Monday, December 31, 2018
2018 was a big year for developments in law and tax that impact farmers, ranchers, agribusinesses and the professionals that provide professional services to them. It was also a big year in other key areas which are important to agricultural production and the provision of food and energy to the public. For example, carbon emissions in the U.S. fell to the lowest point since WWII while they rose in the European Union. Poverty in the U.S. dropped to the lowest point in the past decade, and the unemployment rate became the lowest since 1969 with some sectors reporting the lowest unemployment rate ever. The Tax Cuts and Jobs Act (TCJA) doubles the standard deduction in 2018 compared to 2017, which will result additional persons having no federal income tax liability and other taxpayers (those without a Schedule C or F business, in particular) having a simplified return. Wages continued to rise through 2018, increasing over three percent during the third quarter of 2018. This all bodes well for the ability of more people to buy food products and, in turn, increase demand for agricultural crop and livestock products. That’s good news to U.S. agriculture after another difficult year for many commodity prices.
On the worldwide front, China made trade concessions and pledged to eliminate its “Made in China 2025” program that was intended to put China in a position of dominating world economic production. The North-Korea/South Korea relationship also appears to be improving, and during 2018 the U.S. became a net exporter of oil for the first time since WWII. While trade issues with China remain, they did appear to improve as 2018 progressed, and the USDA issued market facilitation payments (yes, they are taxed in the year of receipt and, no, they are not deferable as is crop insurance) to producers to provide relief from commodity price drops as a result of the tariff battle.
So, on an economic and policy front, 2019 appears to bode well for agriculture. But, looking back on 2018, of the many ag law and tax developments of 2018, which ones were important to the ag sector but just not quite of big enough significance nationally to make the “Top Ten”? The almost Top Ten – that’s the topic of today’s post.
The “Almost Top Ten” - No Particular Order
Syngenta litigation settles. Of importance to many corn farmers, during 2018 the class action litigation that had been filed a few years ago against Syngenta settled. The litigation generally related to Syngenta's commercialization of genetically-modified corn seed products known as Viptera and Duracade (containing the trait MIR 162) without approval of such corn by China, an export market. The farmer plaintiffs (corn producers), who did not use Syngenta's products, claimed that Syngenta's commercialization of its products caused the genetically-modified corn to be commingled throughout the corn supply in the United States; that China rejected imports of all corn from the United States because of the presence of MIR 162; that the rejection caused corn prices to drop in the United States; and that corn farmers were harmed by that market effect. In April of 2018, the Kansas federal judge handling the multi-district litigation preliminarily approved a nationwide settlement of claims for farmers, grain elevators and ethanol plants. The proposed settlement involved Syngenta paying $1.5 billion to the class. The class included, in addition to corn farmers selling corn between September of 2013 and April of 2018, grain elevators and ethanol plants that met certain definition requirements. Those not opting out of the class at that point are barred from filing any future claims against Syngenta arising from the presence of the MIR 162 trait in the corn supply. Parties opting out of the class can't receive any settlement proceeds, but can still file private actions against Syngenta. Parties remaining in the class had to file claim forms by October of 2018. The court approved the settlement in December of 2018, and payments to the class members could begin as early as April of 2019.
Checkoff programs. In 2018, legal challenges to ag “checkoff” programs continued. In 2017, a federal court in Montana enjoined the Montana Beef Checkoff. In that case, Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, No. CV-16-41-GF-BMM, 2017 U.S. Dist. LEXIS 95861 (D. Mont. Jun. 21, 2017), the plaintiff claimed that the federal law requiring funding of the Montana Beef Council (MBC) via funds from the federal beef checkoff was unconstitutional. The Beef Checkoff imposes a $1.00/head fee at the time cattle are sold. The money generated funds promotional campaigns and research, and state beef councils can collect the funds and retain half of the collected amount with the balance going to the Cattleman’s Beef Production and Research Board (Beef Board). But, a producer can direct that all of the producer’s assessment go to the Beef Board. The plaintiff claimed that the use of the collected funds violated their First Amendment rights by forcing them to pay for “speech” with which they did not agree. The defendant (USDA) motioned to dismiss, but the Magistrate Judge denied the motion. The court determined that the plaintiffs had standing, and that the U.S. Supreme Court had held in prior cases that forcing an individual to fund a private message that they did not agree with violated the First Amendment. Any legal effect of an existing “opt-out” provision was not evaluated. The court also rejected the defendant’s claim that the case should be delayed until federal regulations with respect to the opt-out provision was finalized because the defendant was needlessly dragging its heels on developing those rules and had no timeline for finalization. The court entered a preliminary injunction barring the MBC from spending funds received from the checkoff. On further review by the federal trial court, the court adopted the magistrate judge’s decision in full. The trial court determined that the plaintiff had standing on the basis that the plaintiff would have a viable First Amendment claim if the Montana Beef Council’s advertising involves private speech, and the plaintiff did not have the ability to influence the advertising of the Montana Beef Council. The trial court rejected the defendant’s motion to dismiss for failure to state a claim on the basis that the court could not conclude, as a matter of law, that the Montana Beef Council’s advertisements qualify as government speech. The trial court also determined that the plaintiff satisfied its burden to show that a preliminary injunction would be appropriate.
The USDA appealed the trial court’s decision, but the U.S. Court of Appeals for the Ninth Circuit affirmed the trial court in 2018. Ranchers-Cattlemen Action Legal Fund, United Stockgrowers of America v. Perdue, 718 Fed. Appx. 541 (9th Cir. 2018). Later in 2018, as part of the 2018 Farm Bill debate, a provision was proposed that would have changed the structure of federal ag checkoff programs. It did not pass, but did receive forty percent favorable votes.
GIPSA rules withdrawn. In the fall of 2016, the USDA sent to the Office of Management and Budget (OMB) an interim final rule and two proposed regulations setting forth the agency’s interpretation of certain aspects of the Packers and Stockyards Act (PSA) involving the buying and selling of livestock and poultry. The proposals generated thousands of comments, with ag groups and producers split in their support. The proposals concern Section 202 of the PSA (7 U.S.C. §§ 192 (a) and (e)) which makes it unlawful for any packer who inspects livestock, meat products or livestock products to engage in or use any unfair, unjustly discriminatory or deceptive practice or device, or engage in any course of business or do any act for the purpose or with the effect of manipulating or controlling prices or creating a monopoly in the buying, selling or dealing any article in restraint of commerce. The “effect” language of the statute would seem to eliminate any requirement that the producer show that the packer acted with the intent to control or manipulate prices. However, the federal courts have largely interpreted the provision to require a plaintiff to show an anti-competitive effect in order to have an actionable claim.
The interim final rule and the two proposed regulations stemmed from 2010. In that year, the Obama administration’s USDA issued proposed regulations providing guidance on the handling of antitrust-related issues under the PSA. 75 Fed. Reg. No. 119, 75 FR 35338 (Jun. 22, 2010). Under the proposed regulations, "likelihood of competitive injury" was defined as "a reasonable basis to believe that a competitive injury is likely to occur in the market channel or marketplace.” It included, but was not limited to, situations in which a packer, swine contractor, or live poultry dealer raises rivals' costs, improperly forecloses competition in a large share of the market through exclusive dealing, restrains competition, or represents a misuse of market power to distort competition among other packers, swine contractors, or live poultry dealers. It also includes situations “in which a packer, swine contractor, or live poultry dealer wrongfully depresses prices paid to a producer or grower below market value, or impairs a producer's or grower's ability to compete with other producers or growers or to impair a producer's or grower's ability to receive the reasonably expected full economic value from a transaction in the market channel or marketplace." According to the proposed regulations, a “competitive injury” under the PSA occurs when conduct distorts competition in the market channel or marketplace. The scope of PSA §202(a) and (b) was stated to depend on the nature and circumstances of the challenged conduct. The proposed regulations specifically noted that a finding that a challenged act or practice adversely affects or is likely to affect competition is not necessary in all cases. The proposed regulations also specified that a PSA violation could occur without a finding of harm or likely harm to competition, contrary to numerous court opinions on the issue.
On April 11, 2017, the USDA announced that it was delaying the effective date of the interim final rule for 180 days, until October 19, 2017, with the due date for public comment set at June 12, 2017. However, on October 17, 2017, the USDA withdrew the interim rule. The withdrawal of the interim final rule and two proposed regulations was challenged in court. On December 21, 2018, the U.S. Court of Appeals for the Eighth Circuit denied review of the USDA decision. In Organization for Competitive Markets v. United States Department of Agriculture, No. 17-3723, 2018 U.S. App. LEXIS 36093 (8th Cir. Dec. 21, 2018), the court noted that the USDA had declined to withdraw the rule and regulations because the proposal would have generated protracted litigation, adopted vague and ambiguous terms, and potentially bar innovation and stimulate vertical integration in the livestock industry that would disincentivize market entrants. Those concerns, the court determined, were legitimate and substantive. The court also rejected the plaintiff’s argument that the court had to compel agency action. The matter, the court concluded, was not an extraordinary situation. Thus, the USDA did not unlawfully withhold action.
No ”clawback.” In a notice of proposed rulemaking, the U.S Treasury Department eliminated concerns about the imposition of an increase in federal estate tax for decedents dying in the future at a time when the unified credit applicable exclusion amount is lower than its present level and some (or all) of the higher exclusion amount had been previously used. The Treasury addressed four primary questions. On the question of whether pre-2018 gifts on which gift tax was paid will absorb some or all of the 2018-2025 increase in the applicable exclusion amount (and thereby decrease the amount of the credit available for offsetting gift taxes on 2018-2025 gifts), the Treasury indicated that it does not. As such, the Treasury indicated that no regulations were necessary to address the issue. Similarly, the Treasury said that pre-2018 gift taxes will not reduce the applicable exclusion amount for estates of decedents dying in years 2018-2025.
The Treasury also stated that federal gift tax on gifts made after 2025 will not be increased by inclusion in the tax computation a tax on gifts made between 2018 and 2015 that were sheltered from tax by the increased applicable exclusion amount under the TCJA. The Treasury concluded that this is the outcome under current law and needed no regulatory “fix.” As for gifts that are made between 2018-2025 that are sheltered by the applicable exclusion amount, the Treasury said that those amounts will not be subject to federal estate tax in estates of decedents dying in 2026 and later if the applicable exclusion amount is lower than the level it was at when the gifts were made. To accomplish this result, the Treasury will amend Treas. Reg. §20.2010-1 to allow for a basic exclusion amount at death that can be applied against the hypothetical gift tax portion of the estate tax computation that is equal to the higher of the otherwise applicable basic exclusion amount and the basic exclusion amount applied against prior gifts.
The Treasury stated that it had the authority to draft regulations governing these questions based on I.R.C. §2001(g)(2). The Treasury, in the Notice, did not address the generation-skipping tax exemption and its temporary increase under the TCJA through 2025 and whether there would be any adverse consequences from a possible small exemption post-2025. Written and electronic comments must be received by February 21, 2019. A public hearing on the proposed regulations is scheduled for March 13, 2019. IRS Notice of Proposed Rulemaking, REG-106706-18, 83 FR 59343 (Nov. 23, 2018).
These were significant developments in the ag law and tax arena in 2018, but just not quite big enough in terms of their impact sector-wide to make the “Top Ten” list. Wednesday’s post this week will examine the “bottom five” of the “Top Ten” developments for 2018.
December 31, 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)
Friday, December 21, 2018
Depreciation is a familiar concept to a farmer or rancher. It’s an allowance for the wear-and-tear over the life of an asset that is used (for a farmer) in the business of farming. But what is depletion? It’s conceptually similar to depreciation. In tax “lingo” it’s a deductible allowance for the exhaustion of mineral deposits, timber and other natural resources. If a taxpayer has an economic interest in the resource, the cost of the diminishing resource can be recovered through the depletion allowance.
Depletion – it’s the topic of today’s blog post.
The depletion allowance is claimed either on a cost-per-unit basis or as a percentage of gross income from the disposal of the resource. I.R.C. §611. Cost depletion allocates to each unit of production a pro rata portion of the original cost or investment in the resource. In general, the total projected number of units in the deposit or timber tract (tons, barrels, boardfeet, etc.) is divided into the cost of the resource to obtain the amount of cost which should be deducted for each unit of production sold. I.R.C. §612. Cost depletion is required for timber. See IRS Pub. 535.
Percentage depletion is applicable to all minerals. With percentage depletion, a flat percentage of the gross income from the property each year is treated as the depletion deduction to allow the taxpayer to recover the cost of the minerals/resources. The percentage depletion rates are set forth in the statute. I.R.C. §613(b). The percentage figures range from a top of 22 percent for deposits in the United States of sulphur and uranium (and other specified elements such as bauxite and nickel), to 5 percent for clay that is used or sold for use in the manufacture of drainage and roofing tile, flower pots, and kindred products. Id.
The taxpayer has the choice of using the higher of cost depletion or percentage depletion and may make the choice each year. However, special rules apply when the predominant property (by value) is hydrocarbon gas. Another point to remember is that the depletion deduction under the percentage depletion method cannot exceed 100 percent of the taxable income from the property computed without the deduction for depletion.
As noted above, percentage depletion is allowed to one who has an “economic interest” in the minerals in place. That generally means that it is available to an owner or lessee. But what if the lessor can terminate the lease on short notice? In that situation does the lessee still have an economic interest entitling the lessee to a deduction for percentage depletion? That question was answered in United States v. Swank, 451 U.S. 571 (1981). In that case, the lessor owned a coal mine and leased the unmined coal (e.g., mineral interest) to lessees in exchange for a fixed royalty per ton based on the sale of the mined coal at prices the lessee would determine. The lessee mined the coal over an uninterrupted period of several years and the proceeds of the sale of the coal were the only revenue from which the lessees recovered royalties that were paid to the lessors. The lessor had the right to terminate these leases with 30 days' notice. But, that termination right was never exercised. The lessee sought to claim a percentage depletion deduction for the cost of the mined coal. The IRS claimed that the lessee should not have been allowed to take a percentage depletion allowance because the lessor had the right to terminate the lease on short notice. That termination right, the IRS asserted, deprived the lessee of an economic interest. The trial court disagreed with the IRS and the U.S. Supreme court affirmed. The mere existence of the unexercised right to terminate leases did not destroy the lessee’s economic interest in the leased mineral deposits. A deduction based on percentage depletion of the coal deposit was proper. See also Rev. Rul. 83-160, 1983-2 C.B. 99; and FSA 1999-927 (date redacted).
The impact of the U.S. Supreme Court opinion in Swank, is that a when a farmer leases a mineral deposit to a lessee to extract the minerals, the farmer should have little trouble in being able to claim a deduction for depletion based on an application of a percentage to the gross royalties received. The tax issues get more complex, however, if the farmer become the operator of the mineral deposit.
Depletion of Soil
Soil, sod, dirt, turf, water and mosses are not included within the terms “all other minerals” for purposes of claiming 14 percent percentage depletion. I.R.C. §613(b)(7)(A)-(C). However, soil in place can be subject to depletion under the cost method. Rev. Rul. 78, 1953-1 C.B. 18. While no depletion allowance is generally allowed for sod, a federal district court in Florida has held that sod was a natural deposit and that the removal of the grass resulted in a loss of the soil for which a depletion allowance could be claimed. Flona Corp. v. United States, 218 F. Supp. 354 (S.D. Fla. 1963). Likewise, cost depletion of topsoil is allowed to a taxpayer upon the sale of sod and balled nursery where the taxpayer can establish that each cutting removed some part of the natural deposit. Rev. Rul. 77-12, 1977-1 C.B. 161, revoking Rev. Rul 54-241, 1954-1 C.B. 63.
Other points on soil. Soil presents some interesting depletion questions. Here are a few of the more common ones:
- If a mineral or natural resource deposit is continuously replenished by the decomposition of other plants, no depletion is available. See, e.g., Rul. 79-267, 1979-2 C.B. 243.
- Loam is a natural deposit subject to depletion, but not percentage depletion. Rul. 79-411, 1979-2 C.B. 246.
- “Peat” is eligible for percentage depletion at a 5 percent rate, but various types of “moss” are not. See, e.g., I.R.C. §613(b)(7)(A).
- Peat moss is subject to a percentage depletion allowance of 5%. The question, then, is the point at which moss becomes peat moss.
- Peat moss must actually be extracted rather than merely subside. See, e.g., A. Duda & Sons, Inc. v. United States, 560 F.2d 669 (5th Cir. 1977), rev’g., 383 F. Supp. 1303 (M.D. Fla. 1974).
Depletion of Timber
The sale of standing timber typically triggers capital gain for a farmer-seller. The tax basis in the timber can be recovered either through depletion or by an offset against the selling price. But, if the income from a timber sales is reported as “Other income…” on Schedule F, timber depletion should be claimed in order to preserve the basis. Alternatively, if the income from timber sales is reported as an item purchased for resale, depletion on the timber should be listed as the cost (or other) basis. There is no line on Schedule F for depletion. That means that the taxpayer will have to indicate how the depletion was computed. The taxpayer should complete Form T to show the depletion computation.
Depletion of Groundwater
In some parts of the country, the IRS permits a depletion allowance for water deposits in an aquifer beneath the surface. In portions of the Ogallala formation which runs through Western Nebraska and Kansas, Eastern Colorado, part of New Mexico and the panhandles of Oklahoma and Texas, taxpayers are permitted to claim a depletion deduction for water. In these areas, the water is being pumped at a level exceeding the recharge rate for the underlying aquifer. The IRS permits a depletion allowance on water in these areas where it can be shown that the rate of recharge in the underlying aquifer is extremely low. In 1965, the Fifth Circuit Court of Appeals held that groundwater in the Ogallala formation in the Southern High Plains of Texas and New Mexico was a depletable mineral and natural deposit. United States v. Shurbet, 347 F.2d 103 (5th Cir. 1965).
The IRS stated that it would follow this case, but that it would limit the application of the rule to situations similar to those in the Southern High Plains of Texas and New Mexico where water is extracted from the Ogallala formation. Rev. Rul. 65-296, 1965-2 C.B. 181.
In late 1982, IRS announced a broadening of the rule in Shurbet to areas where it could be demonstrated that the groundwater is being depleted and that the rate of recharge is so low that, once extracted, the “groundwater would be lost to the taxpayer and immediately succeeding generations.” Rev. Rul. 82-214, 1982-2 C.B. 115.
Depletable Property Held by an Estate or Trust
For mineral or timber property held in trust, the allowable deduction for depletion is to be apportioned between the income beneficiaries and the trustee on the basis of trust income from the property allowable to each unless the governing instrument allows the trustee to maintain a reserve for depletion. If the trust instrument or local law requires or permits the trustee to maintain a reserve for depletion, however, the allowance may be allocated first to the trustee to the degree that income is placed in the depletion reserve. Any excess amount is apportioned between the income beneficiaries and the trustee on the basis of the trust income allocable to each. Rev. Rul. 60-47, 1960-1 C.B. 250; Regs. § 1.611-1(c)(4). Rev. Rul. 61-211, 1961-2 C.B. 124, modified by Rev. Rul. 74-71, 1974-1 CB 158, governs the situation if the trust or estate is entitled to a portion of a depletion deduction from a partnership or another estate or trust. See also Rev. Rul. 66-278, 1966-2 C.B. 243.
While depreciation is a commonly understood concept, depletion is less understood in its application. But, the point remains that a tax deduction may be available for the exhaustion of mineral deposits, timber and other natural resources.
Note: There won't be any postings next week in light of the Christmas holiday. To all of the blog post readers, may you and your family have a very Merry Christmas! Postings will resume on Dec. 31.
Wednesday, December 19, 2018
For agriculture, drainage of surface water is a significant legal issue. When surface water is sufficient, problems can arise concerning disposal of rainfall and/or melting snow which water-logs valuable fields and pastures forming bogs and sinkholes, thereby making cultivation difficult or impossible. The drainage of excess surface water can create disputes among rural landowners. While it’s an issue that arises more frequently in the areas of the U.S. that are east of the Missouri River, it sometimes comes up in the more arid parts of the country. When too much surface water is present, how can it be disposed of without creating legal problems with an adjoining property owner?
The rules governing the disposal of excess surface water – that’s the topic of today’s post
In general, it has historically been wrongful for a landowner to disturb the existing pattern of drainage and thereby obstruct the flow of water from another's lands, or cast upon the lands of another more water than would naturally flow thereupon, or cause an usually high concentration of water in the course of drainage. While that’s the general rule, there are exceptions. Indeed, at least three different legal theories may be utilized to resolve surface water drainage conflicts.
The rule of absolute ownership. The rule of absolute ownership, also known as the common enemy rule, is the oldest legal theory applicable to the use of surface water. This rule is based upon the theory that surface water is the enemy of every landowner and a property owner is given complete freedom to discharge surface waters regardless of the harm that might result to others. The owner is allowed to dispose of surface water in any manner that will result in the highest benefit to his or her land. In its original form, the common-enemy doctrine encouraged land development, but also encouraged conflict both between and among landowners.
Today, most courts have modified this rule by importing into it qualifications based on concepts of reasonable use, negligence, and/or nuisance to prohibit discharges of large quantities of water onto adjoining land by artificial means in a concentrated flow, except through natural drainways. For example, in Currens v. Sleek, 138 Wash. 2d 858, 983 P.2d 626 (1999), the court determined that a landowner has an unqualified right to make lawful improvements on their own land, but those improvements must limit the harm caused by changes in the flow of surface water to that which is reasonably necessary. See also Johnson v. Philips, 433 S.E.2d 895 (S.C. Ct. App. 1993). If land clearing activities alter the surface drainage significantly, it may give an adjoining landowner the basis to bring a nuisance suit. For example, in Lucas v. Rawl Family Partnership, 359 S.C. 505, 598 S.E.2d 712 (2004), the evidence showed that after the neighbors cleared their land, the owner's fields flooded in every heavy rain, making it unsuitable for crops. The court held that there was a jury question presented as to whether the neighbors' actions constituted a nuisance per se and were dangerous to the property at all times. Similarly, in Mullins v. Greer, 26 Va. 587, 311 S.E.2d 110 (1984), a landowner had constructed an embankment causing excess water to flow onto a neighbor. The landowner claimed that the embankment was properly constructed and didn’t interfere with the natural channel and flow of a stream. The court ordered the landowner to remove the embankment.
The civil law rule. The civil law rule imposes liability upon one who interferes with the natural flow of surface water and, as a result, invades another's interest in land. This rule is the opposite of the common enemy rule, and is phrased in terms of dominant and servient estates. This rule imposes a servitude upon the lower or servient estate which requires that it receive all waters which flow in the course of nature from the higher or dominant tract. The owner of the dominant tract cannot, however, do anything that would increase the natural drainage burden imposed upon the lower estate. But, the complaining party must prove that they incurred damage. For example, in Mullen v. Natural Gas Line Company of America L.L.C., 801 N.W.2d 627 (Iowa Ct. App. 2011), the plaintiff failed to prove that the defendant’s drainage activity increased the quantity of water or changed the manner of discharge onto the plaintiff’s property. As a result, the plaintiff was denied injunctive relief and damages.
Essentially, the civil law rule involves accepting the natural flow of water. While this rule minimizes conflict between and among landowners, it also discourages land improvement. As a result, some states have modified the civil law rule to accommodate artificial changes in the natural flow of surface water if the change is incidental to the normal use and improvement of land. These changes are most likely to be acceptable when the water empties into an existing natural watercourse. However, substantial changes in natural drainage flows resulting in damages to an adjoining landowner are not permissible. This rule applies even in connection with governmentally approved soil conservation practices that substantially alter the natural flow of surface water. For example, in O’Tool v. Hathaway, 461, N.W.2d 161 (Iowa 1990), a farmer constructed several conservation terraces as part of his soil and water conservation plan for the farm. One of the terraces broke during a heavy rainfall and the resulting flow of the previously ponded water in the terrace damaged the basement of neighboring homeowners. The homeowners sued, alleging liability because the flow of the water from the terrace break had altered the natural flow of water from the dominant to the servient estate. The trial court agreed and awarded them damages for materials to fix their basement. The appellate court tacked on labor expenses, finding that the farmer was liable under the "natural flow" doctrine because the farmer had substantially changed the water drainage method. The appellate court found that the farmer was negligent in constructing a terrace in a location that if it broke, the resulting water flow would cause foreseeable damages to the homeowners.
The strict application of the civil law rule has also been modified by a so-called “husbandry” exception, and interference with natural drainage will be allowed if the interference is limited to that which is incidental to reasonable development of the dominant estate for agricultural purposes. See, e.g., Callahan v. Rickey, 93 Ill. App. 3d 916, 418 N.E.2d 167 (1981).
Reasonable Use Rule. Today, many jurisdictions have adopted the rule of reasonable use which attempts to avoid the rigidities of either the civil-law or common-enemy doctrines. Instead, the reasonable use rule determines the rights of the parties by an assessment of all the relevant factors with respect to interference with the drainage of surface waters. Under the reasonable use rule, a landowner is entitled to make a reasonable use of diffused surface water, with such use being a factual question for a jury. For example, in Kral v. Boesch, 557 N.W.2d 597 (Minn. Ct. App. 1996), a landowner created a channel to drain surface water from his property to a tile intake bordering the parties' properties by lowering the intake in order to allow the channel water to flow into it. The neighbor discovered what the landowner had done and raised the intake to keep the water out and plugged it with cement, which caused surface water to stand in three areas of the landowner’s property and damaged the landowner’s crops. The trial court determined that the granted injunctive relief to the landowner under the reasonable use rule. On appellate court affirmed. It was appropriate for the landowner to drain water into the adjoining owner’s tile drainage system.
Ultimately, in legal disputes over the application of the reasonable use rule, it’s often up to a jury. The jury must determine whether the benefit to the actor's land outweighs the harm that results from the alteration of the flow of surface water onto neighboring lands. A landowner will be liable for damages only to the extent that interference with the flow of surface water is unreasonable. Whether a landowner has acted reasonably in removing excess surface water depends upon such things as the degree or extent of harm, the foreseeability of damage, and the amount of care that was exercised to prevent damage. Is the drainage reasonably necessary? Did the party draining the excess water take reasonable care to avoid unnecessary damage to a neighbor’s property? Is the benefit from diverting the excess water greater than the harm to the neighbor? Does the draining improve the “normal and natural” system of drainage? These are all important questions to ask before diverting excess water on to a neighbor. These are often the questions a jury will weigh.
Drainage codes. Many states have adopted statutory drainage codes. Under those codes, a landowner can institute drainage proceedings for the construction, repair or improvement of agricultural drainage ditches. These codes, if they apply in a particular situation, must be complied with.
Excess surface water can be can be diverted and discharged onto a neighbor. However, care must be taken in doing so.
Monday, December 17, 2018
A fundamental point about tax law is that deductions, especially those associated with a business, must be substantiated. In addition, given the complexity of the tax Code, it is often in the best interest of a small business owner or farmer/rancher to hire a professional tax preparer. Simply relying on tax software will not eliminate penalties that the IRS can impose if the tax liability is understated.
Substantiating deductions and the peril of self-prepared business returns – that’s the topic of today’s post.
A recent Tax Court case illustrates the necessity of properly substantiating business deductions. In Dasent v. Commissioner, T.C. Memo. 2018-202, the taxpayers were a married couple that claimed various business expenses on Schedule C. They self-prepared their return for 2014, the year in issue. Their Schedule C reported no gross receipts and total expenses of $28,173. They also claimed unreimbursed employee expenses of $23,931 on Schedule A. The IRS denied the Schedule C and Schedule A deductions and also asserted that the couple failed to report $25,622 of IRA distributions (and the associated penalty for early withdrawal). The IRS also determined that the couple failed to report $123,168 of cancelled debt income. The IRS also imposed a penalty for underpayment of tax associated with the substantial understatement of tax.
The Tax Court determined that the wife failed to provide sufficient evidence that she was engaged in a business with a profit motive. The Tax Court also concluded that the wife failed to substantiate any of the business expenses associated with the wife’s business and provided no means for the court to estimate those expenses under the Cohan rule.
The Cohan rule. What’s the Cohan rule? The rule comes from a 1930 decision of the U.S. Court of Appeals for the Second Circuit involving George M. Cohan. Cohan was an American entertainer, playwright, composer, lyricist, actor, singer, dancer and producer. He wrote, composed, produced and appeared in about 40 Broadway musicals (which means that I would never have heard of him had he not found himself the subject of a tax case!).
Mr. Cohan might have been a good entertainer, but he wasn’t so hot at keeping good records for his travel and entertainment expenses associated with his business activities. In Cohan v. Comr., 39 F.2d 540 (2nd Cir. 1930), the famous judge Learned Hand ruled for the IRS on numerous points but in the process set forth the principle that when the IRS asserts a tax deficiency in cases where the evidence clearly shows that some deduction should be allowed, the court can estimate those expenses. As a result, the court allowed Mr. Cohan to use estimates to establish his business expenses.
But, it’s not a sure thing when a taxpayer relies on the use of the Cohan rule to get deductions for expenses that haven’t been properly substantiated. There are numerous cases where the court has refused to use the rule. See, e.g., Sam Kong Fashions, Inc. v. Comr., T.C. Memo. 2005-157; Stewart v. Comr., 2005-212; Harlan v. Comr., T.C. Memo. 1995-309. That means that the burden remains on the taxpayer when records substantiating expenses are missing. In addition, under I.R.C. §274(d) (which was enacted after the Cohan decision) substantiation is required for travel, entertainment, business gifts and any expenses associated with “listed property” (a special classification for assets that can be used for both personal and business purposes). Indeed, in the present case, the Tax Court noted that the Cohan rule has no application to I.R.C. §274(d) expenses.
Other points of the case. The petitioners also claimed that they should not be subject to the 10 percent penalty for early withdrawal from their IRA because the withdrawn funds were used to pay for their daughter’s college tuition, The Tax Court, however, upheld the penalty because the petitioners failed to establish that the withdrawn funds were actually used to pay the daughter’s tuition. The Tax Court also upheld the imposition of a 20 percent penalty for substantial understatement of tax. On that issue, the Tax Court noted that the petitioners were college-educated and used a tax software (TurboTax). However, the Tax Court noted, tax software is not the same as relying on professional tax advice. The software only produces a result that is as good as the information that is input. The taxpayer must still understand tax law good enough to properly use the software.
Return Prep – Post TCJA
Given the increased complexity of many parts of the Code that the Tax Cuts and Jobs Act (TCJA) has introduced, self-prepared returns will be even more difficult for those taxpayers with a Schedule C or F business. That’s particularly true with respect to the new I.R.C. §199A, the 20 percent pass-through deduction for non-C corporate businesses. Some taxpayers may assume that they are entitled to a straight-up 20 percent deduction from their taxable income (some may even incorrectly assume it’s taken from gross income). While a full 20 percent deduction is possible, it’s not likely to be the case in many situations due to the presence of capital gain income, other types of non-qualified income, certain deductions, and income level. In addition, what about rental income? Is it business income or not? We won’t know the answer to that question (and numerous others) until the final regulations are issued. I.R.C. §199A is just one area of complexity added by the new law. Many other changes also apply, such as with respect to depreciation, that will make preparation of the return for taxpayers with businesses more difficult for 2018 as compared to prior years.
Properly substantiating business expenses is the key to claiming deductions for them. Don’t assume that the court will estimate them for you under the Cohan rule even if the expenses involved are those for which the rule could apply. The TCJA has ramped-up the complexity of return preparation (and planning) for those with small businesses (including farms and ranches). Relying on tax software will not be enough to eliminate penalties for an understatement of tax. This might be the year, for those that haven’t done so already, to hire a professional return preparer.
Thursday, December 13, 2018
In general, a farmer or rancher that uses the cash method of accounting gets to deduct business-related expenses in the year that they are paid. But, is that always the case? What about livestock that is purchased for resale, or growing crops associated with the purchase of a farm? Are there other special situations in the farm or ranch setting? Does the Tax Cuts and Jobs Act (TCJA) have any impact?
The cash method of accounting and special situations for farmers and ranchers – it’s the topic of today’s blog post.
As stated above, the general rule for taxpayers on the cash method of accounting is that a deduction can be claimed for expenses when those expenses are paid. However, for farmers and ranchers that utilize the cash method of accounting, a deduction can be taken for the cost of livestock and other items that are purchased for resale only when the items are sold. Treas. Regs. §1.61-4(a). For example, in Alexander v. Comr., 22 T.C. 234 (1954), acq., 1954-2 C.B. 3, the petitioner was a cattle feeder that purchased calves and yearlings. He fed them for approximately nine to 18 months and then sold them as beef cattle. He was on the cash method of accounting and deducted the cost of the cattle in the year of purchase as an operating expense rather than deferring the deduction until the year he sold the cattle. The IRS disagreed with that approach and the Tax Court upheld the IRS position and the underlying Treasury Regulation. The cattle feeder’s gain on later sale was to be reduced by the cost of purchase.
Other Ag Products
The rule applied in the Alexander case is widely recognized as the “feeder calf” rule whereby the cost of feeder calves is not deductible until the calves are sold. However, the rule has much broader application beyond the feeder calf scenario. For instance, in Dodds v. Comr., T.C. Memo. 1986-174, the Tax Court held that the rule required the taxpayers to deduct the cost of their Valencia orange tree grove attributable to the growing orange crop when the crop was sold. The Tax Court noted that Treas. Reg. §1.61-4 applies to livestock and produce.
The same tax treatment applies to grain and other items that are purchased for resale. For example, if a farmer pledges grain to the Commodity Credit Corporation (CCC) as collateral for a loan and the grain goes out of condition and is sold, if that grain is replaced with the same quantity of grain (that meets CCC standards for quality) that will be sold, the purchased grain acquires an income tax basis equal to the purchase price. The purchase price amount would then offset (either partially or fully) the amount realized on later sale of the grain. The same rationale applies when a farmer buys a commodity certificate and then uses the certificate to acquire grain for later resale, the purchase price of the grain would establish the farmer’s tax basis in the grain. That tax basis would then be used to offset gain (or create a loss) on later sale.
Inventory Method Application
The IRS also takes the position that a “last-in-first-out” (LIFO) method to account for inventory costs may not be used to determine the cost to be deducted in the year of sale. In Rev. Rul. 88-60, 1988-2 C.B. 30, the taxpayer was engaged in the business of acquiring livestock for the purpose of resale. The taxpayer, a corporation, utilized the cash method and computed the profits from the sale of the livestock by determining the cost of the livestock sold as if the latest cattle acquired were the first sold. The cost basis of the remaining unsold cattle at the end of the year reflected the cost of the earliest cattle that the taxpayer had acquired. The IRS took the position that this method did not reflect the actual cost of the livestock sold, and was not permitted by Treas. Reg. §1.61-4 because it reflected the cost of the latest purchases of calves and yearlings. That wasn’t, the IRS determined, consistent with the cash method of accounting. Instead, the cost was to be subtracted from the particular item sold and cannot be deducted from other similar items sold. Allowing the use of the LIFO method would allow the taxpayer to deduct part of the cost of the feeder cattle in the year in the year of purchase rather than deferring the deduction until the year of sale. In other words, “cost” in Treas. Reg. §1.61-4 meant the actual cost of the livestock rather than the base year cost as determined under LIFO. See also, Priv. Ltr. Rul. 8406003 (Oct. 18, 1983); Peterson v. Vinal, 225 F. Supp. 478 (D. Neb. 1964).
Farmland With Growing Crop
When a farm is purchased that has a growing crop (or crops) on it, the IRS position is that the portion of the purchase price allocated to the growing crop does not produce a current income tax deduction. Instead, the amount allocated to the growing crop is to be capitalized and taken into account when determining net profit or loss in the year that the crop is sold. Rev. Rul. 85-82, 1985-1 C.B. 57. See also Priv. Ltr. Rul. 8350002 (Aug. 8, 1983); GCM 39096 (Dec. 21, 1983). It is not deductible on purchase of the farm as a purchase of “feed” unless the taxpayer intends to feed the crop to livestock. In that case, current deduction would seem to be permissible as to a reasonable amount of the acquired crop that is necessary to feed the taxpayer’s livestock.
What About Poultry?
A current deduction is allowed for the cost of purchasing baby chick and egg-laying hens by a farmer that uses the cash method of accounting as long as the method is consistently followed and clearly reflects income. The same is true if they are purchased for the purpose of raising and later resale. In Rev. Rul. 60-191, 1960-1 C.B. 78, the IRS took this position because it determined that the cost of the chicks was nominal compared to the cost of raising them, and because cost identification would be difficult. See also Priv. Ltr. Rul. 8528027 (Apr. 15, 1985). Whether that same rationale applies to other types of poultry, such as ostriches and emus, is an open question.
Impact of the TCJA
Section 13102 of the TCJA makes several amendments to the accounting rules for “small” businesses. In a significant change from prior law, for tax years beginning after 2017, a farming business (including a farm C corporation or a farming partnership with a C corporation partner) can qualify for the cash method of accounting if average gross receipts over the prior three years immediately before the tax year at issue do not exceed $25 million ($26 million for 2019). I.R.C. §448. The TCJA also contains a provision that exempts taxpayers that meet the gross receipts test from the requirement to account for inventories so as to clearly reflect income. However, the taxpayer’s method of accounting for inventory must either treat the inventory as non-incidental materials and supplies, or conform to the taxpayer’s method of accounting reflected in an applicable financial statement (AFS) for the tax year. If the taxpayer doesn’t have an AFS, the taxpayer’s method of accounting must conform to the taxpayer’s books and records “prepared in accordance with the taxpayer’s accounting procedures.” I.R.C. §471(c).
So what does this mean for farmers? For starters, if inventory is accounted for as incidental materials and supplies, inventory accounting methods don’t apply. As noted above, the IRS will not allow the use of LIFO, but FIFO or average cost method could be used. See, Rev. Proc. 2002-28, 2002-1 C.B. 815. But, does this mean that a farmer can claim a deduction in the year of purchase for livestock and other items that will be resold in a later year? That may be the case if the items fit within the definition of incidental supplies, and the farmer’s books and records consistently expense the items, and the farmer does not have an AFS (very few will).
Under the tangible property regulations, the IRS provided a de minimis safe harbor limit for those without an AFS. See Treas. Reg. §1.263(a)-1(f)(1)(ii)(D). In Notice 2015-82,2015-50 IRB, the IRS set that safe harbor at $2,500 (effective beginning with tax year 2016) for purposes of administrative convenience to allow a taxpayer to deduct amounts within the safe harbor limit that are expended for the acquisition or production of new property or for the improvement of existing property which would otherwise have to be capitalized under I.R.C. §263(a). To use the safe harbor, the item must be substantiated by an invoice. The $2,500 safe harbor should apply for feeder pigs. Cattle, however, may not as easily fit within the safe harbor.
Thus, for a farmer eligible for the cash method of accounting, the prior law current write-off rule for baby chicks and hens still applies. In addition, a current deduction is allowed (under the tangible property regulations) for the cost of tangible property that has an acquisition cost (or production cost) of $200 (per unit or per item) or less. That $200 amount should cover the cost of feeder pigs. The acquisition cost of other livestock purchased for resale, such as cattle, would also be currently deductible if the acquisition cost is within the $2,500 safe harbor.
Currently deducting the cost of livestock purchased for resale, if this is not an approach the taxpayer has previously taken, amounts to an accounting change requiring the filing of Form 3115. A full I.R.C. §481(a) adjustment will occur. I.R.C. §471(c)(4). The automatic change number is 235. However, this does not mean that IRS will grant audit protection for the change and even though the IRS grants consent to the change in how to account for livestock purchased for resale, that doesn’t mean it’s permissible and creates no presumption that it's a permissible method of accounting under a provision of the Code. See Rev. Proc. 2018-40, 2018-34 IRB 320.
The cash method of accounting allows the taxpayer to claim a deduction in the year the expense in incurred. However, there are some special situations in agriculture where the deduction is deferred. In addition, it is not presently known how the IRS will view the TCJA changes on this issue. Clearly, a farm taxpayer need not currently deduct the acquisition cost of items purchased for resale. The old rules can still be followed. But, if a current deduction is desired, there may be a way to accomplish that result.
Tuesday, December 11, 2018
For tangible depreciable personal property, all or part of the income tax basis can be deducted currently in the year in which the property is placed in service (defined as when property is in a state of readiness for use in the taxpayer's trade or business) under I.R.C. §179, regardless of the time of year the asset was placed in service. See, e.g., Brown v. Comm’r., T.C. Sum. Op. 2009-171. This expense method depreciation amount is an off-the-top depreciation allowance that may be taken at the taxpayer's election each year.
The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under I.R.C. §179 to $1 million. The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017. The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018. For 2019, the maximum amount that can be expenses under the provision increases to $1,020,000 and the phase-out threshold will be $2,550,000.
But, farm structures present an interesting issue as to whether they qualify for expense method depreciation. Farm buildings don’t count, but what about other types of structures? Where is the line drawn? The eligibility for I.R.C. §179 of certain farm structures – that’s the topic of today’s post.
As noted, for the farmer or rancher, expense method depreciation is potentially available for a wide array of assets. For example, not only can expense method depreciation be claimed on machinery and equipment, as well as purchased breeding stock, pickup trucks and business automobiles, it can also be claimed on tile lines, fences, feeding floors, grain bins, silos and similar “structures” because these structures are not “buildings.”
Eligibility of Farm “Structures”
In general, tangible property is eligible for expense method depreciation if it is I.R.C. §1245 property and is used as an integral part of manufacturing, production or extraction, or constitutes a facility used in connection with manufacturing, production or extraction for the bulk storage of fungible commodities, or is a single purpose agricultural or horticultural structure as defined in I.R.C. §168(i)(13). I.R.C. §1245(a)(3). But, a “building” (or its structural components) is not eligible. I.R.C. §1245(a)(3)(B).
Unfortunately, the term “building” is not defined in I.R.C. §179. The regulations under I.R.C. §1245 specify that language used to describe property in I.R.C. §1245(a)(3)(B) (which includes “a building or structural components”) is to have the same meaning as utilized for the (now repealed) investment tax credit (ITC) and associated regulations. Treas. Reg. §1.48-1(a). The term “building” was defined for investment tax credit purposes (“buildings” were not eligible for investment tax credit) as follows: “The term building generally means any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, packing, display, or sales space.” Treas. Reg. §§1.48-1(e)(1)-(2).
Also, I.R.C. §48(p), even though it has been repealed, contains the current, valid definition of a single purpose agricultural or horticultural structure. That provision (and subsections thereunder) defined property which qualified for the ITC. Tax legislation in 1986 moved that language into I.R.C. §1245 for depreciation recapture purposes. Under that definition, a single purpose ag structure (which is not a farm “building”) is used for housing, raising and feeding a particular type of livestock and their produce and the housing of the necessary equipment. Structures that fit this definition include hog houses, poultry barns, livestock sheds, milking parlors and similar structures. Also included within the definition are greenhouses that are constructed and designed for the commercial production of plants and a structure specifically designed and used for the production of mushrooms. Thus, only livestock structures and greenhouses qualify under this category.
IRS and court guidance. In the context of the ITC, certain the IRS and the courts have provided guidance. This guidance remains instructive on where the line is drawn between a “building” (not eligible for I.R.C. §179) and other structures that are eligible for I.R.C. §179 because they don’t meet the definition of a “building.”
- As to whether ag commodity storage facilities are “buildings,” in Rev. Rul. 66-89, 1966-1 C.B. 7, the IRS set forth two basic criteria for determining what improvements qualify as storage facilities, rather than buildings (for investment credit purposes): (1) the facility must provide storage space but not work space; and (2) the facility must not be reasonably adaptable to other uses.
- Catron v. Comr., 50 T.C. 306 (1968), acq., 1972-2 C.B. 1, involved a pre-fabricated Quonset-type structure used in the taxpayers’ apple farming business. Two-thirds of the structure was devoted to the selecting, grading and boxing of apples. The other one-third of the structure was refrigerated. The refrigerated area was held to not be a building as “other tangible property” that the taxpayer used in connection with agricultural production.
- Similar to the rationale applied in Catron, the Tax Court, in Palmer Olson v. Comr., T.C. Memo. 1970-296, determined that property constitutes a storage facility if it does not include working space.
- In Rul. 68-132, 1968-1 C.B. 14, modified by Rev. Rul. 71-359, 1971-2 C.B. 61, the IRS determined that a controlled temperature facility that provided specialized storage for potatoes for a potato farmer was not “building” despite its outward appearance. It, thus, qualified for investment tax credit. The IRS noted that the cleaning, processing, grading and packaging of the potatoes was carried on in an adjacent building.
- In Rul. 71-359, 1971-2 C.B. 6, the IRS ruled that a structure that was used for the storage of raw peanuts in the course of the taxpayer’s business of buying peanuts from growers and selling peanuts to manufacturers was not a “building.”
- In Merchants Refrigeration Co. of California v. Comr., 60 T.C. 856 (1973), acq., 1974-2 C.B. 3, a large freezer room in which frozen food stuffs were stored in cartons or bags was a storage facility and not a building.
- The Tax Court, in Central Citrus Co. v. Comr., 58 T.C. 365 (1972), determined that “sweet rooms” that occupied approximately one-sixth of a facility and where fruit was stored subject to controlled atmospheric conditions were not buildings. The Tax Court noted that the “sweet rooms” were not reasonably adaptable for other uses.
- In Giannini Packing Corp. v. Comr., 83 T.C. 526 (1984), the Tax Court held that rooms built to cool and preserve fruit were integral parts of production process of the fresh fruit and were not “buildings.”
- In Ltr. Rul. 8227012 (Mar. 30, 1982), the IRS determined that a freezer storage facility for pre-packaged food products was a building because it was similar to a warehouse. It was built on a concrete slab, had roof constructing consisting of structural steel and decking, and was constructed with steel racks from the floor to the ceiling located throughout. It also wasn’t used, the IRS noted, for the bulk storage of fungible commodities.
Hoop structures. There really isn’t any good guidance on the eligibility of “hoop” structures for I.R.C. §179. “Hoop” structures generally fit in the category of 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 potentially be eligible for first-year “bonus” depreciation). The key to the determination of 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.” If it is a general purpose ag building, it would not qualify for I.R.C. §179 depreciation.
Significant case. In Hart v. Comr., T.C. Memo. 1999-236, the taxpayers grew and processed tobacco on their Kentucky farm. After harvesting the tobacco in the summer, the taxpayers placed the plants over sticks in the field to cure. After the tobacco cured, the taxpayers transported the plants to a tobacco barn where the plants were hung to cure for several months. The taxpayers acquired a new tobacco barn in 1994. The barn was an enclosed “A-frame” structure with wooden walls and a dirt floor. The structure had three doors that were big enough to allow farm machinery to enter and exit. While the structure did not have a strong foundation, the foundation could be strengthened easily. It wasn’t suitable for the storage of grain because of ventilation and cracks. It also had minimal electrical wiring and fixtures, no insulation and no heating or plumbing. The structure contained a “stripping room” where the taxpayers cured, stripped, graded, baled and boxed tobacco leaves. The stripping room was enclosed only if the weather was cold.
On their tax return, the taxpayers reported the cost of the tobacco barn as $16,730 and elected to deduct $6,750 as expense method depreciation under I.R.C. §179 and depreciate the balance of the structure’s cost over 10 years under the 150 percent declining balance method (as a single-purpose agricultural/horticultural structure). The taxpayers’ position was that the structure was a structure other than a building used either as “an integral part of manufacturing or production” of tobacco or as “a facility used in connection with manufacturing or production.” The IRS, however, claimed that the structure was not entitled to I.R.C. §179 treatment and that its recovery period was 20 years.
The Tax Court upheld the IRS position, determining that the tobacco barn was a “building” rather than a “structure.” The Tax Court noted that the barn looked like a building and it provided working space for employees beyond what was required to cure tobacco. On that latter point, the Tax Court noted that the barn was used for five months out of the year to strip, grade, bale and box tobacco. The employees did more in the barn than simply hanging tobacco plants for curing. The barn also wasn’t a single purpose agricultural/horticultural structure as defined in I.R.C. §1245(a)(3)(D) because the taxpayers didn’t use it exclusively for the commercial production of plants in a greenhouse, or for the commercial production of mushrooms. See, e.g., I.R.C. §168(i)(13). Instead, it was a general-purpose structure that didn’t satisfy the “specific design” or “exclusive use” tests of Treas. Reg. §1.48-10(c)(1) or the “actual use” test of Treas. Reg. §1.48-10(e)(2). Thus, the barn was a “farm building” with a 20-year recovery life. It was also not a land improvement that could be depreciated over 15 years.
The significant increase in the I.R.C. §179 amount in recent years, and particularly as a result of the TCJA, makes the determination of qualified assets very important. On the farm or ranch, “buildings” aren’t eligible, but if a structure provides storage space for ag commodities and can’t easily be adapted to other uses, it just might be eligible property.
Friday, December 7, 2018
The Endangered Species Act (ESA) has the potential to restrict substantially agricultural activities because many of the protections provided for threatened and endangered species under the ESA extend to individual members of the species when they are on private land. Many endangered species have some habitat on private land. Current estimates are that half of the species listed as endangered or threatened have about 80 percent of their habitat on privately owned land.
When a species is listed as endangered or threatened, the Secretary of the Interior (Secretary) must consider whether to designate critical habitat for the species. Once a critical habitat designation is made, activities on the designated land are severely restricted. But how is that designation made, and can a court review the decision to list an area as critical habitat? Those are important questions for landowners, both rural and otherwise. Those questions are also the topic of today’s post – critical habitat designations under the ESA and judicial review.
The ESA establishes a regulatory framework for the protection and recovery of endangered and threatened species of plants, fish and wildlife. 16 U.S.C. § 1531 et seq. The U.S. Fish and Wildlife Service (USFWS), within the Department of the Interior, is the lead administrative agency for most threatened or endangered species, but the National Marine Fisheries Service (NMFS), within the Department of Commerce administers the ESA for certain endangered or threatened marine or anadromous species.
Under the ESA, an “endangered species” is a species which is in danger of extinction throughout all or a significant part of its range other than a species determined by the USFWS to constitute a pest whose protection under the provisions of the Act would present an overwhelming and overriding risk to humans. 16 U.S.C. § 1532(6). A “threatened species” is a species which is likely to become endangered within the foreseeable future throughout all or a significant portion of its range. 16 U.S.C. § 1532(20). The term “species” includes any subspecies of fish or wildlife or plants and any distinct population segment of any species of vertebrate fish or wildlife which interbreeds when mature. 16 U.S.C. § 1532(16).
The Listing Process. Secretary determines when a species is to be listed as either threatened or endangered, and other federal agencies have a duty to conserve listed species by consulting with the FWS when developing their own programs. See, e.g., Sierra Club v. Glickman, 156 F.3d 606 (5th Cir. 1998). As of December 6, 2018, 1,661 species in the United States had been listed under the ESA, with 1,275 species listed as endangered and 386 listed as threatened. Presently, the states with the greatest number of species listed as endangered or threatened are: Hawaii, California, Florida, Alabama and Texas.
An endangered or threatened listing is to be made on the basis of the best available scientific and commercial data without reference to possible economic or other impacts after the USFWS conducts a review of the status of the species. 16 U.S.C. § 1533(b)(1)(A) (2002); 50 C.F.R. 424.11 (20). There is, however, no statutory threshold definition or quantification of the level of data necessary to support a listing decision. Indeed, the information supporting a listing decision need not be credible; only the “best available.”
The Secretary's decision to list a species as endangered or threatened is based upon the presence of at least one of the following factors; (1) the present or threatened destruction, modification, or curtailment of a species' habitat or range; (2) the over-utilization for commercial, sporting, scientific or educational purposes; (3) disease or predation; (4) the inadequacy of existing regulatory mechanisms; or (5) other natural or manmade factors affecting a species' continued existence. 16 U.S.C. § 1533(a)(1). The USFWS may decline to list a species upon publishing a written finding either that listing is unwarranted or that listing is warranted, but that the USFWS lacks the resources to proceed immediately with the proposal. 16 U.S.C. § 1533(b)(3)(C)(ii).
Ever since the effective date of the 1982 amendments to the ESA, when a species is listed as endangered or threatened, the Secretary must designate critical habitat for the species. See Center for Biological Diversity v. United States Fish & Wildlife Service, 450 F.3d 930 (9th Cir. 2006). “Critical habitat” is the specific area within the geographical range occupied by the species at the time of listing that is essential to the conservation of the species. Critical habitat may also include specific areas outside the geographical area occupied by the species at the time it is listed if the USFWS determines that such areas are essential for conservation of the species. 16 U.S.C. §1532(5)(A). However, critical habitat need not include the entire geographical range which the species could potentially occupy. 16 U.S.C. § 1532(5). In making a critical habitat determination, the USFWS must consider economic impacts and other relevant impacts, as well as best scientific data. See, e.g., New Mexico Cattle Growers Association v. United States Fish and Wildlife Service, 248 F.3d 1277 (10th Cir. 2001). The failure to consider the economic and social impacts of a critical habitat designation at the time of the designation can be cause to set aside the designation. Home Builders Association of Northern California, et al. v. United States Fish and Wildlife Service, 268 F. Supp. 2d 1197 (E.D. Cal. 2003). The USFWS may exclude any area from critical habitat if the benefits of the exclusion outweigh the benefits of specifying the area as critical habitat, unless the USFWS determines on the basis of best scientific and commercial data available that the failure to designate an area as critical habitat will result in the extinction of the species. 16 U.S.C. § 1533(b)(2).
Under the facts of Weyerhaeuser Co. v. United States Fish & Wildlife Service, No. 17-71, 2018 U.S. LEXIS 6932 (U.S. Sup. Ct. Nov. 27, 2018), the USFWS, in 2001, listed the dusky gopher frog as an endangered species after determining that its wild population had dwindled to about 100 that were found at a single pond in Mississippi. It’s habitat had covered coastal areas of Alabama, Louisiana and Mississippi in certain open-canopy pine forests that have since been almost entirely replaced with urban development, agricultural operations and closed-forest timber farming enterprises. Upon making the designation, the Secretary had to designate the critical habitat for the frog. It did so in 2010. Among the areas designated as critical habitat was a 1,544-acre site in Louisiana where the frog species had last been seen in 1965. While that acreage was largely comprised of closed-canopy timber, it contained five ephemeral ponds and the USFWS believed that the tract met the statutory definition of “unoccupied critical habitat” because it could be a prime breeding ground for the frog. The USFWS then issued a report on the probable economic impact of designating the tract (and the other areas) as critical habitat.
The plaintiff owns part of the 1,544-acre tract and leased the balance from a group of landowners that had plans for development of the portion of the tract that they owned. Those development costs could amount to over $30 million (in timber farming and development) if the USFWS barred all development on the tract. But, according the USFWS, those potential costs would not be “disproportionate” to the conservation benefits of the designation. Consequently, the USFWS decided to not exclude the 1,544-acre tract from the frog’s critical habitat.
The plaintiff and the landowners sued to vacate the designation on the basis that the tract couldn’t be designated as critical habitat because it hadn’t been habitat for the frog since 1965 and couldn’t be habitat without significant modification. The plaintiff also challenged the decision of the USFWS not to exclude the tract from the frog’s critical habitat on the basis that the USFWS had failed to adequately weigh the benefits of designating the tract against the economic impact of the designation. The claim was that the USFWS used an unreasonable methodology for estimating economic impact and failed to consider certain categories of costs.
The trial court upheld the designation on the basis that the tract fit the definition of “unoccupied critical habitat” which only required the USFWS to decide that the tract was essential for the frog’s conservation. On appeal, the U.S. Court of Appeals for the Fifth Circuit affirmed on the basis that that definition of “critical habitat” required a “habitability” requirement. The appellate court also determined that the decision of the USFWS was not subject to judicial review.
On further review, the Supreme Court unanimously reversed 8-0 (Justice Kavanaugh did not participate). Chief Justice Roberts wrote the Court’s opinion, and pointed out that to be “critical habitat,” the designated area must first be “habitat.” Indeed, the Court pointed out that once a species is designated as endangered, the Secretary must designate the habitat of the species which is then considered to be critical habitat. 16 U.S.C. §1533(a)(3)(A)(i). That also applied in the context of unoccupied critical habitat that is determined to be essential for conservation of the species – the area must be “habitat.” Because the appellate court did not interpret the term “habitat” (the appellate court simply concluded that “critical habitat” was not limited to areas that were “habitat”), the Supreme Court vacated the appellate court’s opinion and remanded on this issue.
The Supreme Court also disagreed with the appellate court’s holding that the determination of the USFWS to not exclude the tract as critical habitat was not subject to judicial review. The Supreme Court noted that the plaintiff’s claim involving the alleged improper weighing of costs and benefits of the designation as critical habitat was the type of claim that the federal court’s routinely review when determining whether to set aside an agency decision as an abuse of discretion. Thus, the Supreme Court also vacated this part of the appellate court’s decision and remanded on the issue.
The case is important to private landowners for a couple of reasons. First, on remand the appellate court will have to redetermine the designation of the frog’s critical habitat on the basis that it first must actually be habitat for the frog. There is a “habitability” requirement when the Secretary designates an area as “critical habitat.” Second, the USFWS doesn’t get a free pass when designating an area as critical habitat. That designation is subject to judicial review (as are all USFWS decisions to decline to list a species).
Tuesday, December 4, 2018
Next week, on December 12-13 the final KSU Tax Institute will be held live from the Memorial Union at Pittsburg State University. The two-day event will be simulcast live over the web. It’s a chance to get more education on the new tax law and pick up on some of the important year-end tax planning opportunities under the Tax Cuts and Jobs Act (TCJA).
The KSU Tax Institutes started in late October and finish up at PSU next week. During this timeframe, we have continued to get dribs and drabs of additional information from the IRS and the Treasury about certain aspects of the TCJA. While we don’t have final regulations on the new pass-through business deduction for non-C corporate businesses, the final regulations might be issued by the time of the seminar next week. If that happens, I would especially encourage you to take part either in the live presentation or the webinar. I will cover the QBID in detail on Day 2 – December 13. I will go through many examples and show the practical application of how the deduction works and the best way to structure the business to best take advantage of the new provision. As a web participant, you will be able to interact and have your questions heard and answered.
While the seminar is not exclusively (or even primarily) devoted to ag-related tax issues, I will spend a good deal of time on Day 2 addressing planning concepts for farmers and ranchers as well as other small businesses.
You can register for next week’s seminar/webinar here: https://www.agmanager.info/events/kansas-income-tax-institute
If you are looking to fulfill an ethics requirement. I will be offering a 2-hour ethics session along with Prof. Lori McMillan, my tax colleague at Washburn Law school. The event will be the afternoon of Dec. 14 live from the law school in Topeka and will also be simulcast over the web. You can register for the ethics session here: http://washburnlaw.edu/employers/cle/taxethicsregister.html
Monday, December 3, 2018
Partnerships are a common entity form for farming operations. This is particularly true when the farming operation participates in federal farm programs. A general partnership is the entity form for a farming operation that can result in the maximization of federal farm program payments. But, tax issues can get complex when a partner sells or exchanges a partnership interest. In addition, the 20 percent deduction for non-C corporate businesses may also come into play.
The tax issues surrounding the sale or exchange of a partnership interest – that’s the topic of today’s post.
When a partner sells or exchange a partnership interest to anyone other than the partnership itself, the partner generally recognizes a capital gain or loss on the sale. I.R.C. §741. That’s a good tax result for capital gain because of the favorable tax rates that apply to capital gain income, but not a good tax result if a loss is involved because of the limited ability to deduct capital losses (e.g., they offset capital gain plus $3,000 of other income for the year). When a partner sells his interest in the partnership to the partnership in liquidation of the partner’s interest, the liquidating partner generally does not recognize gain (except to the extent money is received that exceeds the partner’s basis in the partnership interest or the partner is relieved of indebtedness). The liquidating partner receives a basis in the distributed property equal to what his basis had been in the partnership interest.
The general rule that a partner’s sale or exchange of his partnership interest triggers capital gain doesn’t apply to the extent the gain realized on the transaction is attributable to “hot assets.” “Hot assets” (as defined under I.R.C. §751) are unrealized receivables or inventory items of the partnership. In essence, “hot assets” are ordinary income producing assets that have not already been recognized as income, but eventually would have been recognized by the partnership and allocated to the partner in the ordinary course of partnership business and taxed at ordinary income rates. The partner’s sale or exchange of their interest merely accelerates the recognition of the income (such as with depreciation recapture). Thus, the income on the transaction is recharacterized from capital to ordinary. I.R.C. §751(a). The rationale for the recharacterization is that if the partnership were to sell such “hot assets,” ordinary income or loss would be recognized on the sale. Thus, when a partner sells or exchanges a partnership interest, the partner should recognize ordinary income on the portion of the income from the sale of the partnership interest that is attributable to the “hot assets.” If this recharacterization rule didn’t apply, a partner would be able to transform what would have been ordinary income into capital gain by selling or exchanging their partnership interest.
Similarly, when a partnership distributes property to a partner in exchange for the partner’s interest in the “hot assets” of the partnership, the transaction may be treated as sale or exchange of the hot assets between the partner and the partnership that generates ordinary income. It is possible, and perhaps frequent, for a partner involved in farming to recognize ordinary income and a capital loss, even though the partner had an overall gain on the sale. The ordinary income is taxed immediately, but the capital loss is limited as described above.
Types of “Hot Assets”
Unrealized receivables. There are three categories of unrealized receivables: (1) goods; (2) services; and (3) recapture items. I.R.C §751(c) defines the term “unrealized receivables” as including, “to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (2) services rendered, or to be rendered.” In addition, the term “unrealized receivables” includes not only receivables, but also depreciation recapture. See, e.g., Treas. Reg. §§1.751-1(c)(4)(iii) and (v).
In the farming context, the “goods” terminology contained in the definition of “unrealized receivables” would include property used in the trade or business of farming that is subject to depreciation or amortization as defined by I.R.C. §1245. Included in the definition of I.R.C. §1245 property is personal property (I.R.C. §1245(a)(3)(A)) such as farm equipment and machinery. Also included in this definition are horses, cattle, hogs, sheep, goats, and mink and other furbearing animals, irrespective of the use to which they are put or the purpose for which they are held. Treas. Reg §1.1245-3(a)(4). The definition also includes certain real property that has an adjusted basis reflective of accelerated depreciation adjustments. I.R.C. §1245(a)(3)(C). That would include such assets as farm fences and farm field drainage tile. It also includes grain bins and silos by virtue of a definitional provision including a facility that is used for the bulk storage of fungible commodities. I.R.C. §1245(a)(3)(B)(iii). In addition, the definition includes single purpose agricultural or horticultural structures as defined in I.R.C. §168(i)(13). I.R.C. §1245(a)(3)(D).
The “goods” terminology also includes real property defined by I.R.C. §1250 that has been depreciated to the extent that accelerated depreciation incurred to the date of sale is in excess of straight-line depreciation. Farm property that falls in the category of I.R.C. §1250 property includes barns, storage sheds and work sheds. If these properties are sold after the end of their recovery period, there is no ordinary income. Also, included in this definition is farmland on which soil and water conservation expenses have been recaptured. I.R.C. §751(c); IRC §1252(a).
The “unrealized receivables” definition also includes rights (contractual or otherwise) to payment for goods delivered or to be delivered to the extent that the payment would be treated as received for property other than a capital asset, or services rendered or to be rendered to the extent that the income from such rights to payment was not previously included in income under the partnership’s method of accounting. The rights must have arisen under contracts or agreements that were in existence at the time of the sale or distribution, although the partnership may not be able to enforce payment until a later time. Treas. Reg. §1.751-1(c)(1). Thus, in the ag realm, the definition includes the present value of ordinary income attributable to deferred payment contracts for grain and livestock, installment notes for assets sold under the installment method, cash rent lease income, and ag commodity production contracts.
Inventory. The other category of “hot assets,” inventory items, includes stock in trade or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the tax year, and property the taxpayer holds primarily for sale to customers in the ordinary course of business. I.R.C. §751(d) referencing I.R.C. §1221(a)(1). Whether a taxpayer holds property as a capital asset or for use in the ordinary course of business is a dependent on the facts. See, e.g. United States v. Winthrop, 417 F.2d 905 (9th Cir. 1969). For many farm partnerships, inventory items that constitute “hot assets” might include harvested crops, livestock that are being fed-out, poultry, tools and supplies, repair parts, as well as crop inputs (e.g., seed, feed and fertilizer) not yet applied to the land. On the other hand, an unharvested crop is not included in the definition of “inventory” if the unharvested crop is on land that the taxpayer uses in the trade or business that has been held for more than a year, if the land and the crop are sold or exchanged (or are the subject of an involuntary conversion) at the same time and to the same person. I.R.C. §1231(b)(4).
Inventory also includes any other property that, if sold by the partnership, would neither be considered a capital asset nor I.R.C. §1231 property. I.R.C. §751(d)(2). I.R.C. §1231 property is real or depreciable business property held for over a year (two years for some livestock). Thus, for a farm partnership, included in the definition of “inventory” by virtue of not being I.R.C. §1231 property would be single purpose agricultural or horticultural structures, grain bins, or farm buildings held for one year or less from the date of acquisition (I.R.C. §1231(b)(1); personal property (other than livestock) held for one year or less from the date of acquisition (Id.); cows and horses held for less than 24 months from the date of acquisition (I.R.C. §1231(b)(3)(A)); and other livestock (regardless of age, but not including poultry) held by the taxpayer for less than 12 months from the date of acquisition (I.R.C. §1231(b)(3)(B)).
Qualified Business Income Deduction
The Tax Cuts and Jobs Act (TCJA) creates new I.R.C. §199A effective for tax years beginning after 2017 and before 2026. The provision creates an up to 20 percent deduction from taxable income for qualified business income (QBI) of a business other than a C corporation. To be QBI, only ordinary income is eligible. Income taxed as capital gain is not. If gain on the sale or exchange of a partnership interest involves “hot assets,” the gain is taxed as ordinary income. Is it, therefore, QBI-eligible?
Under Prop. Treas. Reg. §1.199A-3, any gain that is attributable to a partnership’s hot assets is considered attributed to the partnership’s trade or business and may constitute QBI in the hands of the partner. Thus, if I.R.C. §751(a) or (b) applies on the sale or exchange of a partnership interest, the gain or loss attributable to the partnership assets that gave rise to ordinary income is QBI. Given the potentially high amount of “hot assets” that a farm partnership might contain (particularly when depreciation recapture is considered), the QBI deduction could play an important role in minimizing the tax bite on sale or exchange of a partnership interest.
When a partnership interest is sold or exchanged, the resulting tax issues have to be sorted out. An understanding of what qualifies as a “hot asset” helps in properly sorting out the tax consequences. In addition, the new QBI deduction can help soften the tax blow.