership is comprised of two or more partners. There is no such thing as a one-person partnership, but there is no maximum number of partners that can be members of any particular general partnership.
If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. A partnership agreement (or articles of partnership) is a contract among the parties in which they agree to certain arrangements about income, rights to decision making, and accounting procedures. These are the practical kinds of problems that are addressed in a partnership agreement.
If there is no written partnership agreement, questions may arise as to whether a landlord/tenant lease arrangement constitutes a partnership. Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. There are numerous factors for determining partnership existence, but one of those involves the sharing of net income – an issue that can arise in oral lease arrangements.
Is a lease a partnership? A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists.
For written farm leases where partnership treatment is not desired, it is often suggested to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership. In addition, it’s advisable for the landlord and tenant to not hold themselves out publicly as being in a partnership.
Death of a Partner
As mentioned, if a partnership arrangement exists, the death of a partner can create issues. For example, in In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009), a farmer died intestate and an implied partnership was deemed to exist with the decedent’s surviving spouse which entitled the surviving spouse to one-half of the assets of the farm business with the balance distributed to the decedent’s estate. While the couple filed Schedule F only in the decedent’s name, the Schedule F included the incomes of both the decedent and the surviving spouse.
Similarly, in a case from Montana in 1985, In re Estate of Palmer, 218 Mont. 285, 708 P.2d 242 (1985), the court determined that a partnership existed even though title to the real estate and the farm bank account were in joint tenancy. As such, the surviving spouse of the deceased “partner” was entitled to one-half of the farm assets instead of the land and bank account passing to the surviving joint tenant.
A recent North Dakota case involving the death of a partner illustrates what can happen in the written partnership agreement doesn’t clearly address the matter of a partner’s death. In, Estate of Moore v. Moore, 2018 N.D. 221 (2018), two brothers were co-equal partners in a farming partnership. Under the written partnership agreement, upon the death of a partner, the partnership continued, but the estate of a deceased partner could not make business decisions without the surviving partner’s approval. Also, the written partnership agreement stated that, “Land owned as tenants in common by [the partners] is contributed to the partnership without charge.
The partnership was responsible for all of the costs and management associated with the land and treated the land as if it were owned by the partnership. This contribution could not be retracted except on dissolution of the partnership or agreement by both partners. The partnership agreement also specified that, “Any land owned [by] other persons operated by the partnership is leased by the partnership and not by individual partners.”
One of the partners died in 2012, and his will devised part of his land to his brother and the rest to his step children and nephew. The land that was devised to the step-children and nephew was burdened with a condition stating that the property should, "be sold in a commercially reasonable manner so as to derive the most value therefrom within six (6) months of my death." In 2012 this land was conveyed to the children and they also requested partition and sale of the land held as co-tenants. The defendant challenged the conveyance stating the estate should have sold the property rather than conveying it.
In 2014 the trial court agreed and vacated the conveyance and returned the property to the deceased partner’s estate. The surviving partner continued to farm, and the deceased partner’s estate sued for rent due on the partnership property. The trial court denied the estate rent, stating that partnership was not liable for rent six months after the decedent’s death. It also determined that the agreement continued the partnership for six months so that the surviving partners could decide what to do. The trial court also held that the partnership lacked standing during the litigation between 2012 and 2014 over the conveyance because the estate did not own the property. Finally, the trial court held that the estate did not show that they were due relief as they could not show that the defendant was unjustly enriched.
On appeal, the appellate court affirmed in part, reversed in part, and remanded the case. The appellate court, based on the partnership agreement, determined that the partnership was not dissolved upon death, but that the estate became a partner that was owed profits and losses. The appellate court determined that the district court erred when interpreting the statement in the partnership agreement that, "the partners intend… that there be an extended time to deal with a partner leaving or the death of a partner before the necessary wind up of the partnership or its continuation by the remaining partners." The appellate court held that this did not invoke a dissolution and winding up period after one of their deaths. Because the appellate court held that the partnership was not dissolved, and the land was held as co-tenants, there was no rent due. The partnership was still valid, and the land was being used within the guidelines of the agreement. As a result, the use of the land was correct, the surviving partner was not unjustly enriched, bur was merely continuing the business as a partner.
The ultimate holding of the appellate court affirmed that the estate was not due any rent between the decedent’s death and sale of the property. However, the estate may be still owed profits from the partnership. Since the estate became a partner, with limited abilities, the court remanded the case for an accounting of profits or losses after the decedent’s death.
A partnership is often a preferred form of business organization for a farm or ranch business. It’s best to formalize the arrangement with a carefully crafted written agreement. Death of a partner is one of those issues that a written agreement should address. If it doesn’t, or the arrangement is an oral one, unexpected consequences can result.
Friday, October 26, 2018
The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017. However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.” But, what does that mean?
Real estate tax-deferred trades and what counts as “like-kind” – that’s the focus of today’s post.
Definition of “Real Estate”
Broad definition. Under the former rules governing trades of personal property, such as farm machinery, the Treasury Regulations determined if property was like-kind by reference to being within the same product class. See Treas. Reg. §1.1031-2(b)(2). Also, property was of a like-kind to property that was of the same nature or character. See Temp. Treas. Reg. §1.1031(a)-2T(d). However, like-kind property personal property did not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind had to be made on an asset-by-asset basis. Thus, a like-kind trade could involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the taxpayer continues to use the replacement property for business or investment. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in the exchange.
Unique situations. While the definition of real estate is rather broad, some distinctions are present. For example, a leasehold interest can be exchanged for fee interests if the leasehold interest has at least 30 years to run at the time the exchange is entered into. Treas. Reg. §1.1031(a)-1(c). Case law also indicates that, at the time the transaction is entered into, the lease must have at least 30 years remaining. See, e.g., VIP Industries Inc. & Subsidiaries v. Comm’r, T.C. Memo. 2013-357.
That 30-year rule is important. The IRS has, apparently, taken the position that an exchange of a remainder interest in a tract of real estate for a life estate (where the life expectancy of the life tenant exceeds 30 years) for another tract of real estate can qualify for like-kind exchange treatment. Rev. Rul. 72-601, 1977-2 C.B. 467. Likewise, a remainder interest in real estate can qualify for like-kind exchange treatment when it is exchanged for a remainder interest (or, probably, a reversionary interest) in a different tract of farmland. Rev. Rul. 78-4, 1978-1 C.B. 256. Also, real estate owned in fee simple can qualify for like-kind exchange treatment when traded for real estate subject to 99-year leases. See, e.g. Koch v. Comr., 71 T.C. 54 (1978).
Also, a sale followed by a leaseback involving terms of 30 years or more has been deemed to be like-kind. Rev. Rul. 60-43, 1960-1 C.B. 687; Jordan Marsh Company v. Comr., 269 F.2d 453 (2d Cir. 1959).
As for land that is being sold under an installment land contract, the buyer’s rights under the contract have been held to be the same as a fee simple interest in the real estate. See, e.g., Starker v. Comr., 602 F.2d 1341 (9th Cir. 1979).
In Peabody Natural Resources Co. v. Comr., 126 T.C. 261 (2006), the Tax Court determined that under New Mexico law, coal supply contract constituted real property interests and were like-kind to gold mine. The case involved the exchange of an operating gold mine, including real estate, for operating coal mines which were subject to coal supply contracts obligating the owner to provide electric utilities with coal. The IRS denied like-kind exchange treatment on the basis that the coal supply contracts weren’t real property. However, the Tax Court determined that under New Mexico law (the state where the coal mines were located) the coal contracts were servitudes (an interest on the underlying land) under New Mexico law. As for the nature and character of the contracts, the Tax Court determined that they couldn’t be separated from the ownership of the coal reserves. They were ancillary to the ownership of the coal reserves. As a result, the contracts were like-kind to the gold mining property.
Perpetual water rights are like-kind to land. Rev. Rul. 55-749, 1955-2 C.B. 295. However, water rights that are limited in duration are not considered like-kind to a fee interest in land. Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002). But, there can be an exception to that outcome. If the water rights are limited only as to annual use the IRS has ruled that they are of sufficient like-kind to a fee interest in land to qualify the transaction for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).
Impact of State Law
It could be concluded from a read of the above cases and rulings that state law plays a predominant role in determining whether a property interest is an interest in real property that can potentially be eligible for like-kind exchange treatment. That was certainly the case in the early cases dealing with the issue. See, e.g., Morgan v. Comr., 309 U.S. 78 (1940); Aguilino v. United States, 363 U.S. 509 (1960); Comr. v. Crichton, 122 F.2d 181 (5th Cir. 1941); Priv. Ltr. Rul. 200424001 (Dec. 8, 2003). But, other cases indicate that the like-kind determination is a matter of federal law rather than state law. See, e.g., Fleming v. Comr., 24 T.C. 818 (1955), rev’d., 241 F.2d 78 (5th Cir. 1957).
In 2012, the IRS clarified its position on the impact of state law in determining whether a property interest is in interest in real property. In C.C.A. 201238027 (Sept. 21, 2012), the IRS determined that federal income tax law, not state law, controls whether exchanged properties are of like kind for I.R.C. §1031 purposes. While the IRS stated that state law property classifications are relevant for determining if property is real or personal, they aren't determinative of whether properties are of the same nature and character. Instead, that determination is to be made by considering all of the facts and circumstances of the particular transaction and the property interests involved. Id.
The TCJA eliminated the ability to treat personal property trades under the I.R.C. §1031 rules. However, real estate can still be traded in a tax deferred exchange transaction. What constitutes “real estate” is an important first determination. The nature and character of the properties involved in the transaction is the next determination. If those hurdles are successfully cleared, the I.R.C. §1031 rules can provide a preferential tax result.
Wednesday, October 24, 2018
An issue that can be confusing and difficult to understand is the proper classification of items of depreciable real estate for a farm taxpayer. More specifically, how are farm “buildings” and other structures treated for depreciation purposes? The Tax Code (Code) treats “buildings” and “structures” in a special way. But, that treatment is not always intuitive.
So just what is a “farm building”? What is depreciable farm real property? What is the appropriate tax treatment of these items for depreciation purposes? That’s the topic of today’s post.
“Buildings and Structures”
The IRS classifies depreciable farm real property in at least four ways. Land improvements have a cost recovery period of 15 years and are in depreciation class 00.3 (Modified Accelerated Cost Recovery System depreciation class). Single purpose agricultural or horticultural structures are in Class 01.4 and have a cost recovery period of 10 years. The cost recovery period for farm buildings is 20 years, and they are in Class 01.3. What is known as I.R.C. §1245 real property has no class life and a cost recovery period of seven years. The specifications are set forth in Rev. Proc. 87-56, 1987-2 C.B. 674.
In general, depreciable real estate must use straight-line depreciation. I.R.C. §168(b)(3). But, that’s not the case for depreciable real estate that has a recovery period of less than 27.5 years. I.R.C. §168(e)(2)(B). As such, the applicable depreciation method for depreciable farm real estate is the 150 percent declining balance method.
Land improvements. A land improvement is a tangible depreciable item that is added to the underlying land. It is either I.R.C. §1245 or I.R.C. §1250 property. Such items as sidewalks, roads, canals, waterways, wharves, docks, bridges, fences, landscaping, shrubbery and transmission towers all meet the definition of a land improvement. Other land improvements (and similar structures) include such things as silage bunkers, concrete ditches, stock watering pond outlets and wells used for irrigation and livestock watering. See Rev. Proc. 87-56, 1987-2 C.B. 674.
Sometimes farmers and ranchers incur costs for improvements associated with windbreaks, excavation, dredging, and other earth moving activities. The common IRS position on the cost of these types of improvements is that they are not depreciable and must be capitalized into the cost basis of the underlying land. See, e.g., Everson v. United States, 108 F.3d 234 (9th Cir. 1997). However, they might be depreciable if the taxpayer can establish that the improvement will deteriorate over time and ultimately become worthless unless it is maintained (and the exhaustion of the asset can be measured). See, e.g., Ekberg v. United States, No. 711 W.D., 1959 U.S. Dist. LEXIS 4467 (D. S.D. 1959); Rev. Rul. 75-137, 1975-1 C.B. 74; Rudolph Investment Corp. v. Comr., T.C. Memo. 1972-129. Associated maintenance costs would be currently deductible as a repair expense.
Single purpose structures. The definition of a single purpose agricultural or horticultural structure is contained in I.R.C. §48(p), even though that Code section has since been repealed. Under that definition, a single purpose agricultural or horticultural structure is one that is used for the housing, raising and feeding of a particular type of livestock and the associated equipment that is required to properly house, raise and feed the livestock. I.R.C. §48(p)(2)[repealed]. Examples of these structures on a farm include hog houses, poultry barns, livestock sheds, milking parlors and similar structures.
Likewise, a single purpose agricultural or horticultural structure includes a greenhouse that is specifically designed, constructed and used for the commercial production of plants. I.R.C. §48(p)(3)(B)[repealed].
I.R.C. §1245 assets and I.R.C. §38. Assets which have the appearance of a building but qualify as I.R.C. §1245 assets (and not separately classified as single purpose ag or horticultural structures) are not “buildings” Treas. Reg. 1.48-1(e)(1)(i)]. They are, in essence, items of machinery or equipment which are an “integral part of manufacturing [or] production” I.R.C. §1245(a)(3)(B)(i)]. Structures such as storage facilities for potatoes, onions and other cold storage facilities for fruits and vegetables are included in this category. But, if the structure is used for other purposes after the commodities have been removed, the structures are buildings, rather than I.R.C. §1245(a)(3).
Now repealed I.R.C. §48(a)(1)(B)(i) defined property which qualified for the I.R.C. §38 investment tax credit (ITC). The Tax Reform Act of 1986 moved that language into I.R.C. §1245 for depreciation recapture purposes. Thus, property that qualified as pre-1986 investment tax credit property will qualify as property defined under I.R.C. §1245(a)(3).
For property that is easily adaptable to other uses, it is properly classified as a building. For example, a building with a kit installed for commodity storage did not qualify for the ITC. Tamura v. United States, 734 F.2d 470 (9th Cir. 1984); Bundy v. United States, No. CV85-L-575, 1986 U.S. Dist. LEXIS 17497 (D. Neb. 1986). However, if the property is of special design and unsuitable for other uses, it is not a building. See, e.g., Palmer Olson v. Comm., TC Memo 1970-296. Obviously, the proper determination is based on the facts of the particular situation. The key question is whether a particular structure is closely related to the use of the property that it houses based on its design and whether it can be economically used for other purposes. See, e.g., Priv. Ltr. Rul. 200013038 (Dec. 27, 1999).
Farm buildings. Farm buildings are defined by default – they are depreciable structures that don’t fit in any other class. Examples include shops, machine sheds and other general purpose buildings on a farm that are not integral to the manufacturing, production or growing process. “Hoop” structures generally fit in this category as a general purpose farm building. At least that’s the likely IRS position. Granted, a fact-dependent argument can be made that a hoop structure is used as an integral part of production or is akin to a bulk storage facility used in connection with production. If that argument prevails, a hoop structure is I.R.C. §1245 property with no class life and a seven-year recovery period. In that case, a hoop structure would be eligible for I.R.C. §179 depreciation, and would also potentially be eligible for first-year “bonus” depreciation. The key to the determination a hoop structure’s status is determining whether it is easily adaptable to other uses. If it is, it is properly classified as a “building.”
What About I.R.C. §179 Depreciation?
The Tax Cuts and Jobs Act (TCJA) increased the maximum level of expense method (I.R.C. §179) depreciation to $1,000,000 with the phase-out set at $2,500,000 of qualified assets purchased and placed in service during the year. Do the various structures mentioned above qualify for I.R.C. §179? If the structure is a general purpose ag building, it would not qualify for I.R.C. §179 depreciation. However, property that is “other property,” that is not a building or its structural components, used as an integral part of manufacturing or production qualifies for I.R.C. §179. I.R.C. §179(d)(1)(B). That definition includes single purpose ag and horticultural structures. I.R.C. §1245(a)(3)(D)]. Land improvements, such as irrigation and livestock watering wells and silage bunkers, may qualify for I.R.C. §179 if they are used in the manufacturing, production or growing process. I.R.C. §1245(a)(3)(B)(i). Similarly, grain storage in connection with a manufacturing and production activity qualifies for I.R.C. §179 by virtue of I.R.C. §1245(a)(3)(B)(iii).
The TCJA made changes to the Code’s cost recovery provisions. For tax years beginning after 2017, a five-year recovery period applies for machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which commences with the taxpayer and is placed in service after December 31, 2017.
The TCJA also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3, 5, 7, and 10-year property). But, the 150 percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight-line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method.
However, those TCJA modifications don’t change the rules for determining what is a “farm building” or depreciable farm real property. Those tricky rules and factual situations remain.
Monday, October 22, 2018
The purpose of the Clean Water Act (CWA) is to eliminate the discharge of pollutants into the nation's waters without a permit. The CWA recognizes two sources of pollution. Point source and nonpoint source pollution. Under the CWA, point source pollution is the concern of the federal government and it is the type of pollution that comes from a clearly discernable discharge point, such as a pipe, a ditch, or a concentrated animal feeding operation. Nonpoint source pollution, while not specifically defined under the CWA, is pollution that comes from a diffused point of discharge, such as fertilizer runoff from an open field. Control of nonpoint source pollution is to be handled by the states through enforcement of state water quality standards and area-wide waste management plans.
What if pollution enters CWA-regulated waters (“Waters of the United States”) through groundwater? Is groundwater a point source of pollution? If so, that has serious implications for agriculture. A recent federal appeals court opinion brings good news for agriculture. It also creates a split amongst the courts that the U.S. Supreme Court may be asked to resolve.
Groundwater and point-source pollution – that’s the topic of today’s post.
The CWA and “Point Source” Pollution
No one may discharge a “pollutant” from a point source into the “navigable waters of the United States” without a permit from the EPA. An NPDES permit is not required unless there is an “addition” of a pollutant to regulable waters. See e.g., Friends of the Everglades, et al. v. South Florida Water Management District, et al., 570 F.3d 1210 (11th Cir. 2009) reh’g., den., 605 F.3d 962 (11th Cir. 2010), cert. den., 131 S. Ct. 643 (2010).
The definition of “pollutant” has been construed broadly to include the tillage of soil which causes the soil to be “redeposited” into delineated wetlands constitutes the discharge of a “pollutant” into the navigable waters of the United States requiring an NPDES permit. See, Duarte Nursery, Inc. v. United States Army Corps of Engineers , No. 2:13-cv-02095-KJM-AC, 2016 U.S. Dist. LEXIS 76037 (E.D. Cal. Jun. 10, 2016). The court also determined that farming equipment, a tractor and ripper attachment constituted a point source pollutant under the CWA. The discharge was not exempt under the “established farming operation” exemption of 33 U.S.C. §1344(f)(1) because farming activities on the tract had not been established and on-going but had been grazed since 1988. As a result, the planting of wheat could not be considered a continuation of established and on-going farming activities. Id.
Under 1977 amendments to the CWA, irrigation return flows are not considered point sources. See, e.g., Pacific Coast Federation of Fishermen’s Associations, et al. v. Glaser, et al., No. CIV S-2:11-2980-KJM-CKD, 2013 U.S. Dist. LEXIS 132240 (E.D. Cal. Sept. 16, 2013). In Pacific Coast, the plaintiff directly challenged the exemption of tile drainage systems from CWA regulation via “return flows from irrigated water” on the basis that groundwater discharged from drainage tile systems is separate from any irrigation occurring on farms and is, therefore, not exempt. In dismissing the case, the court also noted that “return flows” narrows the type of water permissibly discharged from irrigated agriculture and covers discharges from irrigated agriculture that don’t contain additional discharges unrelated to crop production.
What About Groundwater?
The NPDES system only applies to discharges of pollutants into surface water. Discharges of pollutants into groundwater are not subject to the NPDES permit requirement even if the groundwater is hydrologically connected to surface water. Indeed, the legislative history of the CWA demonstrates that the Congress, did not intend that the CWA regulate hydrologically-connected groundwater. Groundwater regulation was to be left to the states as nonpoint source pollution. See, e.g., Umatilla Water Quality Protective Association v. Smith Frozen Foods, 962 F. Supp. 1312 (D. Or. 1997).
While it seems clear that the CWA was never intended to apply to pollution discharges into groundwater that eventually finds its way into a WOTUS, in recent years a split has developed between a few of the federal circuit courts of appeal. For example, in Upstate Forever, et al. v. Kinder Morgan Energy Partners, LP, et al., 887 F.3d 637 (4th Cir. 2018), the plaintiffs, a consortium of environmental and conservation groups, brought a citizen suit under the Clean Water Act (CWA) claiming that the defendant violated the CWA by discharging “pollutants” into the navigable waters of the United States without a required discharge permit via an underground ruptured gasoline pipeline owned by the defendant’s subsidiary. The plaintiff claimed that a discharge permit was needed because the CWA defines “point source pollutant” (which requires a discharge permit) as “any discernible, confined and discrete conveyance, included but not limited to any…well…from which pollutants are or may be discharged.”
The trial court dismissed the plaintiffs’ claim, but the appellate court held that a pollutant can first move through groundwater before reaching navigable waters and still constitute a “discharge of a pollutant” under the CWA that requires a federal discharge permit. The discharge need not be channeled by a point source until reaching navigable waters that are subject to the CWA. The appellate court did, however, point out that a discharge into groundwater does not always mean that a CWA discharge permit is required. A permit in such situations is only required if there is a direct hydrological connection between groundwater and navigable waters. In the present case, however, the appellate court noted that the pipeline rupture occurred within 1,000 feet of the navigable waters. The court noted that the defendant had not established any independent or contributing cause of pollution.
Similarly, in Hawai’i Wildlife Fund v. Cty. of Maui, 881 F.3d 754 (9th Cir. 2018), the defendant owned and operated four wells at the Lahaina Wastewater Reclamation Facility (LWRF), which is the principal municipal wastewater treatment plant for a city. Although constructed initially to serve as a backup disposal method for water reclamation, the wells became the defendant’s primary means of effluent disposal into groundwater and, ultimately, the Pacific Ocean. The LWRF received approximately 4 million gallons of sewage per day from a collection system serving approximately 40,000 people. That sewage was treated at LWRF and then either sold to customers for irrigation purposes or injected into the wells for disposal. The defendant injected approximately 3 to 5 million gallons of treated wastewater per day into the groundwater via its wells. The defendant conceded, and its expert, confirmed that wastewater injected into wells 1 and 2 enters the Pacific Ocean. In addition, in June 2013 the EPA, the Hawaii Department of Health, the U.S. Army Engineer Research and Development Center, and researchers from the University of Hawaii conducted a study on wells 2, 3 and 4. The study involved placing tracer dye into Wells 2, 3, and 4, and monitoring the submarine seeps off Kahekili Beach to see if and when the dye would appear in the Pacific Ocean. This study, known as the Tracer Dye Study, found that 64% of the treated wastewater from wells 3 and 4 discharged into the ocean.
The plaintiff sued, claiming that the defendant was in violation CWA by discharging pollutants into a WOTUS without a permit. The trial court agreed, holding that a permit was required for effluent discharges into navigable waters via groundwater. On appeal, the appellate court held that the wells were point sources that could be regulated through CWA permits despite the defendant’s claim that a permit was not required because the wells discharged only indirectly into the Pacific Ocean via groundwater. Specifically, the appellate court held that “a point source discharge to groundwater of “more than [a] de minimis” amount of pollutants that is “fairly traceable from the point source . . . such that the discharge is the functional equivalent of a discharge into a navigable water” is regulated under the CWA.”
A recent decision by the U.S. Circuit Court of Appeals for the Sixth Circuit, however, reached a different decision. In Tennessee Clean Water Network v. Tennessee Valley Authority, No. 17-6155, 2018 U.S. App. LEXIS 27237 (6th Cir. Sept. 24, 2018). The defendant, a utility that burns coal to produce energy, produces coal ash as a byproduct. The coal ash is discharged into man-made ponds. The plaintiffs, environmental activist groups, claimed that the chemicals from the coal ash in the ponds leaked into surrounding groundwater where it was then carried to a nearby lake that was subject to regulation under the Clean Water Act (CWA). The plaintiffs claimed that the contamination of the lake without a discharge permit violated the CWA and the Resource Conservation and Recovery Act (RCRA). The trial court had dismissed the RCRA claim but the appellate court reversed that determination and remanded the case on that issue.
On the CWA claim, the trial court ruled as a matter of law that the CWA applies to discharges of pollutants from a point source through hydrologically connected groundwater to navigable waters where the connection is "direct, immediate, and can generally be traced." The trial court held that the defendant’s facility was a point source because it "channel[s] the flow of pollutants . . . by forming a discrete, unlined concentration of coal ash," and that the Complex is also a point source because it is "a series of discernible, confined, and discrete ponds that receive wastewater, treat that wastewater, and ultimately convey it to the Cumberland River." The trial court also determined that the defendant’s facility and the ponds were hydrologically connected to the Cumberland River by groundwater. As for the defendant’s facility, the court held that "[f]aced with an impoundment that has leaked in the past and no evidence of any reason that it would have stopped leaking, the Court has no choice but to conclude that the [defendant’s facility] has continued to and will continue to leak coal ash waste into the Cumberland River, through rainwater vertically penetrating the Site, groundwater laterally penetrating the Site, or both." The trial court determined that the physical properties of the terrain made the area “prone to the continued development of ever newer sinkholes or other karst features." Thus, based on the contaminants flowing from the ponds, the court found defendant to be in violation of the CWA. The trial court also determined that the leakage was in violation of the defendant “removed-substances” and “sanitary-sewer” overflow provisions. The trial court ordered the defendant to "fully excavate" the coal ash in the ponds (13.8 million cubic yards in total) and relocate it to a lined facility.
On further review, the appellate court reversed. The appellate court held that the CWA does not apply to point source pollution that reaches surface water by means of groundwater movement. The appellate court rejected the plaintiffs’ assertion that mere groundwater is equivalent to a discernable point source through which pollutants travel to a CWA-regulated body of water. The appellate court noted that, to constitute a “conveyance” of groundwater governed by the CWA, the conveyance must be discernible, confined and discrete. While groundwater may constitute a conveyance, the appellate court reasoned that it is neither discernible, confined nor discrete. Rather, the court noted that groundwater is a “diffuse medium” that “seeps in all directions, guided only by the general pull of gravity. This it [groundwater] is neither confined nor discrete.” In addition, the appellate court noted that the CWA only regulates pollutants “…that are added to navigable waters from any point source.” In so holding, the court rejected the holdings in of the prior decisions of the Fourth and Ninth Circuits.
The Sixth Circuit’s decision is a breath of fresh air for agriculture. It is the state’s responsibility to regulate nonpoint source pollution. A hydrological connection was never intended to suffice for federal jurisdiction under the CWA, and the Sixth Circuit said that the other courts finding as such was “misguided.” The Sixth Circuit stated, “Reading the CWA to extend liability to groundwater pollution is not the best one.”
Groundwater is not a point source. The Sixth Circuit’s opinion has big implications for agricultural farming activities and will help keep the federal government out of the farm field in Kentucky, Michigan, Ohio and Tennessee. It’s also likely that the U.S. Supreme Court will be asked to clear up the split between the circuit courts. Stay tuned.
Thursday, October 18, 2018
For the Spring 2019 academic semester, Kansas State University will be offering my Agricultural Law and Economics course online. No matter where you are located, you can enroll in the course and participate in it as if you were present with the students in the on-campus classroom.
Details of next spring’s online Ag Law course – that’s the topic of today’s post.
The course provides a broad overview of many of the issues that a farmer, rancher, rural landowner, ag lender or other agribusiness will encounter on a daily basis. As a result, the course looks at contract issues for the purchase and sale of agricultural goods; the peril of oral contracts; the distinction between a lease and a contract (and why the distinction matters); and the key components of a farm lease, hunting lease, wind energy lease, oil and gas lease, and other types of common agricultural contractual matters. What are the rules surrounding ag goods purchased at auction?
Ag financing situations are also covered – what it takes to provide security to a lender when financing the purchase of personal property to be used in the farming business. In addition, the unique rules surrounding farm bankruptcy is covered, including the unique tax treatment provided to a farmer in Chapter 12 bankruptcy.
Of course, farm income tax is an important part of the course. Tax planning is perhaps the most important aspect of the farming business that every day decisions have an impact on and are influenced by. As readers of this blog know well, farm tax issues are numerous and special rules apply in many instances. The new tax law impacts many areas of farm income tax.
Real property legal issues are also prevalent and are addressed in the course. The key elements of an installment land contract are covered, as well as legal issues associated with farm leases. Various types of interests in real estate are explained – easements; licenses; profits, fee simples, remainders, etc. Like-kind exchange rules are also covered as are the special tax rules (at the state level) that apply to farm real estate. A big issue for some farmers and ranchers concerns abandoned railways, and those issues are covered in the course. What if an existing fence is not on the property line?
Farm estate and business planning is also a significant emphasis of the course. What’s the appropriate estate plan for a farm and ranch family? How should the farming business be structured? Should multiple entities be used? Why does it matter? These questions, and more, are addressed.
Agricultural cooperatives are important for the marketing of agricultural commodities. How a cooperative is structured and works and the special rules that apply are also discussed.
Because much agricultural property is out in the open, that means that personal liability rules come into play with respect to people that come onto the property or use farm property in the scope of their employment. What are the rules that apply in those situations? What about liability rules associated with genetically modified products? Ag chemicals also pose potential liability issues, as do improperly maintained fences? What about defective ag seed or purchased livestock that turns out to not live up to representations? These issues, and more, are covered in the scope of discussing civil liabilities.
Sometimes farmers and ranchers find themselves in violation of criminal laws. What are those common situations? What are the rules that apply? We will get into those issue too.
Water law is a very big issue, especially in the western two-thirds of the United States. We will survey the rules surrounding the allocation of surface water and ground water to agricultural operations.
Ag seems to always be in the midst of many environmental laws – the “Clean Water Rule” is just one of those that has been high-profile in recent years. We will talk about the environmental rules governing air, land, and water quality as they apply to farmers, ranchers and rural landowners.
Finally, we will address the federal (and state) administrative state and its rules that apply to farming operations. Not only will federal farm programs be addressed, but we will also look at other major federal regulations that apply to farmers and ranchers.
Further Information and How to Register
Information about the course is available here:
You can also find information about the text for the course at the following link (including the Table of Contents and the Index):
If you are an undergraduate student at an institution other than Kansas State, you should be able to enroll in this course and have it count as credit towards your degree at your institution. Consult with your academic advisor to see how Ag Law and Economics will transfer and align with your degree completion goals.
If you have questions, you can contact me directly, or submit your questions to the KSU Global Campus staff at the link provided above.
I hope to see you in January!
Checkout the postcard (401 KB PDF) containing more information about the course and instructor.
October 18, 2018 in Bankruptcy, Business Planning, Civil Liabilities, Contracts, Cooperatives, Criminal Liabilities, Environmental Law, Estate Planning, Income Tax, Insurance, Real Property, Regulatory Law, Secured Transactions, Water Law | Permalink | Comments (0)
Tuesday, October 16, 2018
In recent years, all states except California and Maryland have enacted Equine Activity Liability Acts designed to encourage the continued existence of equine-related activities, facilities and programs, and provide the equine industry limited protection against lawsuits. The laws vary from state-to-state, but generally require special language in written contracts and liability releases or waivers, require the posting of warning signs and attempt to educate the public about inherent risks in horse-related activities and immunities designed to limit liability. The basic idea of these laws is to provide a legal framework to incentivize horse-related activities by creating liability protection for horse owners and event operators.
Equine activity laws – that’s the topic of today’s post.
State Law Variations
The typical statute covers an “equine activity sponsor,” “equine professional,” or other person (such as an employer in an employment setting involving livestock) and specifies that such "covered" person can only be sued in tort for damages related to the knowing provision of faulty tack, failure to determine the plaintiff’s ability to safely manage a horse, or failure to post warning signs concerning dangerous latent conditions. See, e.g., Baker v. Shields, 767 N.W.2d 404 (Iowa 2009); Pinto v. Revere Saugus Riding Academy, No. 08-P-318, 2009 Mass. App. LEXIS 746 (Mass. Ct. App. Jun. 8, 2009). For example, in Germer v. Churchill Downs Management, No. 3D14-2695, 2016 Fla. App. LEXIS 13398 (Fla. Ct. Ap. Sept. 7, 2016), state law “immunized” (among other things) an equine activity sponsor from liability to a “participant” from the inherent risks of equine activities. The plaintiff, a former jockey visited a race course that the defendant managed. It was a spur-of-the-moment decision, but he was required to get a guest pass to enter the stables. He was injured by a horse in the stables and the court upheld the immunity provisions of the statute on the basis that the requirement to get a guest pass before entering the stables was sufficient protocol to amount to “organization” which made the plaintiff’s visit to the stables “an organized activity” under the statute.
While many state equine activity laws require the postage of warning signs and liability waivers, not every state does. For example, the statutes in CT, HI, ID, MT, NH, ND, UT, WA and WY require neither signage nor particular contract language.
Recovery for damages resulting from inherent risks associated with horses is barred, and some state statutes require the plaintiff to establish that the defendant’s conduct constituted “gross negligence,” “willful and wanton misconduct,” or “intentional wrongdoing.” For example, in Snider v. Fort Madison Rodeo Corp., No. 1-669/00-2065, 2002 Iowa App. LEXIS 327 (Iowa Ct. App. Feb. 20, 2002), the plaintiff sued a parade sponsor and a pony owner for injuries sustained in crossing the street during a parade. The court determined that the omission of a lead rope was not reckless conduct and that the plaintiff assumed the risk of crossing the street during the parade. Similarly, in Markowitz v. Bainbridge Equestrian Center, Inc., No. 2006-P-0016, 2007 Ohio App. LEXIS 1411 (Ohio Ct. App. Mar. 30, 2007), the court held that there was no evidence present that the plaintiff’s injuries sustained in the fall from a horse was a result of the defendant’s willful or wanton conduct or reckless indifference. In addition, the signed liability release form complied with statutory requirements. However, in Teles v. Big Rock Stables, L.P., 419 F. Supp. 2d 1003 (E.D. Tenn. 2006), the provision of a saddle with stirrups that could not be shortened enough to reach plaintiff’s feet which then caused the plaintiff to fall from a horse raised jury question as to whether faulty tack provided, whether the fall was the result of the inherent risk of horseback riding, and whether the defendant’s conduct was willful or grossly negligent and, thus, not covered by the signed liability release form.
What constitutes an “inherent risk” from horse riding is a fact issue in many states due to the lack of any precise definition of “inherent risk” in the particular state statute. For example, under the Texas Equine Activity Liability Act, the phrase “inherent risk of equine activity” refers to risks associated with the activity rather than simply those risks associated with innate animal behavior. See, e.g., Loftin v. Lee, No. 09-0313, 2011 Tex. LEXIS 326 (Tex. Sup. Ct. Apr. 29, 2011). The Ohio equine activities immunity statute has been held to bar recovery for an injury incurred while assisting an employer unload a horse from a trailer during a day off, because the person deliberately exposed themselves to an inherent risk associated with horses and viewed the activity as a spectator. Smith v. Landfair, No. 2011-1708, 2012 Ohio LEXIS 3095 (Ohio Sup. Ct. Dec. 6, 2012). Also, in Einhorn v. Johnson, et al., No. 50A03-1303-CT-93, 2013 Ind. App. LEXIS 495 (Ind. Ct. App. Oct. 10, 2013), the Indiana Equine Activity Act barred a negligence action after a volunteer at a county fair was injured by a horse. The plaintiff’s injuries were determined to result from the inherent risk of equine activities. Likewise, in Holcomb v. Long, No. A14A0815, 2014 Ga. App. LEXIS 726 (Ga. Ct. App. Nov. 10, 2014), the Georgia Equine Activities Act barred recovery for injuries sustained as a result of slipping saddle during horseback ride; slipping saddle inherent risk of horseback riding. See also, Fishman v. GRBR, Inc., No. DA 17-0214, 2017 Mont. LEXIS 602 (Mont. Sup. Ct. Oct. 5, 2017).
In Franciosa v. Hidden Pond Farm, Inc., No. 2017-0153 2018 N.H. LEXIS 174 (N. H. Sup. Ct. Sept. 21, 2018), the plaintiff was severely injured in a horseback riding accident. At the time of the accident, she was thirteen years old, had been riding horses for eight years, and had been taking weekly riding lessons from the defendant, an expert equestrian, for almost two years. Approximately once each seek, the plaintiff went for a “free ride”—a ride that did not involve a lesson. On those occasions the defendant was not always present, and no one was assigned to supervise the plaintiff. The day before the accident the plaintiff texted the defendant to arrange a lesson for the following day. The defendant texted the plaintiff that, although she would not be present at the farm on the following day, the plaintiff had permission to take a free ride on a horse that the plaintiff had ridden without incident on at least two occasions.
The next day after riding the horse for about 30 minutes the plaintiff fell to the ground as she tried to dismount and was seriously injured when the horse subsequently stepped on her. The plaintiff sued, and the defendant moved for summary judgment on the basis that the equine immunity provisions set forth N.H. Rev. Stat. §508:19 barred the plaintiff’s negligence claim. The plaintiff then filed a cross-motion for partial summary judgment, arguing that the plaintiff’s injuries were not caused by an “inherent risk” of horseback riding and, therefore, the defendant was not immune from liability. Alternatively, the plaintiff argued that even if the statute applied, a jury trial was necessary to resolve issues of material fact regarding the statutory exceptions in N.H. Rev. Stat. §508:19. The trial court entered summary judgment for the defendant, denied the plaintiff’s cross motion, and also denied the plaintiff’s motion for reconsideration.
On further review, the appellate court held that the statute clearly operated “to shield persons involved in an equine activity from liability for negligence claims related to a participant’s injuries resulting from the inherent risks of equine circumstances.” The appellate court also determined that it didn’t have to decide whether the defendant’s physical absence and inability to supervise the plaintiff at the time of the accident placed the accident outside of the risks inherent in equine activities, because under RSA 508:19, I(f)(5) a failure to take “corrective measures” was relevant only when the participant was negligent and that negligence can be reasonably foreseen, which was not present in the case. The court also determined that there was no evidence to support the plaintiff’s argument that the defendant’s failure to supervise the plaintiff amounted to willful or wanton disregard for the plaintiff’s safety. Consequently, the appellate court held that the trial court did not err in holding that the defendant was entitled to immunity under N.H. Rev. Stat. §508:19. As such, the decisions of the trial court were affirmed.
State Equine Activity Liability laws are designed to provide liability protection for injuries arising from horse-related activities. If you have horses or are involved in horse-related activities, it might be a good idea to determine what rules your particular state has.
Friday, October 12, 2018
Interest in the corporate form of farm or ranch organization has varied over the years. That interest has generally peaked when corporate rates are lower compared to rates applicable to individuals and pass-through entities. In the 1970s, many farming operations were incorporated for succession planning reasons. But, with the Tax Cuts and Jobs Act (TCJA) establishing a flat C corporate rate of 21 percent effective for tax years beginning after 2017, some taxpayers may be enticed to structure their business in the C corporate form.
Is the C corporation a good business format for a farming operation? As with many tax planning considerations, numerous factors must be accounted for. Farming C corporations post-TCJA – that’s the topic of today’s post.
For tax years beginning before 2018, corporations paid tax on income at progressive marginal rates, with the first $50,000 of taxable income taxed at 15 percent. Dividends paid by a corporation (if any) to its shareholders were (and still are) generally taxed to the shareholder at a 15 percent or 20 percent rate. That combined 30 percent rate (15 percent on corporate income and 15 percent rate on the dividend) was less than the 39.6 rate which was the highest marginal rate for individuals. Thus, if a farm corporation’s income could be kept at approximately $50,000 of taxable income a year, tax savings could be achieved in the corporate structure. The tax planning for many farming C corporations was designed to accomplish that objective.
For tax years beginning after 2017, however, the C corporate rate is a flat 21 percent and no domestic production deduction of nine percent (I.R.C. §199) is available. In addition, for tax years beginning after 2017, a C corporation cannot claim the 20 percent deduction for qualified business income. I.R.C. §199A. This all means that for many farming corporations, the effective tax rate in 2018 could be at least 40 percent higher than it was in 2017 (at least through 2025).
But, it is also true that many farm C corporations were established as means of providing tax-deductible meals and lodging to the owners on a tax-free (to the owners) basis. That can still be done post-2017, except that the deduction for the cost of meals is only 50 percent rather than being fully deductible.
In general, firms turn to the corporation because they are seeking a collection of advantages they cannot achieve with a partnership, joint venture, limited partnership or limited liability company. For instance, the corporation provides a means for simplified internal accounting, extension of the planning horizon and a way to keep the business together beyond the present generation. Also, if plans are not made for continuity of the farm or ranch business, there is a tendency for individuals, over time, to focus less on the future. This causes decision making to be less than optimal. The corporation, as an entity of perpetual existence, helps to extend the planning horizon over which decisions are made which may result in a more rational set of economic decisions.
The corporation also tends to smooth the family farm cycle and make it possible for the continuation of the operation into subsequent generations with greater efficiency. Empirical studies in several states reveal that four major factors account for most of the decisions to incorporate in those states. These factors are: (1) ease of transferring interests in property by transferring shares of stock to accomplish specific estate planning objectives; (2) possibilities for planning management and ownership succession to make continuation of the business easier after death of the original owners; (3) avoidance of full owner liability for obligations of the business through shareholder limited liability; and (4) opportunities for income tax saving.
Thus, there still exist significant non-tax reasons to form a farming C corporation. However, it may not be the best entity structure for federal farm program payment limitation purposes. If a C corporation (or any other entity that limits liability) is the farming entity, the Farm Service Agency will limit the eligibility for payment limitations to the entity itself. Then, the owners of that entity will have to split the amount of government payments attributable to the one “person” determination between themselves. If a pass-through entity were utilized that did not limit owner liability at the entity level, then each owner (member) of the entity would be entitled to its own payment limit.
Anti-Corporate Farming Laws
When it comes to agricultural law and agricultural taxation, special rules apply in many situations. One of those special situations involves farming corporations. Historically, the first significant wave of interest in the corporate form for farm and ranch businesses dates back to the 1920s at a time when change was occurring very rapidly in the agricultural industry. The prevailing belief at the time was that the mechanization of agriculture was going to produce a few large “factories in the field.” This widespread belief produced a wave of state legislation, much of it still in existence today, limiting the use of the farm or ranch corporation. Kansas was the first state to legislate anti-corporate farming restrictions. Other states, primarily in the Midwest and the Great Plains, followed suit. Restrictions were enacted (in addition to Kansas) in North Dakota, Oklahoma, Minnesota, South Dakota, Missouri, Wisconsin, Nebraska and Iowa. Other restrictions were enacted in Colorado, Texas, West Virginia and South Carolina. In many of these states, the restrictions remain on the books (albeit modified in some states).
Recent case. The North Dakota anti-corporate farming restriction bars corporations, other than family farming corporations, from owning farm land and engaging in farming or agriculture. The specific statutory language states: “All corporations and limited liability companies, except as otherwise provided in this chapter, are prohibited from owning or leasing land used for farming or ranching and from engaging in the business of farming or ranching. A corporation or a limited liability company may be a partner in a partnership that is in the business of farming or ranching only if that corporation or limited liability company complies with this chapter.” However, by virtue of a 1981 amendment, the statute also states: “This chapter does not prohibit a domestic corporation or a domestic limited liability company from owning real estate and engaging in the business of farming or ranching, if the corporation meets all the requirements of chapter 10-19.1 or the limited liability company meets all the requirements of chapter 10-32.1 which are not inconsistent with this chapter.” This amended language became known as the “family farm exception” because it requires shareholders to have a close family relation who is actively engaged in the operation. Historically, the state attorney general and secretary of state have interpreted the “family farming” exception as a way to allow out-of-state family farming corporations to own farm land and conduct agricultural operations in North Dakota. However, in North Dakota Farm Bureau, Inc. v. Stenehjem, No. 1:16-cv-137, 2018 U.S. Dist. LEXIS 161572 (D. N.D. Sep. 21, 2018), the plaintiff, North Dakota’s largest farm group along with other family farming corporations challenged the law as written on the basis that the law violated the “Dormant Commerce Clause” as discriminating against interstate commerce. The court agreed, enjoining the State from enforcing the family farm exception against out-of-state corporations that otherwise meet the statutory requirements (which the State didn’t do anyway).
The C corporation remains a viable entity structure for the farm or ranch business. While some of the tax advantage has been reduced, other factors indicate that the C corporation still has its place. In any event, wise tax and legal counsel should be consulted to determine the right approach for any particular situation
Wednesday, October 10, 2018
The changes made by the Tax Cuts and Jobs Act (TCJA) for tax years beginning after 2017 could have a significant impact on charitable giving. Because of changes made by the TCJA, it is now less likely that any particular taxpayer will itemize deductions. Without itemizing, the tax benefit of making charitable deductions will not be realized. This has raised concerns by many charities.
Are there any tax planning strategies that can be utilized to still get the tax benefit from charitable deductions? There might be. One of those strategies is the donor-advised fund.
Using a donor-advised fund for charitable giving post-TCJA – that’s the topic of today’s post.
A taxpayer gets the tax benefit of charitable deductions by claiming them on Schedule A and itemizing deductions. However, the TCJA eliminates (through 2025) the combined personal exemption and standard deduction and replaces them with a higher standard deduction ($12,000 for a single filer; $24,000 for a couple filing as married filing jointly). The TCJA also either limits (e.g., $10,000 limit on state and local taxes) or eliminates other itemized deductions. As a result, it is now less likely that a taxpayer will have Schedule A deductions that exceed the $12,000 or $24,000 amount. Without itemizing, the tax benefit of charitable deductions is lost. This is likely to be particularly the case for lower and middle-income taxpayers.
One strategy to restore the tax benefit of charitable giving is to bundle two years (or more) of gifts into a single tax year. Doing so can cause the total amount of itemized deductions to exceed the standard deduction threshold. Of course, this strategy results in the donor’s charities receiving a nothing in one year (or multiple years) until the donation year occurs.
A better approach than simple bundling (or bunching) of gifts might be to contribute assets to a donor-advised fund. It’s a concept similar to that of bundling, but by means of a vehicle that provides structure to the bundling concept, with greater tax advantages. A donor-advised fund is viewed as a rather simple charitable giving tool that is versatile and affordable. What it involves is the contribution of property to a separate fund that a public charity maintains. That public charity is called the “sponsoring organization.” The donor retains advisory input with respect to the distribution or investment of the amounts held in the fund. The sponsoring organization, however, owns and controls the property contributed to the fund, and is free to accept or reject the donor’s advice.
While the concept of a donor-advised fund has been around for over 80 years, donor-advised funds really weren’t that visible until the 1980s. Today, they account for approximately 4-5 percent of charitable giving in the United States. Estimates are that over $150 billion has been accumulated in donor advised funds over the years. Because of their flexibility, ease in creating, and the ability of donors to select from pre-approved investments, donor advised funds outnumber other type of charitable giving vehicles, including the combined value included in charitable remainder trusts, charitable remainder annuity trusts, charitable lead trusts, pooled income funds and private foundations.
Mechanics. The structure of the transaction involves the taxpayer making an irrevocable contribution of personal assets to a donor-advised fund account. The contribution is tax deductible. Thus, the donor gets a tax deduction in the year of the contribution to the fund, and the funds can be distributed to charities over multiple years.
The donor also selects the fund advisors (and any successors) as well as the charitable beneficiaries (such as a public charity or community foundation). The amount in the fund account is invested and any fund earnings grow tax-free. The donor also retains the ability to recommend gifts from the account to qualified charities along with the fund advisors. The donor cannot, however, have the power to select distributes or decide the timing or amounts of distributions from the fund. The donor serves in a mere advisory role as to selecting distributees, and the timing and amount of distributions. If the donor retains control over the assets or the income the transaction could end up in the crosshairs of the IRS, with the fund’s tax-exempt status denied. See, I.R. News Release 2006-25, Feb. 7, 2006; New Dynamics Foundation v. United States, 70 Fed. Cl. 782 (2006).
No time limitations apply concerning when the fund assets must be distributed, but the timing of distributions is discretionary with the donor and the fund advisors.
When highly appreciated assets are donated to a donor advised fund, the donor’s overall tax liability can be reduced, capital gain tax eliminated, and a charity can benefit from a relatively larger donation. For taxpayer’s that are retiring, or have a high-income year, a donor advised fund might be a particularly good tax strategy. In addition, a donor advised fund can be of greater benefit because the TCJA increases the income-based percentage limit on charitable donations from 50 percent of adjusted gross income (AGI) to 60 percent of AGI for cash charitable contributions to qualified charities made in any tax year beginning after 2017 and before 2026. The percentage is 30 percent of AGI for gifts of appreciated securities, mutual funds, real estate and other assets. Any excess contributed amount of cash may be carried forward for five years. I.R.C. §170(b)(1)(G)(ii).
Donor-advised funds are not cost-free. It is common for a fund to charge an administrative fee in the range of 1 percent annually. That’s in addition to any fees that might apply to assets (such as mutual funds) that are contributed to the donor advised fund. Also, the fund might charge a fee for every charitable donation made from the fund. That’s likely to be the case for foreign charities.
In addition, as noted above, the donor can only recommend the charities to be benefited by gifts from the fund. For example, in 2011 the Nevada Supreme Court addressed the issue of what rights a donor to a donor advised fund has in recommending gifts from the fund. In Styles v. Friends of Fiji, No. 51642, 2011 Nev. Unpub. LEXIS 1128 (Nev. Sup. Ct. Feb. 8, 2011), the sponsoring charity of the donor-advised fund used the funds in a manner other than what the donor recommended by completely ignoring the donor’s wishes. The court found that to be a breach of the duty of good faith and fair dealing by the fund advisors. But, the court determined that the donor didn’t have a remedy because he had lost control over his contributed assets and funds based on the agreement he had signed at the time of the contribution to the donor-advised fund. As a result, the directors of the organization that sponsored the donor-advised fund could use the funds in any manner that they wished. That included paying themselves substantial compensation, paying legal fees to battle the donor in court, and sponsoring celebrity golf tournaments.
Also, an excise tax on the sponsoring organization applies if the sponsoring organization makes certain distributions from the fund that don’t satisfy a defined charitable purpose. I.R.C. §4966. Likewise, an excise tax applies on certain distributions from a fund that provide more than an incidental benefit to a donor, a donor-advisor, or related persons. I.R.C. §4967.
The TCJA changes the landscape (at least temporarily) for charitable giving for many taxpayers. To get the maximum tax benefit from charitable gifts, many taxpayers may need to utilize other strategies. One of those might include the use of the donor-advised fund. If structured properly, the donor-advised fund can be a good tool. However, there are potential downsides. In any event, competent tax counsel should be sought to assist in the proper structuring of the transaction.
Monday, October 8, 2018
The Tax Cuts and Jobs Act (TCJA) has made estate planning much easier for most farm and ranch families. Much easier, that is, with respect to avoiding the federal estate tax. Indeed, under the TCJA, the exemption equivalent of the unified credit is set at $11.18 million per decedent for deaths in 2018, and an unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax. Indeed, according to the IRS, there were fewer than 6,000 estates that incurred federal estate tax in 2017 (out of 2.7 million decedent’s estates). In 2017, the exemption was only $5.49 million. For 2018, the IRS projects that there will be slightly over 300 taxable estates.
The TCJA also retains the basis “step-up” rule. That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death. I.R.C. §1014.
But, with the slim chance that federal estate tax will apply, should estate planning be ignored? What are the basic estate planning strategies for 2018 and for the life of the TCJA (presently, through 2025)?
Married Couples (and Singles) With Wealth Less Than $11.18 Million.
Most people will be in this “zone.” For these individuals, the possibility and fear of estate tax is largely irrelevant. But, there is a continual need for the guidance of estate planners. The estate planning focus for these individuals should be on basic estate planning matters. Those basic matters include income tax basis planning – utilizing strategies to cause inclusion of property in the taxable estate so as to get a basis “step-up” at death.
Existing plans should also focus on avoiding common errors and look to modify outdated language in existing wills and trusts. For example, many estate plans utilize "formula clause" language. That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction. The intended result of the language is to cause that trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption, and create a life estate in the credit shelter trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon death. As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.
But, here’s the rub. As noted above, the TCJA’s increase in the exemption could cause an existing formula clause to “overfund” the credit shelter trust with up to the full federal exemption amount of $11.18 million. This formula could potentially result in a smaller bequest for the benefit of the surviving spouse to the marital trust than was intended, or even no bequest for the surviving spouse at all. It all depends on the value of assets that the couple holds. The point is that couples should review any existing formula clauses in their current estate plans to ensure they are still appropriate given the increase in the federal exemption amount. It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.
In addition, for some people, divorce planning/protection is necessary. Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection. Likewise, a consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and qualifying deductions to the entity. The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits. In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for many clients in this wealth range.
Most persons in this zone will likely fare better by not making gifts, and retaining the ability to achieve a basis step-up at death for the heirs. That means income tax basis planning is far more important for most people. Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability It also may be possible to recast insurance to fund state death taxes (presently, 12 states retain an estate tax and six states have an inheritance tax (one state (Maryland) has both)) and serve investment and retirement needs, minimize current income taxes, and otherwise provide liquidity at death.
Other estate planning points for moderate wealth individuals include:
- For life insurance, it’s probably not a good idea to cancel the polity before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance. For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
- Evaluate irrevocable trusts and consider the possibility of “decanting.” I did a blog post on decanting earlier this summer.
- For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $15,000) and make sure to not have inflation adjusting references to the annual exclusion.
- For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
- While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate. This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP. Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
Other Planning Issues
While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern. Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse. A “beneficiary-controlled” trust has also become a popular estate planning tool. This allows assets to pass to the beneficiary in trust rather than outright. The beneficiary can have a limited withdrawal right over principal and direct the disposition of the assets at death while simultaneously achieving creditor protection. In some states, such as Nebraska, the beneficiary can be the sole trustee without impairing creditor protection.
Powers of attorney for both financial and health care remain a crucial part of any estate plan. For a farm family, the financial power should be in addition to the FSA Form 211, and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could.
While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary. Reviewing existing plans with an estate planning professional is important. Also, the TCJA is only temporary. The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation. For deaths in 2026, the federal estate and gift tax exemption is estimated to be somewhere between $6.5 and $7.5 million dollars. While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $11.18 million amount. One thing is for sure – a great deal of wealth is going to transfer in the coming decades. One estimate I have seen is that approximately $30 trillion in asset value will transfer over the next 30-40 years. That’s about a trillion per year over that time-frame. A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.
Is your plan up-to-date?
Thursday, October 4, 2018
The Tax Cuts and Jobs Act (TCJA) added a new section to the Internal Revenue Code (Code) to provide temporary deferral from gross income of capital gains incurred on the sale or exchange of an investment in a Qualified Opportunity Fund. I.R.C. §1400Z-2, as added by TCJA §13823. A Qualified opportunity fund is part of an “Opportunity Zone” - essentially an economically distressed area where long-term investments by a taxpayer in a Qualified Opportunity Fund are incentivized by the deferral of capital gain taxes. It is not necessary that the investor actually live in the opportunity zone. It’s only required that the taxpayer invest in a Qualified Opportunity Fund.
Farmers and ranchers can qualify to take their capital gains and invest them in a Qualified Opportunity Fund (an investment vehicle that is organized as a corporation or a partnership that holds at least 90 percent of its assets in Qualified Opportunity Zone property) that, in turn, invests in a Qualified Opportunity Zone property So, this new TCJA provision could be of particular interest to farmers and ranchers that have large gains that they are looking to defer capital gain taxes on.
The tax implications of Qualified Opportunity Zone investments – that’s the topic of today’s post.
As noted, I.R.C. §1400Z-2 provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the Qualified Opportunity Fund. I.R.C. §1400Z-2. The fund must be located in a Qualified Opportunity Zone, which is a “designated low-income community population census tract.” The number of designated tracts in any particular State cannot exceed 25 percent of the number of population census tracts in that State that are “low income communities.” A Qualified Opportunity Zone remains in effect for ten calendar years after the date of the designation. I.R.C. §1400Z-1.
A taxpayer that incurs a capital gain but who reinvests it in a Qualified Opportunity Fund that is located in a Qualified Opportunity Zone obtains temporary deferral of that gain (both short-term or long-term). The maximum amount of the deferred gain equals the amount invested in the Qualified Opportunity Fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. Excess capital gains are included in the taxpayer’s gross income. The unrealized gain can then be realized on a tax-deferred basis until at least December 31, 2026. In addition, the taxpayer receives a 10 percent stepped-up basis on the deferred capital gains (10 percent of the amount of the deferred gain) if the investment in the Qualified Investment Fund are held for at least five years, and 15 percent if it is held for at least seven years. Once the investment has been held for 10 years, the tax on the gain is eliminated.
The deferred gain can be elected to be permanently excluded upon the sale or exchange of the investment in a Qualified Opportunity Fund that the taxpayer has held for at least 10 years. What the election does is cause the taxpayer’s income tax basis in the investment to be the fair market value of the investment as of the date of the sale or exchange. In addition, any loss on the investment can be recognized. I.R.C. §1400Z-2.
In Revenue Procedure 2018-16, the IRS announced the designation of Qualified Opportunity Zones in 18 states. In addition, a safe harbor was provided for applying the 25 percent limitation to the number of population census tracts in a State that can be designated as a Qualified Opportunity Zone. Rev. Proc. 2018-16, I.R.B. 2018-9. The IRS noted that a State Governor can nominate a census tract for designation as a Qualified Opportunity Zone by notifying the IRS in writing of the nomination. The IRS then will certify the nomination and designate the tract as a Qualified Opportunity Zone beyond the end of the “consideration period.” I.R.C. §1400Z-1(b).
Earlier this year, the IRS approved submissions for areas in Arizona, California, Colorado, Georgia, Idaho, Kentucky, Michigan, Mississippi, Nebraska, New Jersey, Oklahoma, South Carolina, South Dakota, Vermont and Wisconsin.
In Notice 2018-48, the IRS listed all of the designated Qualified Opportunity Zones. Presently, every state has submitted to the Treasury Department its list of proposed Opportunity Zones. Notice 2018-48, I.R.B. 2018-28.
What About I.R.C. §1031?
The TCJA eliminated (on a permanent basis) the tax-deferred exchange provision under I.R.C. §1031 for exchanges of personal property. Real estate exchanges remain eligible for I.R.C. §1031 treatment. So, how does this new TCJA provision compare with I.R.C. §1031?
- Unlike a real estate trade under I.R.C. §1031, a taxpayer’s investment in a Qualified Opportunity Fund only requires that the capital gains portion from the sale of property be reinvested. An I.R.C. §1031 transaction requires that the entire sale proceeds be reinvested.
- In addition, the investment in a Qualified Opportunity Fund does not have to involve like-kind property, and the investment property can be real or personal.
- The replacement property need not be identified (as it does in an I.R.C. §1031 transaction).
- The 180-day rule applies in both situations. In other words, the closing on the “replacement property” must occur within 180 days with respect to a Qualified Opportunity Zone as well as with respect to an I.R.C. §1031 exchange.
- Also, with respect to an investment in a Qualified Opportunity Zone, a partnership interest is allowed. That’s not the case with an I.R.C. §1031 exchange. The same can be said for stock in a corporation.
- The gain is deferred permanently (excluded from income) if the property is held in a Qualified Opportunity Fund for at least 10 years. With an I.R.C. §1031 exchange, the gain is deferred until the replacement property is sold, unless the gain is deferred in another like-kind exchange (or the taxpayer dies).
- With an investment in a Qualified Opportunity Zone, the sale of the invested property cannot be to a related party. Related party sales are not barred for like-kind exchange property where gain is deferred under I.R.C. §1031, but a two-year rule applies – the property must be held for at least two years after the exchange if a related party is involved.
Assume that Bob owns Blackacre that with a current fair market value of $1,000,000. Bob’s income tax basis in Blackacre is $500,000. Bob sold Blackacre for $1,000,000 on October 1, 2018, resulting in a realized gain of $500,000. Bob has until March 1, 2019 (180 days after the sale date) to invest the sale proceeds in a Qualified Opportunity Fund equal to the amount of gain that he elects to defer.
Now assume that Bob elects to defer the full amount of the realized gain and invests the $500,000 in a Qualified Opportunity Fund in a timely manner. Further assume that Bob sells his investment in the Fund on March 1, 2024, for $600,000. Bob could exclude the lesser of the amount of gain previously excluded ($500,000) or $600,000 (the fair market value of the investment on the sale date). From that $500,000 amount is subtracted Bob’s basis in the Fund investment (initial basis in Fund investment ($0), increased by the amount of the original gain previously recognized ($0)). Thus, Bob’s basis in the Fund’s investment is zero.
Note: Because Bob held the investment for at least five years, his basis is increased by 10 percent of the deferred gain or $50,000 ($500,000 x .10). Had Bob held the investment for at least seven years, he would have qualified for an additional five percent basis adjustment.
Bob’s recognized gain in 2024 associated with the prior deferral would be $450,000 ($500,000 less the $50,000). In 2024, Bob would also recognize a $100,000 gain associated with the sale of his Fund investment. Thus, Bob’s total recognized gain in 2024 is $550,000. If Bob were to hold the investment in the Fund for at least 10 years, he could exclude all of the gain associated with the investment. However, the 10-year holding period has no impact on the taxability of Bob’s original deferred gain. That gain cannot be deferred beyond 2026.
The Opportunity Zone provision of the TCJA is particularly tailored to a taxpayer that has an asset (or assets) with inherent large built-in gain. In other words, the provision may be particularly attractive to a taxpayer with a low income tax basis in the property and the property has appreciated greatly in value. There is a great deal of farm and ranch land that falls into that category. In addition, many opportunity zones are located in rural areas and farmland and timberland investments tend to be long-term. It’s these long-term investments that can be a prime candidate for using this new tax provision.
Tuesday, October 2, 2018
Many farmers and ranchers are reaching retirement age for Social Security benefit purposes. That raises numerous questions involving such things as benefits, earnings, what counts as “wages” and the cash renting of farmland. These are all important questions for farmers and ranchers to have answers to so that appropriate planning can be engaged in and expectations realized.
Social Security benefit planning – that’s the topic of today’s post.
For 2009-2020, the full retirement age for persons born in 1943-1954 is 66. Under present rules, in 2027, the full retirement age will be 67.
During the calendar year in which an individual reaches age 66, an earnings limit applies for the months before the individual reaches full retirement age. For example, for an individual that turns age 66 during 2018, there is a monthly earnings limit of $3,780 ($45,360 ¸ 12 months) for the months before full retirement age is reached. Excess earnings for this period result in a $1 reduction in benefits for each $3 of excess earnings received before attaining the age of 66 years. But, for a person that hasn’t reached full retirement age, benefits are reduced by $1 for every $2 of earnings over the annual limit of $17,040 for 2018. For those drawing benefits after reaching full retirement age, there is no limit on earnings – benefits are not reduced.
An individual can receive full Social Security benefits if they aren’t drawn until full retirement age is achieved. Another way to state it is that if an individual delays taking social security benefits until reaching full retirement age, the individual receives additional benefits for each year of postponement until reaching age 70. The rate of increase is a fraction of one percent per month. In essence, the impact of drawing Social Security benefits before reaching full retirement age is that such a person must live longer to equalize the amount of benefits received over their lifetime compared to waiting until full retirement age to begin drawing benefits.
Taxability of Benefits
About 20 million people each year, some that are undoubtedly farmers and ranchers, pay tax on their Social Security benefits. These people are commonly in the 62-70 age range. Taxing Social Security benefits seems harsh, inasmuch as the person has already paid income tax and Social Security payroll taxes on the earnings that generated the benefits. But, not every dollar of benefits is taxed. What matters is a person’s total income from non-Social Security sources such as wages and salaries, investment income (and capital gains on those investments) and pension income. To that amount is added one-half of the person’s Social Security income. The total amount then is measured against a limit. For example, a person that files as married-filing-jointly (MFJ) will subject 50 percent of their Social Security benefits to tax if the total amount exceeds $32,000 for 2018 (it’s $25,000 for a single filer). The 50 percent changes to 85 percent once the total amount exceeds $44,000 (MFJ) or $34,000 (single) for 2018. Those are the maximum percentages in theory. In reality, however, there is a complex formula that often results in less Social Security benefits being taxed than that maximum percentage. To boil it down, the formula often results in about 20 percent of Social Security benefits being taxed once the total amount threshold is exceeded.
Some farmers receive wages in-kind rather that in cash. In-kind wages such as crops or livestock, count toward the earnings limitations test. The earnings limit test includes all earnings, not just those that are subject to Social Security (FICA/Medicare) tax. But, employer-provided health insurance benefits are not considered to be “earnings” for purposes of the earnings limitation test. They are not taxed as wages. I.R.C. §3121; SSA Program Operations Manual System, §§RS 01402.040; 01402,048.
Federal farm program payments that a farmer receives are not deemed to be “earnings” when calculating each calendar year's earnings limitation. SSA Program Operations Manual System §RS 02505.115. That is the case except for the initial year of Social Security benefit application. In that initial year, all FSA program payments are counted along with other earned income and earnings for purposes of the annual earnings limitation test.
For farmers that cash rent farm ground to their employer, the cash rental income that the farmer receives will likely be treated as “earnings” even though the farmer is getting a wage from the employer. This is particularly the case if the farmer is farming the ground on the employer’s behalf. The result would be a “doubling-up” of the wage income and the cash rent income for purposes of the age 62-66 earnings test.
For a farmer that is drawing Social Security benefits, whether retired or not, Conservation Reserve Program Payments received are not subject to Social Security tax. I.R.C. §1402(a)(1).
Social Security benefit planning is an item that is often overlooked by farmers and ranchers. However, it is useful to know how such planning may fit into the overall retirement plan of a farmer or rancher. It is just one piece of the retirement, succession, estate plan that should be considered in terms of how it fits in with other strategies. While a farmer or rancher may never actually “retire,” there is a benefit to properly timing the drawing of Social Security benefits. In addition, as noted above, there are some special situations that a farmer or rancher should be aware of.
The Social Security Administration website (ssa.gov) has some useful online calculators that can aid in estimating retirement benefits. It may be worth checking out.